It’s impossible to think about business these days without thinking about private equity. These investment firms, with names like Blackstone, KKR, Bain Capital and Washington’s own Carlyle Group, now control more than $7 trillion in corporate assets around the world, including 8,000 companies in the United States employing more than 11 million people. Last year, U.S. private equity firms bought and sold companies worth more than $700 billion, while raising $385 billion in fresh capital from pension funds, university endowments and wealthy individuals. And because of their spectacular growth and financial success, these firms now exercise an outsized influence on how all companies are managed, financed and valued.
For just that reason, Democratic presidential candidate Elizabeth Warren recently laid out a provocative plan to regulate private equity firms. As with many of the other economic policies proposed by the Massachusetts senator, this one suffers from overreaching and being cloaked in overwrought populist rhetoric. (She calls it the “Wall Street Looting Act of 2019.”) But also as with her other initiatives, she is asking the right questions and raising the right issues
Warren says she has no problem with the good parts of the private equity model, in which private equity firms buy underperforming companies, make them better and sell them off at a profit. Rather, her focus is when acquisitions don’t work out, and Plan B involves stripping them of their assets before running them through a bankruptcy, leaving workers, suppliers and communities in the lurch. Indeed, that’s exactly what happened in a recent spate of high-profile bankruptcies of PE-owned retailers including A&P/Pathmark, Southeastern Grocers (owner of Winn-Dixie), Payless Shoes, Radio Shack, The Limited, Toys R Us and Sears. A similar pattern is also emerging with PE investments in the news business.
Unfortunately, Warren’s fixes for these problems — making PE firms liable for all the debt and obligations of the companies they buy, limiting how much cash they can take out of those companies and upending bankruptcy law by putting employees and suppliers first in line for repayment — would pretty much guarantee that nobody invests in or lends to private equity firms.
“It would be the end of private equity as we know it,” says Bilge Yilmaz, who heads the private equity program at the University of Pennsylvania’s Wharton School.
The reason private equity has become as big as it has is because, for the past 30 years, it has consistently delivered higher returns to investors than the public stock markets — and that even after taking out the outlandish fees paid to private equity managers. While those premiums have declined from the heady early days of the 1990s, and nearly disappeared in the years immediately following the Great Recession, a recent survey by Steven Kaplan of the University of Chicago’s business school found that U.S. buyout funds are once again delivering rates of return that, on average, are 15 percent higher than comparable investments in the S&P 500.
There are two schools of thought as to why private equity has been able to deliver superior returns.
One view, put forward by the firms and embraced by most finance professors, is that PE firms generate higher returns because they are willing to take on more debt, invest over a longer period and use lucrative pay packages to attract better fund managers and operating executives. In other words, this is the free market working as it should by rewarding talent, risk-taking and making the economy more productive.
The other view, embraced by Warren, labor unions and other industry critics, is that private equity earns higher returns because it is willing to be more ruthless in capturing all the surplus when things go well while avoiding the losses when they don’t, shifting the pain onto employees, pensioners, suppliers and taxpayers. For them, this heads-I-win, tails-you-loose arrangement is symptomatic of an economy rigged in favor of those with money and power.
My own view is that the industry story explains much of private equity’s success in its early days of the 1990s, when buyout firms focused on middle market companies and unwanted divisions of large corporations that benefited from the additional capital and better management. PE firms were also able to achieve efficiencies of scale and scope by buying up and combining several companies in the same industries.
In the past decade, however, PE firms have found it harder to repeat those early successes. In terms of poorly run, undercapitalized companies and divisions, most of the low-hanging fruit has already been picked. And with so much money pouring into private equity, the competition for deals has bid up the price of target companies to the point that it’s harder for them to make an outsize profit even when they can turn them around. That explains why the big PE firms are increasingly turning to megadeals, buying huge public companies and taking them private, often in a consortium with other PE firms. And it explains why PE-owned firms are increasingly be sold to other PE firms, raising the question of how much fixing up there is left to do.
At the same time, public companies have improved their returns by mimicking the financial and operating strategies of private equity. Public companies have become equally adept at outsourcing, automating and laying off employees, and now routinely load up their top executives with exorbitant stock grants and performance bonuses. They are also taking on more debt. And just as PE firms routinely borrow money to return capital to their investors through special dividends, public companies now routinely do the same, borrowing heavily to buy back shares.
In other words, with their old advantages eroding, the only way PE firms can continue to offer higher returns is by placing bigger bets and becoming more ruthless in shifting the costs to others when those bets don’t pan out.
Private equity executives naturally reject such suggestions, noting that PE-backed companies were slightly less likely to default on their debts than non-PE companies during the Great Recession. But as the analysts at Moody’s discovered, when it came to the megadeals involving debt of $10 billion or more, PE-backed firms actually did substantially worse, with a default rate of nearly 18 percent, compared with just over 6 percent for similarly rated public companies.
Warren now proposes special rules for PE firms to ensure that they and their investors absorb the full costs of their excessive risk-taking.
For starters, she would upend centuries of corporate law by making PE firms liable for all of the debts and obligations of the companies in which they own more than a 20 percent stake. That’s a rather blunt instrument for dealing with a relatively narrow problem that will scare away a lot of investors. Moreover, those same rules would not apply to a non-PE corporation and corporate subsidiary over which it has the exact same ownership and control. Not only is that unfair, but it would also invite all sort of legal gamesmanship by PE firms to get around the liability. A better approach would be to identify a narrow set of exceptions for when one corporation is responsible for the debts of another corporation that it controls, and apply them to every business, whether PE- backed or not.
By the same logic, it hardly makes sense to restrict private equity firms from returning capital to themselves and their investors with “dividend recapitalizations,” as Warren proposes, while having no restrictions on stock buybacks at public companies, which amount to the same thing. Or to use the tax code to discourage excessive borrowing at PE-backed companies, as the senator proposes, but not other kinds of companies. Applying some limited restrictions on all companies would be a better approach.
Warren is also right to target inequities in the bankruptcy law that disadvantage workers and small-business suppliers. But as one of the country’s leading experts on bankruptcy law, she surely knows that private equity firms are hardly the only ones who practice such looting strategies and that outlawing them will require a more complex and comprehensive reform than simply requiring that workers and suppliers always be paid before bankers and bondholders.
In many ways, private equity represents everything that has gone right and gone wrong with American capitalism — all the things that have made it more innovative, efficient and competitive, but also all the things that have made it more ruthless and unequal. The industry’s size and influence have now grown to the point that leaving it unregulated is no longer an option. Warren may not have the last word in determining the shape and scope of that regulation, but she has provided a provocative and thoughtful first draft. Rather than dismiss the criticism out of hand with exaggerated claims of jobs created and pensioners enriched, the industry should do itself and the country a favor and suggest better ways to protect the public from private equity’s excesses and predations.