An article in the Financial Times reports on something truly extraordinary: rating agency Moody’s issuing a report, due out Monday, that is highly critical of the private equity industry. And we don’t mean because they have gotten away with a lot of “cov lite” deals, which are debt financings for their transactions that lack the usual lender protections, called covenants.
No, Moody’s takes on the fundamental premises of the private equity business and finds them to be bogus. Namely:
Despite their freedom from public market pressures, private equity equity firms don’t take a longer-term perspective. Instead they load firms up with debt and pay themselves special dividends
Performance improvements are due mainly to financial engineering, not better management
Why is this broadside so exceptional? Moody’s is a member of the corporate establishment. So far, critiques of LBOs have come mainly from those sympathetic to labor, which makes them easy to dismiss as being partisan, no matter how well founded or well documented their charges might be. By contrast, Moody’s cannot be dismissed as either partisan or lacking in knowledge, They have a formidable array of industry analysts, in addition to their debt rating specialists
In my 25+ years in the financial services industry, I cannot recall a ratings agency taking a stand like this. They have nothing to gain financially from this move and are certain to ruffle quite a few feathers. The only possible business motivation might be to burnish their image a bit in the light of the criticism they are getting on being slow to downgrade CDOs, but this seems an awfully roundabout way to address that problem.
It is actually possible that someone very senior at Moody’s is sick and tired of the free pass private equity firms are getting and decided to take a stand. And the specter of someone in Corporate America doing the right thing is rare indeed.
It will also be revealing to see how broadly this story is carried in the US. As of this hour (9:00 p.m. EDT), I see no mention on the Wall Street Journal’s or Bloomberg’s site.
Update (7/9, 12:30 AM): Still nothing on the WSJ or Bloomberg sites.
From the Financial Times:
Moody’s, the credit rating agency, will on Monday launch an attack on the booming private equity industry, criticising its increasing use of debt to buy companies and questioning its claims that listed companies are better off in private hands.
Moody’s voice adds to the growing chorus of US critics, which includes trade unions, politicians of both parties and some company executives.
The critical position of Moody’s comes at a sensitive time for both the private equity industry and credit rating agencies. The former is facing a deterioration in debt markets just as a number of buy-out firms, including Blackstone and Kohlberg Kravis Roberts, have listed or are seeking to do so. Rating agencies have been criticised by investors for being slow in spotting credit markets problems such as the crisis in the subprime sector.
In its report, to be issued on Monday, Moody’s takes issue with the argument that private ownership frees companies from the short-term pressures of the equity markets, enabling them to invest and plan for the long term.
The claim, often repeated by buy-out executives, is central to the industry’s efforts to prove its activities benefit portfolio companies and the economy as a whole.
Moody’s report says: “The current environment does not suggest that private equity firms are investing over a longer-term horizon than do public companies despite not being driven by the pressure to publicly report quarterly earnings.”
The agency says buy-out funds’ tendency to increase a portfolio group’s indebtedness to pay themselves large dividends runs counter to their claim of being long-term investors. The report cites as examples of this trend the dividend received by Thomas H. Lee, Bain Capital and Providence Equity following their takeover of Warner Music in 2004 and the one paid to Blackstone after the purchase of Celanese.
The document also takes aim at private equity’s claim that improvements in companies’ performance are driven by more focused management teams rather than financial engineering and higher debt levels.
The private equity industry rejected Moody’s claims. “Corporate leaders who have experienced … the positive effects of private equity ownership are quick to tell you that this structure can and does liberate management to focus on long-term growth,” said Doug Lowenstein, president of the Private Equity Council, the sector’s trade body. “We believe that real world case studies … offer compelling evidence of private equity’s impact on making companies stronger.”