Focus on TBTF Banks Misses How Even More Powerful Private Equity Kingpins Are Moving More into Unregulated Parts of Banking

The fact that the world’s biggest banks drove themselves off a cliff yet managed to save their hides and even profit from the exercise while leaving ordinary citizens to pick up the tab is ample reason for citizens and the small cohort of non-captured regulators and politicians focused on their continuing misdeeds.

But as a result, an even more powerful set of financial players, namely, private equity firms, is continuing to expand the scope of their activities with little scrutiny and pushback by the press and public interest groups. For instance, when it was much smaller that it was today, and branded first as “raiders” and then “leveraged buyout firms” in the 1980s, the industry was the driver of the now-well established trend towards rewarding CEOs lavishly for cutting headcount and other expenses, relying on financial engineering rather than investing in the business of the business, and fixating on short-term results rather than long-term indicators of corporate health. The raiders initially focused on too-fat-and-happy companies, stripping out bloat and breaking them up to sell the constituent pieces for more than the former whole.

But as more and more capital was deployed into this strategy, stock prices rose to reflect the possibility of a takeover, forcing the takeover artists to engage in more radical makeover when they succeeded in closing a deal. And big companies mimicked these strategies defensively, to make themselves less attractive to these marauders.

By the 1990s, the executive class realized the raiders had done them a huge favor as the LBO artists had legitimated ideas like paying CEOs like entrepreneurs, heavily in stock (which as we’ve since learned has simply bloated compensation levels and produced an unhealthy fixation on managing investor perceptions and reported results over investing in performing operations and developing new products. As we’ve also chronicled, the “companies exist to maximize shareholder value” is an idea promoted by economists, and not a theory grounded in the legal obligations of management and boards, that became popular around this time and provided intellectual cover from this shift. Thus private equity firms have been the drivers of the continuing trend of “sweating the asset,” which is finance-speak for squeezing workers and suppliers for the benefit of investors and top managers. And that, as Huffington Post points out today, has been a major driver of income inequality.

In other words, to ignore private equity is to ignore the moving forces behind the restructuring of the relationship between capital and labor over the last 35 years. Yes, Reagan breaking the air-traffic controllers’ union and the right wing’s persistent and effective attacks on labor were another critical part of this trend. But LBOs reshaped values and priorities in Corporate America in less than a decade, an astonishingly short period of time.

And the industry only grows in power. As of mid 2012, it had over $3 trillion globally in assets under management. With leverage, this translates into over $6 trillion of buying power. By way of comparison, the total capitalization of the US stock market at that time was roughly $21 trillion.

And the cincher? Private equity kahunas are the top targets for political fundraising. While they do have top hedgies as competition in terms of the size of their personal balance sheets, PE firms are constantly doing deals, and thus provide a huge fee stream to investment banks and top law firms. Thus politically-oriented private equity players can pull on a large network of well-heeled professionals who would be foolish to turn down their requests for political contributions. The proof? Look at the first members of the board of Obama’s library. Two of the three are in or have strong ties to the private equity industry.

Gillian Tett in the Financial Times gives us an update on how these firms are extending their reach yet have managed to remain almost entirely unsupervised by regulators. US readers are no doubt aware, for instance, of their massive move into the rental of single-family homes and how many reports of abusive practices have surfaced in their short tenure as landlords. Tett writes:

What is really striking is the volume of non-bank financing that is quietly being supplied to western economies with minimal regulatory scrutiny – a trend on which my colleague Henny Sender has reported extensively. The “non-bankers” who provide it now matter as much as the bankers, and they appear to be having more fun. Results released in the past two weeks by asset management groups illustrate the point. Last decade, Goldman Sachs’ return on equity peaked at 40 per cent. Last year it was just 11 per cent. Meanwhile, KKR’s return on equity was 27.4 per cent in 2013 – a margin that the banks can only dream of.

These groups’ recent profits were boosted by sales of companies they acquired several years ago. But today they are branching out beyond turnround activity, partly because there are fewer new deals around, and jumping into areas that were the terrain of banks: credit and property.

The only reason non-banks can turn a profit by extending credit is that banks are no longer supplying credit to risky endeavours, such as small companies

Only a quarter of Apollo’s $160bn-odd business is now focused on private equity. It has recently gobbled up so many corporate loans and bonds that its credit portfolio has exploded to more than $100bn, compared to just $4bn seven years ago. At Blackstone and KKR the switch is less dramatic: according to Bloomberg’s calculations, credit is just a quarter of their portfolios. But they are shifting focus too. Just last week, Blackstone announced plans to start extending mortgage credit as part of its property business.

