Andrew Dittmer: Eileen Appelbaum and Rosemary Batt on How Private Equity Really Works

Yves here. Naked Capitalism contributor Andrew Dittmer, perhaps best known for his series on libertarianism (see Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, and his responses to reader comments) has returned from his overlong hiatus to interview the authors of the highly respected new book, Private Equity at Work.

Eileen Appelbaum and Rosemary Batt have produced a comprehensive, meticulously researched, scrupulously fairminded, and therefore even more devastating assessment of how the private equity industry operates, including its deal and tax structuring methods, its impact on employment, and whether its returns are all they are purported to be. Their work was reviewed in the New York Review of Books; we also discussed it in this post.

Earlier this year, Andrew spoke with Appelbaum and Batt, and the first part of their discussion covers the problematic relationship between private equity funds (general partners) and their investors (limited partners) and how private equity affects other businesses.

In some cases, Appelbaum and Batt bending over backwards to be evenhanded. For instance, they attribute the explosion in CEO pay not to the leveraged buyouts industry (private equity before it was rebranded in the 1990s) but to an article by Michael Jensen in the Harvard Business Review that argued for paying CEOs like entrepreneurs. While narrowly true that the Jensen article was the proximate cause of the shift in big corporate pay models, having lived through the 1980s and the way that LBOs captured the attention of the business press, it is hard to imagine Jensen’s thesis being taken seriously in the absence of the LBO boom. The “maximize shareholder value” theory of corporate governance was first presented in a Milton Friedman New York Times op-ed in 1970 and had not gotten traction with the mainstream. It was the wave of takeovers of overly-diversified conglomerates in the 1980s and the easy profits garnered by breaking them up and selling off the pieces that seemed to prove the idea that too many CEOs didn’t have the right incentives to run their businesses well (and in fact, it’s also true that the business press of the 1970s decried American management as hidebound and much less good at working with labor than the Japanese or Germans). But as we’ve seen since then, equity-linked pay has produced rampant short-termism and facilitated looting by executives. Even if the old pay model was problematic, its replacement has performed even worse, save for the CEOs themselves.

By Andrew Dittmer, who recently finished his PhD in mathematics at Harvard and is currently continuing work on his thesis topic as well as teaching undergraduates. He also taught mathematics at a local elementary school. Andrew enjoys explaining the recent history of the financial sector to a popular audience

Interactions of General Partners (GPs) with Limited Partners (LPs)

Eileen Appelbaum: Rose and I did a briefing at the AFL for the investment group. We had investment people from both union confederations who are concerned about the fact pension funds are putting so much money into private equity. They told us that they had never been able to see a limited partner agreement until Yves Smith published them. The pension fund people are so afraid of losing the opportunity to invest in PE. Some general partner could cut them off for having shared the limited partner agreement. Unbelievable.

Andrew Dittmer: In general, LPs seem to have a pretty submissive attitude toward GPs. Where do you think this attitude comes from?

Rosemary Batt: One cause is the difference in information and power. Many pension funds don’t have the resources to hire managers who are sophisticated in their knowledge of private equity firms. They don’t have the resources to do due diligence to the extent they would like to, so they need to rely on the PE fund, essentially deferring to them in what they say. 

Eileen Appelbaum: I think that there is a reluctance to question this information or to share it with other knowledgeable people – they are afraid that if they do, they will not be allowed to invest in the fund because the general partners will turn them away.

I attended a lunchtime lecture recently, the title of which was “How is it that private equity is the only industry in which 70% of the firms are top-quartile?”The general partners have found ways to persuade their investors that they are the top-quartile funds, that “you will make out best if you invest with us,”and “we’re very particular – if you can’t protect our secret sauce, we aren’t going to do business with you.”

The other side of it is that some of the pension funds have their own in-house experts, and some of them believe they’re smarter than the average bear – there’s a certain pride in their ability to get the best possible deal, better than other LPs can get.

It’s the lack of transparency. With more transparency we’d have a lot less of these problems.

Rosemary Batt: Another issue is yield – often they’re thinking, “We need to be investing in private equity or alternative investment funds because this is the only way to get higher yields.” There’s a kind of halo effect, if you will, around the private equity model – many people think it really does produce higher returns without really having the knowledge. In some cases, there are political battles that have to be fought to get legislators to make a decision not to invest in these funds.

