Right now, our economy is experiencing a sea change in how it operates, and very little of it is taking place in the view of the public. This change is making waves in ways that affect the lives of nearly every American, from creating huge profits for investment banks, creating huge movements in the debt market, speeding up the outsourcing of American jobs, stalling efforts to reign in CEO and executive pay, and creating huge risks and huge benefits for the pensions of the majority of all public employees in the nation. This change is being driven by the unprecedented growth in the size and power of private equity firms, and the rapid expansion of the purchase of formerly publicly held corporations by these firms. In the past year alone, private equity firms spent $370 billion purchasing and taking private 1,010 corporations, compared to only 324 corporations five years ago in 2001. In 2005, investors put $139.6 billion into private equity firms, surpassing the $135.8 billion invested in stock mutual funds. For 2006, the disparity should be even larger.
Among those companies are some of the biggest names in America. Hertz, Nieman Marcus, Toys R’ Us, and Dunkin’ Donuts are among those purchased. The hospital chain HCA was purchased this past year for $32 billion. Casino giant Harrah’s Entertainment was purchased for $27 billion. Media giant Clear Channel was purchased for $27 billion as well. And last week, private equity firm Blackstone won a bidding war for Equity Office Properties, the nation’s largest office landlord, for $39 billion in the largest leveraged buy out deal in history.
What are private equity firms, and what is driving their explosive growth? And why is that something that is important for all Americans?
Private equity firms are in a manner of speaking hedge funds writ large. They pool capital from wealthy investors and institutional investors such as pension plans and university endowments. They then leverage that capital by borrowing considerable sums from investment banks, effectively mortgating their capital for three to six times the initial funds giving them considerably greater purchasing power. These private equity firms do not purchase these companies as long-term investments; typically, the companies are resold either in their entirety or in parts in no more than ten years. Blackstone has already made arrangements to sell a division of Equity Office Properties for $7 billion less than a week after the initial purchase.
For those of you who remember the famous story of "Barbarians at the Gate", concerning the leveraged buy out of RJR Nabisco in 1989 for $25.1 billion, this story should sound rather familiar. During the 1980s, the leveraged buy out was a highly predatory process, using a two-pronged attack of cannibalizing corporations for saleable assets and assuming high debt loads for the company which allowed the firms holding that debt to evade corporate taxes while pocketing the profits of their sales. In some cases, such as with the buy out of Federated Department Stores in 1988, the debt financing was so significant (97% of the total purchase) that interest payments exceeded total cash flow and the companies involved were forced into bankruptcy.
The general consesus of the financial world is that the rebirth of the leveraged buy out in the form of private equity firms is not a repeat iteration of the predatory practices of the 1980s. One reason for the resurgence is that a new loophole has emerged for corporations in the tax code. In the late 1980s, Sen. Bob Packwood closed a loophole that allowed profitable companies to purchase unprofitable companies for pennies on the dollar and consolidate their debts with the purchasing companies’ profits to remove those profits from their balance sheets and thereby avoid the corporate income tax of 35% (since 2004, the corporate tax rate has been altered, to give companies categorized as manufacturers, including Hollywood studios and other politically powerful entities, a reduced corporate income tax rate of 32%. The corporate income tax rate of 32-35% in the United States is the second highest of all the member nations of the Organization for Economic Co-operation and Development. However, the loophole closed by Sen. Packwood did not protect against companies which are not profitable, such as private equity firms with heavy debt load, purchasing profitable companies and using those profits to make their income stream but not negate the overall losses, thereby allowing them to conceal corporate income and escape taxation. The leveraged purchase of profitable Time Warner by the unprofitable America Online allowed Time Warner to escape some $4 billion in corporate income tax.
While the financial rewards of evading the corporate income tax are significant, this is not how private equity firms make the bulk of their money. First off, there are now a wide variety of ways for corporations to avoid the corporate income tax, such as the S-Corporation classification, so the advantages of this form of evasion are now less pronounced. By 2000, only 8% of the 22 million businesses who filed US tax returns were eligible to pay income tax as a C corporation. Second, although leverage rates for borrowers are currently very low, the assumed debt payments still consume a significant amount of the savings.
In the end, private equity firms earn their profits from purchasing public corporations by two methods: the charging of management fees to the companies under their control, and by the resale and public offerings of those companies after a period of private management. Experts differ on the consequences of the charging of management fees. Some private equity firms have been accused of using companies under their ownership as piggy banks, from which extravagant management fees can be taken regardless of the overall impact on the company.
