Sunday, August 19, 2018

The Private-Equity Scam


Robert Kuttner examines the factors that led to a healthy economy and a relatively egalitarian distribution of income in the postwar years.  He then details the changes that occurred from the 1970s to the present that altered the nature of the economy to the extremely unegalitarian one we have today.  He presents his thoughts in his book Can Democracy Survive Global Capitalism? 

“The story of the lost social contract of the postwar era has two essential elements.  One was the liberation of finance; the other was the undermining of labor.  Globalization was an instrument of both.”

Numerous examples are highlighted to support that claim.  Here we will focus on one that is particularly noxious; one that illustrates the poisonous relationship between the excesses of finance and workers’ welfare: the private-equity industry.

“The private-equity industry now owns about 4.3 trillion dollars’ worth of operating companies that employ about 12 million workers.”

The practice at issue is what was once referred to as the “leveraged buyout.”  The maneuver involves borrowing money to buy out the owners of a company (often shareholders) and use the assets of the purchased company as collateral for the extended credit.  The private-equity investors put up a small fraction of the required capital for the deal and load the acquired company with the majority of the debt.  The claim is that the new owners will make the business more efficient and ultimately increase its value so it can be resold at a profit at a later date.  However, making this process work leads immediately to the need to cut expenses in order to service the newly acquired debt.  The first cuts are inevitably in the number of employees and their benefits.

“Private-equity companies have even found legal ways of looting employee pension funds.” 

The private equity investors protect their investment by extracting assets up front to limit any risk.

“The truly nefarious aspect of the private-equity business model is that windfall profits are extracted in advance, so that when the actually operating company falters, the equity partners experience very little loss, if any.  This model turns on its head the usual incentives to operate a business prudently and to view workers as long-term assets.”

“Private-equity partners accomplish this trick by borrowing heavily against a newly acquired company, paying themselves an exorbitant ‘special dividend,’ as well as management fees, that together typically far exceed the actual equity they have invested in the company.  They then move to aggressively cut costs.  If they succeed, they often sell the stripped-down company to someone else.  If they cut too deeply, they’ve already made their fortune up front, and they can use bankruptcy either to shut down the operation or to shed its debts and restructure it.”

Bryce Covert produced an article for The Atlantic addressing the effect private equity is having on the retail industry, with a focus on the recent Toys “R” Us bankruptcy.  His piece was titled You Buy It, You Break It: How private equity is killing retail in the paper version of the magazine.  Online, it ran as The Demise of Toys‘R’ Us Is a Warning: The private-equity companies swooping in to buy floundering retailers may ultimately be hastening their demise.



Toys “R” Us was taken over by the private-equity outfits Bain Capital and Kohlberg Kravis Roberts, and the real-estate firm Vornado Realty Trust in 2005.  A worker immediately noticed a difference in working conditions.

“’It changed the dynamic of how the store ran,’ she said. The company eliminated positions, loading responsibilities onto other workers. Schedules became unpredictable. Employees had to pay more for fewer benefits….”

When the company announced it would liquidating assets as part of a bankruptcy process, all sorts of reasons were discussed by analysts for why it was no longer able to compete in the current marketplace.  One that was little mentioned was the burden the private-equity takeover placed on the operation of the company.

“Less attention was paid to the albatross that Bain, KKR, and Vornado had placed around the company’s neck. Toys “R” Us had a debt load of $1.86 billion before it was bought out. Immediately after the deal, it shouldered more than $5 billion in debt. And though sales had slumped before the deal, they held relatively steady after it, even when the Great Recession hit. The company generated $11.2 billion in sales in the 12 months before the deal; in the 12 months before November 2017, it generated $11.1 billion.”

“Saddled with its new debt, however, Toys “R” Us had less flexibility to innovate. By 2007, according to Bloomberg, interest expense consumed 97 percent of the company’s operating profit. It had few resources left to upgrade its stores in order to compete with Target, or to spiff up its website in order to contend with Amazon.”

Servicing the debt imposed on it by the private-equity takeover left it with no funds to address changes required to keep up in an evolving marketplace.  Covert suggests that as the reason for the demise of Toys “R” Us.  And, of course, there were no funds left to provide severance pay for the more than 30,000 employees who lost jobs.

Covert’s take on private equity is even harsher than Kuttner’s.

“Given private equity’s poor track record in retail, it can be difficult to see what companies like Toys “R” Us hope to get from a buyout. For private equity, however, the appeal is clear: The deals are virtually all upside, and carry minimal risk. Many private-equity firms chip in only about 1 to 2 percent of the equity needed for a leveraged buyout, and skim fees and interest throughout the deal. If things go well, the firms take a huge cut of the profit when they exit. If everything blows up, they usually still escape with nary a burn. Toys “R” Us was still paying interest on loans it got from KKR and Bain up until 2016, as well as millions a year in ‘advisory fees’ for unspecified services rendered. According to one estimate, the money KKR and Bain partners earned from those fees more than covered the firms’ losses in the deal.”

Covert provides some data to illustrate private equity’s impact on the retail industry as a whole.

“Toys “R” Us is hardly the only retail operation to learn this lesson the hard way. The so-called retail apocalypse felled roughly 7,000 stores and eliminated more than 50,000 jobs in 2017. For the spate of brands that have recently declared bankruptcy, their demise is as much a story about private equity’s avarice as it is about Amazon’s acumen.”

“In April 2017, an analysis by Newsday found that of the 43 large retail or supermarket companies that had filed for bankruptcy since the start of 2015, more than 40 percent were owned by private-equity firms. Since that analysis, a number of others have joined the list, including Nine West, Claire’s, and Gymboree. An analysis by the firm FTI Consulting found that two-thirds of the retailers that filed for Chapter 11 in 2016 and 2017 were backed by private equity.”

This behavior has aroused some pushback by activists, but enormous profits provide enormous political influence.

“A conglomeration of workers’-rights and financial-reform organizations is seeking to outlaw leveraged buyouts altogether. ‘They weren’t always legal,’ Charles Khan of the Strong Economy for All Coalition, which is part of the group, points out. Before the 1980s, companies couldn’t finance deals with such high levels of debt. One aim of Khan and his allies is to once again force buyouts to rely on a smaller portion of debt. ‘The economy has existed long before private equity,’ he says. ‘I think it can exist without private equity’.”

Robert Kuttner provides an appropriate comment with which to close.

“The losers in these maneuvers are invariably the workers.  They lose wages, benefits, pensions, or their jobs.  Private equity is just one more strand in a complex tapestry of degraded work.  Ordinary workers may not grasp the complex strategies, but they surely understand the results.  Why is this legal?  How can private-equity companies get away with these moves?  They invest heavily in political influence.  The result, as someone said, is that ‘the rules are rigged’ against working people.”


No comments:

Post a Comment