Now admittedly Apollo has a different profile than other so-called private equity firms. Its founder Leon Black came out of Drexel. The firm has long been a big player in real estate and distressed investing, both of which involve higher levels of leverage than more conventional PE strategies, so it isn’t fully representative of the industry as a whole. KKR and Blackstone are better indicators of where the industry is headed, and even a 25% credit product level is impressive (and not in a good way).

Tett continues:

Of course, a $100bn credit book is still smaller than that of JPMorgan. It is bigger than many midsized American banks, however. And the asset managers’ economic footprint is expanding in other ways too. Blackstone’s portfolio companies, for example, now have 600,000 employees and $79bn of revenue…

This may not be entirely desirable. Non-banks are swelling in size because they do not face the same regulatory burdens as banks, allowing them to turn a profit on business that banks now find uneconomic. This worries regulators. The US Office of the Comptroller of the Currency recently warned that the activities of non-banks has fuelled a boom in risky corporate loans – and warned banks not to “skirt rules” by teaming up with non-banks to create more credit.

Tett ends on a cheery note, arguing that the PE firms don’t have the maturity mismatches that banks do by relying on short-term funding like deposits and the interbank market. But the investors in PE funds are overwhelmingly retirement funds, particularly government funds (as in those of public employees). Should we really take cheer that PE funds can dump any mistakes on hapless and locked-in pension funds and walk away scot free? Illiquidity and a lack of aligned incentives are not sound principles (PE firms make money even when their deals crater, as Josh Kosman demonstrates in his book The Buyout of America). And we’ve already seen the the PE model is based on transferring value from ordinary people rather than creating it. It’s hard to see why we should sit by and allow them to expand that model into new markets.

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  1. mcgee

    FYI: Your website was down from roughly 8:30 to 10:15 mountain time. Ran your address through “isitdown” to confirm it wasn’t just me.

  2. lambert strether

    Gee, thanks for the link to Obama’s Presidential Library foundation. Now, where’s my brain bleach?

  3. psychohistorian

    This posting sounds like the basis for one of the planks of the Yves/Lambert Skunk party.

    Reign in the PE plutocrats!

  4. j gibbs

    So the bottom line on PE is this: it deploys the assets set aside for worker retirement to screw the workers and enrich the executives and PE operators, while degrading every imaginable product and service, and it uses leverage supplied by banks themselves supported by Fed largesse, to increase the take. Welcome to the new improved usury economy.

    Legally, the simplest thing imaginable would be to stop all this by limiting pension fund asset management to publicly traded securities, and limiting executive compensation while making executive stock options illegal. Most people don’t realize that Berkshire Hathaway’s spectacular success is attributable to Buffet’s refusal to permit executive stock options. He will lend his executives the dough to buy stock at the market price, but they must pay the same price as everyone else, no bargains.

    It seems to me that every economic impulse in today’s ‘market driven’ economy is perverse. We are essentially no different than France, circa 1785, and I hope we are not moving toward a similar result.

    1. 12312399

      “So the bottom line on PE is this: it deploys the assets set aside for worker retirement to screw the workers and enrich the executives and PE operators, ”

      The documentary, “Mayfair Set” by Adam Curtis (a British libertarian who lots of people think is a leftie) explored very irony that you point out. (episode 2 or 3, can’t remember)

      available on youtube or via your fav. search engine.

      1. Susan

        Yep – we were posting at the same time.
        It was the first thing that came to mind as I started to see the strain of Detroit’s bankruptcy emerging.

  5. Susan

    Adam Curtis, The Mayfair Set, Part 3 Destroy the Technostructure. A fascinating look back. And yes, this is the old shell game. It’s magic, watch my hand, look over here. It’s a whack a mole deal.

    “Should we really take cheer that PE funds can dump any mistakes on hapless and locked-in pension funds and walk away scot free?”

    No. Because there’s no there there. Watch it vanish into thin air, just like in the magic shows.

  6. scraping_by

    I’d like to speak out in favor of fat and happy companies. Their usual offense against morality and humanity is having a large store of cash in the company accounts. Upstanding LBO artists bravely get a majority on the board and solve that problem without fail.