The consensus, however, is that the bulk of private equity firms’ profits are made through the sale and eventual return of the companies under their control to public status. However, doubts have been growing regarding the soundness of the companies in question when they have a new Initial Public Offering after managmeent by private equity firms. And certainly, the record of companies which reemerge into public trading after having been privatized by equity firms have not generally outperformed their competition.
If private equity is not making miracles for the companies they purchase, what is the explanation behind their explosive growth? Well, first of all, they may be creating significant gains for the companies in question, but those gains are outweighed by the equity firm’s fees. Burger King, which went back to being publicly traded in May of last year, paid out $400 million in fees to the equity fund and its investors before its IPO (despite two years of lagging growth and 1,400 of its 11,000 stores closing). Those fees contribute to an average rate of return for the industry of 17% over 12 years, and an even higher rate of return over the near term (est. 20% over three years). Compared to the average 10% rate of return for mutual funds, this performance is remarkable. And that performance is driving higher and higher numbers of investors into private equity funds, with what are at the least troubling consequences.
The principal force driving greater and greater amounts of capital into private equity firms are public pension funds. While other institutional investors such as university endowments are also major investors in private equity, the appeal for pension funds are the much higher rates of return private equity firms offer. Public pensions (meaning pension plans for public employees such as police officers, firefighters, and teachers) have been growing increasingly more troubled, as longer lifespans and lower municipal revenues have begun to cast doubts on the long-term viability of such plans. As such, public pension plan managers are under extreme pressure to find investments which will boost their returns and help keep the pension plans afloat. Ironically, these massive investments in private equity by public pension plans means that public pensions are helping fuel the economic drive for higher profits that results in the outsourcing of many private sector American jobs, lowering the municipal tax receipts which are helping put the squeeze on public pensions in the first place.
A secondary force driving the move to private equity are the twin forces of government regulation in the form of Sarbanes/Oxley and of shareholder advocacy groups and the battle to lower CEO pay. Private equity firms are able to avoid the high costs of the onerous compliance requirements of Sarbanes/Oxley, and since they do not have to publicly disclose executive salaries, they are able and willing to pay top executives the sort of outlandish pay and perks packages that have become the subject of public outcry. As such, they are able to recruit the top executive talent, but more importantly, these factors make taking a company private highly attractive to the executives on the board of the targeted companies. At present, there is both a lawsuit in progress on the behalf of investors who believe that private equity firms and the board members of some purchased companies colluded to depress the sale prices of companies, and a Department of Justice Antitrust Division investigation into anticompetitive practices by private equity firms. In light of the Wall Street-friendly administration, the DOJ investigation requires the particular attention of the liberal community to ensure that the Bush administration does not step in to enable anticompetitive behavior.
But, perhaps the greatest risk is that inherent in private equity trading in the first place. These spectacular rates of return are due to a form of arbitrage trading, when the market distortions due to human factors result in a disparate valuation of commodities that can be exploited. However, these trends tend to mirror one another, making them highly vulnerable. In 1998, the devaluation of Russian currency combined with the closing by Salomon Brothers of their arbitrage trading desk resulted in an industry-wide flight-to-quality (movement away from high-risk/high-return investments) which resulted in the hedge fund Long Term Capital Management losing over $1 billion dollars and the near-bankruptcy of investment bank Lehman Brothers. In those cases, it was mainly wealthy investors and investment banks which took the hit.
In the case of private equity, the principal losers should these firms fail are the retirement plans of our nation’s public employees. Their losses would be on par with those suffered by the employees of Enron and its subsidiaries when the stock in their IRA accounts went bust. Moreover, those public pensions are guaranteed by the municipalities of our nation; should the funds fail, the cost will become translated to the taxpayer.
For those reasons, it is essential that Americans pay attention to the phenomenon of private equity trading, and take care that they are not banking the public’s financial future on a high-risk form of arbitrage trading. I urge you to contact the Department of Justice, Antitrust Division at antitrust.atr@usdoj.gov and let them know this case is important to you. Further, if you are a public employee with a pension plan, please contact your local and ask for information about how you can contact your fund manager to make sure that they are diversified enough to manage the risk of investing in private equity firms.