Eileen Appelbaum: Often the person who is appointed to make the decisions about private equity investments comes from Wall Street, maybe even from a PE background.

Andrew Dittmer: Portfolio theory plays a role here – it tells people that it’s wise to be invested in alternative assets in order to reach the efficient frontier. But PE is cyclical, and so the idea that it helps diversification seems somewhat questionable.

Eileen Appelbaum: Right. It’s a cyclical industry, and it seems to be correlated with the stock market, so exactly how it’s diversifying your investments is also a problem. Portfolio theory has been very, very powerful. Before it was developed and accepted by regulators, pension funds would not have been able to invest in private equity because they were obligated to evaluate the risk of each individual investment – that would have ruled out most private equity investments. But portfolio theory says that you should evaluate the risk of the portfolio and not of each individual investment, and that’s what allows pension funds to invest in PE.

Rosemary Batt: The idea that you can diversify away risk can leave people with the belief that they don’t have to worry about risk. So it leads to a sense of false security.

Effects of Private Equity on Non-PE Firms

Andrew Dittmer: Could you talk about how private equity affects firms not owned by private equity?

Rosemary Batt: It’s hard, of course, to pinpoint causality given that we don’t know if public corporations have directly copied private equity practices. But one example I think is relevant is the use of debt – the leveraged buyout model beginning in the late 70s and early 80s involved the use of extensive debt, and other companies began to look at this model. And while public companies don’t have nearly the level of debt that companies owned by private equity do, they have certainly increased their use of leverage in the last 20 years.

Eileen Appelbaum: I think tax arbitrage is another example. Private equity excels at figuring out every little loophole and taking advantage of it. I think there was a time in the past when a U.S. company was proud to be a U.S. company and would not have moved its headquarters to Ireland in order to avoid paying taxes. But now it’s pretty widespread for companies to do this, and then you have stateless profits. The idea of tax arbitrage as something that’s perfectly okay for a respectable company to do, I think had its roots here.

Andrew Dittmer: Do you think PE has played a role with the pay of top corporate officers?

Eileen Appelbaum: I think PE is part of a larger move from managerial capital to investor capital. This general trend has been helped along by several things that affect private equity but also affect publicly traded companies. One was the idea that you should tie the returns of a company’s presidents and CEOs to the performance of their companies in the stock market. We see this in the carried interest that PE partners receive; and we also see it in stock options as CEO pay. These are two branches from the same tree, but the tree is investor capital.

Rosemary Batt: CEO compensation really skyrocketed in 1990 after Michael Jensen’s articles encouraged all companies to tie their CEO payment more closely to stock price. That practice just exploded in the 1990s, and was a quite widespread phenomenon. As Eileen said, this is tied to a greater focus on the shareholder model of the firm.

Eileen Appelbaum: On the other hand, it’s possible for trends in the general business world to take hold in a more decisive way in private equity. One element promoting certain practices in PE is the managerial literature: the academic literature urging companies to pursue their core competencies.

You may have an overall profitable company and the subsidiaries of it may be profitable as well. -If there are some branches or some facilities that are less profitable than others, PE advertises itself as investing and making the underperforming facilities more profitable. But often it just sells them off or closes them down – which raises the overall profitability numbers of the company. The emphasis on core competence is used to justify this kind of behavior on the part of PE firms.

One thing to keep in mind is that there are some things that PE firms do that ordinary companies just can’t do, or at least can’t do to the same extent. One of these is the fees that are charged. You can’t be the corporate headquarters of a publicly traded company and then charge your subsidiaries separately for any management advice you give them or any transactions you carry out in their name.

Also, the greater transparency of publicly traded companies and the greater amount of information that the SEC collects and makes public about them places limits on what they can do.

Rosemary Batt: An example of how PE acts differently than public corporations has to do with how they use the bankruptcy laws. Because PE loads companies with more debt, those companies have about twice the rate of bankruptcy as public corporations. But since PE companies are not in the eye of the public in the same way, and don’t have to worry as much about their shareholders, they frequently take advantage of a certain section in the bankruptcy law called the 363 sale.

Under normal bankruptcy procedures, you would need to make a complete plan for reorganization, and the different stakeholders would have some say in that plan. But under the 363 sales, they can accelerate the process of bankruptcy, and in doing so they can more easily rid themselves of pension obligations.

