Features > October 29, 2007
Pirates of Private Equity
An insanely lucrative investment strategy finally faces public scrutiny
By Adam Doster
Employees knew that Hastings Manufacturing Co., a family-owned auto-parts supplier 30 miles south of Grand Rapids, Mich., was in deep water. Facing financial pressure, 375 employees—two-thirds of whom were in the United Auto Workers’ (UAW) bargaining unit—conceded $1 million in benefits to save their company, relinquishing newly negotiated pay raises and agreeing to cover part of their own health care costs.
But according to UAW Local 138 Chief Steward Kim Townsend, who testified before the House Commercial and Administrative Law subcommittee in September, when Hastings’ management declared bankruptcy and was taken over by the private equity firm Anderson Group in December 2005, the slicing didn’t stop there. Sick days were cut in half, an existing two-tier wage system with a top rate of $13.49 an hour was maintained and the allotment for bargaining time was limited to two hours a month on company time. For retirees, the consequences were more dire, with pensions and health care coverage all but severed.
To market analysts, Hastings appears more profitable today. But its value stems not from innovation but from breaking obligations to the company’s employees and retirees. “We make the same products,” Townsend said at the hearing, “in the same building, with the same equipment, for the same customers as we did before the asset sale.”
As the Hastings case exemplifies, mysterious financial entities known as private equity funds are laying waste to economies around the world. The firms that manage these funds grab up companies, strip them of their assets, gobble up the profits, and leave workers and local communities to pick over the detritus.
Supporters of private equity schemes argue that takeovers can improve businesses’ financial performance. But the privacy under which fund managers operate makes monitoring and honest analysis difficult. And while only some people understand how this influential investment strategy works, moves are afoot in Congress to rein in these corporate predators, an indication that private equity firms won’t lurk in the shadows forever.
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Private equity funds are complicated entities. Essentially, they are unregulated pools of private capital raised and controlled by investment managers, otherwise known as “general partners.” Typically, managers buy up undervalued companies, de-list them from public exchanges, restructure them through a variety of tactics, and then sell their stake in the leaner, more profitable business to interested buyers, other private equity firms or on the stock market through another Initial Public Offering (IPO). Advocates argue that squeezing inefficiencies out of underperforming companies not only creates a more vibrant economy but also yields returns that support projects from which all citizens benefit, including new construction or job creation.
For example, DaimlerChrysler made headlines this May when it sold a controlling interest in the scuffling but iconic Chrysler Group to Cerberus Capital Management for $7.4 billion. With the agreement, the German auto giant was left with a 19.9 percent stake in Chrysler but freed itself of its responsibility for pension and health care liabilities.
Most of these funds are financed by cash-rich institutional investors known as “limited partners”—pension funds, insurance companies, university endowments, wealthy individuals—that commit large sums of money for a fixed period of time, usually 10 years. Because private equity funds can generate only so much capital from wealthy sponsors, most transactions are leveraged by debt financing, with the acquired company’s assets used as collateral for the loans. Sometimes as much as 80 percent of the transaction value comes from this form of financing.
Private equity investors profit only when the firm sells the restructured companies, but the fiscal acumen of managers and the latitude offered by leverage can lead to returns of 30 percent or 40 percent. While 80 percent of buyout profits flow to the limited partners, the managers retain the carried interest, or 20 percent of the gains realized by the fund. Fund managers also charge an additional 2 percent annual management fee, which can net them hundreds of millions of dollars alone after large buyouts.
Spurred primarily by strong stock prices and low interest rates that have led to massive liquidity growth in world markets, the private equity industry has exploded in recent years. According to Private Equity Intelligence, a London-based company that does research on the industry, these funds raised a record $406 billion in 2006. More than 170 funds each hold $1 billion or more in assets. They brokered $475 billion in deals last year alone, 13 times more than five years ago. And while U.S. companies are spearheading private equity’s expansion, European-based funds raised some $90 billion in 2006, a 25 percent increase from the prior year. Indeed, private equity firms from both continents are now forming partnerships to fund large trans-Atlantic deals, a rare move just 10 years ago.
The $4 billion IPO of prominent private equity firm Blackstone Group this March may have ushered in the next phase for the developing industry. Managers at major firms looking to raise new sources of capital and to augment the company’s compensation package may publicly list portions of their business while at the same time preserving elements of their private managerial culture.
Other iterations, like the decision of the Carlyle Group (one of the most politically connected private equity firms) in September to sell a 7.5 percent share of its general partnership to an investment group owned by the government of Abu Dhabi, are sure to follow.
The investment goals of private equity funds, fueled in part by naked self-interest, have steered more and more companies toward business models that favor short-term profits at the expense of workers and the public at large.
“You have these operators who don’t see companies as producers of anything,” says Kelly Candaele, a trustee of the Los Angeles City Employees’ Retirement System, “but just as assets and liabilities that can be utilized through these various financial techniques to make money.”
The International Trade Union Confederation, in its June report on the dangers of alternative investments, puts it this way: “The protagonists of financialization are more like termites. They leave nothing behind to yield new crops but destroy everything on their way.”
One criticism of private equity firms is that a fund’s general partners divest assets from buyout targets to increase profitability. Takeovers can result in worker layoffs and the disbanding of labor unions, factory or office closings, and the depletion of a company’s pension and health care plans, as well as its resources for long-term research and development.
“Our concern,” says Vineeta Anand, the chief research analyst in the AFL-CIO’s Office of Investment, “is that people lose their jobs, they lose their benefits, they lose their retirement, all in one gulp.” This stripping not only redistributes wealth from workers, customers and suppliers to the financiers brokering the deals, but it also has the potential to permanently eviscerate a company’s value.
The amount of debt that target companies accumulate during a buyout raises concerns, as well. High-risk ventures increase pressure on companies to churn out tremendous quarterly profits. For struggling businesses, a logical way to reduce that debt and avoid bankruptcy is through more layoffs or health care cuts, exacerbating the pitfalls of a company’s reorganization. “From a societal standpoint, it means we’re putting our businesses at much more risk,” says Dean Baker, co-director of the Center for Economic and Policy Research. “It certainly creates a lot of inefficiencies if you’re subjecting firms to bankruptcy unnecessarily or getting them into heavily indebted situations where they can’t undertake normal investment.”
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Challenging such high stakes leveraging is difficult because, unlike mutual funds and other investments, private equity funds have virtually no oversight from regulators like the Securities and Exchange Commission (SEC). This luxury allows funds to conceal what they invest in and how they restructure target companies. This means that it’s less likely that firms will follow sound corporate governance policies or provide information to stakeholders, such as employees, community groups or even the funds’ own investors, who might challenge their tactics.
Worse still, fund managers operate under tax laws that are lenient, to say the least. One loophole allows firms to claim tax relief on the interest payments used to buy target businesses. In essence, general partners employ subsidized leverage that allows them to bid more aggressively on businesses and receive far higher returns on their own equity than can public companies, all while skirting their tax burden.
Another loophole allows partners in private equity firms to benefit from a tax break on their earnings. The carried interest retained as compensation for netting a sizeable return is charged the capital gains rate of only 15 percent, as opposed to the typical income tax rate of 35 percent. “While these managers of private equity and hedge funds make billions of dollars a year,” says Anand, “they pay a [tax] rate that’s less than half of what ordinary working people—firefighters, teachers, police officers—are paying.”
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