    Cash is useful if you’re running a real economy business. It helps you avoid interest charges, control your own capital program, and improve morale for the people who work there. I’ve always had a suspicion that banks support LBOs because it creates debt. Much of the asset stripping is explained as ‘company debts’. Which they didn’t have as an independent company.

    By controlling the company, the raiders can pay off the debts they incurred with company cash. I’m not sure the legal alchemy that makes that not embezzlement, but if they had to keep their own debts, that would make the old loot ‘n scoot a lot less attractive.

    1. j gibbs

      Banks do support LBOs because they create debt. They create the best kind of debt: the kind collateralized by business assets. No sane owner would leverage a business this way, but PE gonifs have none of the own dough in the deals. They rake off fees and collaborate with the banks to set up the equity investors to take the fall. How many people know that big business pretty much stopped borrowing from banks eighty years ago, apart from inventory loans? Fifty years ago these companies had practically no debt. Henry Ford never borrowed from banks in his company’s history. He forced his dealers to do the borrowing.

      Banking was pretty much a cottage industry until the 1970s, when Walter Wriston got the bright idea of borrowing over night from Arab sheiks and lending the money to foreign kleptocracies and banana republics in term loans. His mantra was ‘soverign governments don’t default.’ Mexico very nearly proved him wrong.

      1. Gerard Pierce

        I don’t have a link and I can’t prove it, but a number of years ago I read about Henry Ford’s major financial discovery — he was doing business with banks and hated their guts. He forced his dealers to pay in advance for their floor inventory. He then took the money, paid off the bankers and never did business with them again.

    2. H. Alexander Ivey


      Nice point about fat and happy companies (pre-1980s raiders). As usual, if you don’t know how things work (or don’t want to know), it’s easy to state something is a problem and then here’s a solution. Example, as you mentioned. Pre 1980s companies had “bloated” assets that the raiders took over and sold off. But why were the assets there in the first place? Answer (financial reason): to provide cash and liquidity when things turned down or to prevent a need to have a bank “loan” you the money at interest; or (social / class reason) to provide a social safety net or be the lord of the manor or your brother-in-law needs a job. Why is it “bloated”? So I can label it as “bad” and so do good work by selling it and lining my pocket.

  7. Chauncey Gardiner

    Thank you for this very enlightening post. When the former US Treasury Secretary resigned to accept a senior position with Warburg Pincus, I assumed that the role of these financial intermediaries had shifted. I just didn’t know how or how much. I still don’t, but it is clear from informative articles such as this that a number of these entities have become “Systemically Important Financial Institutions”. The more light that is trained on all these shadow banking entities in terms of their legal structures, their sources and uses of funds, their on and off-balance sheet risks, and their political activities, the better.

  8. flora

    This post importantly connects several dots. Fits with several recent comments.
    Glad to read from Tett that “This worries regulators. The US Office of the Comptroller of the Currency recently warned that the activities of non-banks has fuelled a boom in risky corporate loans – and warned banks not to “skirt rules” by teaming up with non-banks to create more credit.”
    I’ll point out that Fanny Mae – which enjoys the legal fiction of not being a govt entity – has been instrumental in bulk sales of distresses housing properties to the PE firms, many of which helped to create the distress in the first place. Any chance US regulators will limit this sort of govt funded activity? rhetorical question.

  9. allcoppedout

    Hard to fault this argument, though it is fairly easy to make. The hard work is in why we can’t base our societies on fair reward across the board in which these are not taken straight back in economic rents.

    1. Ulysses

      We can have such a society, if we do the hard work of waking people up to the fact that power (for the bottom 80%) can be taken– if we are willing to risk short term individual losses for long term societal improvements. We really should be fearing nothing more than fear itself!

  10. Crazy Horse

    On of the advantages of extreme concentration of wealth is that it requires fewer jail cells to remedy the problem. Why, in Guantanamo alone we have enough cells to accommodate all the members of the Fortune 1,000. If we incarcerate the 1,000 richest individuals plus all the chief officers of TBF banks and PE firms with over ten million in assets would the country not be better off? By waterboarding them daily until they prove that they have repatriated all the assets they offshored and hid in the Caymans and elsewhere, and subsequently have donated 50% of their net worth to charity, we can provide them with the opportunity to be rehabilitated as useful and perhaps even productive citizens.

  11. Alan

    My pet name for the greed/leverage boys is private equity underwriter (PEU). I’ve blogged about various aspects of their shell game since 2007. PEUs became ubiquitous under the Bush years, but have done quite well under Obama. Red and Blue love PEU.

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