Public corporations know about this loophole and they’ve started using it a little more, but they are much more constrained in their ability to take advantage of this kind of thing due to reputational risk.

Eileen Appelbaum: In our discussions with people from the PBGC [the Pension Benefit Guarantee Corporation, the US agency that provides payments to beneficiaries when a private pension plan fails], we were told that there has been some increase in public firms using the 363 sale, but it’s PE firms that have really taken advantage of it and they are still driving the process.

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  1. PaulArt

    It is not for nothing that Napolean, James Madison and George Washington are united in their excoriation of Bankers. Bankers today as of eons past are the personification of greed and evil. All of society must work hard towards making extinct this species from our midst. Banking should become a utility. Some time back I was wondering why a banker more than others would be susceptible to greed and hit upon this explanation. Think of a small time banker in a small town who lends money out. This fellow lends money to all kinds of businesses. His clients who borrow money from him tell him a lot about how they run their businesses and how much money they make. It immediately becomes crystal clear what a fantastic advantage these money changers have when it comes to information. They have the best and they have it first and they have it on almost every sphere of business and economics they have a chance to transact in. Walter Wriston must have become a greedy porker just like this. You watch some hard working guy running a business and you are privy to a lot of the man’s best techniques etc and then from that point the information about him and his business is like gold in your hands. You can then trade this information to other buyout vultures and make money simply trading information. This is the very main reason why banking should NEVER be a private business much like healthcare. Bankers along with Doctors and Lawyers are privy to too much information. Doctors and Lawyers are bound by ethics to keep this private but Bankers in an obscene way are allowed to actually make money off this information under the guise of the ‘free market’.

  2. Jim Haygood

    ‘They don’t have the resources to do due diligence to the extent they would like to, so they need to rely on the PE fund, essentially deferring to them in what they say. ‘

    If you have to rely on a PE fund for all the data, it’s not due diligence, it’s faux diligence.

    “How is it that private equity is the only industry in which 70% of the firms are top-quartile?”

    And why do I see so many soccer moms with bumper stickers on their Beemers proclaiming, ‘My PE fund is a top-quartile honor student’?

    ‘[PE] is a cyclical industry, and it seems to be correlated with the stock market.’

    Seems to be? How could it not be? PE is just publicly traded equities plus beta added by leverage. How fiendishly brilliant that someone thought of this! /sarc

    1. Yves Smith Post author

      Actually, mighty McKinsey says that PE isn’t strongly correlated with the stock market or with levered equity, see the first chart in this post:

      Moreover, remember that PE firms don’t sell portfolio companies in bad markets, so they can lie about portfolio valuations. That “smoothing” makes them look less correlated than they are. So this is less laughworthy than you think, since the dubious data supports the PE industry’s claims.

  3. greg kaiser

    Investment in Investment:
    My take on the article: As finance becomes more abstract (distanced from production, distribution and consumption of real goods) as in Private Equity, the paradigm comes to more closely resemble a confidence game than a legitimate service. It provides more promise and less return and as it evolves. More loot is taken from a broadening investor base, especially w.r.t. the pension funds of the least wealthy and educated [sophisticated] “investors.” Courts and legislators, programmed by Friedman/Chicago School babble in support of the con, contribute through bankruptcy and regulatory rules that facilitate the fraudulent industry.

  4. Jef

    During the boom times when energy was cheap almost free and most resources were plentiful and cheap the world economies generated such huge surpluses that a special breed of vulture was able to proliferate to an extreme degree, feeding off the surplus without negatively effecting the real economy.

    Since oil and natural resources in general peaked (starting in 1998 but revving up to full speed in 2005) there is simply no longer any surplus in the system yet we still have an enormous population of vultures that require feeding. Exacerbating the situation is the fact that the vulture class have successfully positioned themselves in a position of power allowing for the continued feeding frenzy to go on even though it means feeding on the seed stock aka the real economy.

    All gains for the few (vultures) now come at a major loss for the many.

  5. steelhead23

    Under normal bankruptcy procedures, you would need to make a complete plan for reorganization, and the different stakeholders would have some say in that plan. But under the 363 sales, they can accelerate the process of bankruptcy, and in doing so they can more easily rid themselves of pension obligations.

    Let’s unpack this just a bit. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made it much harder for consumers to discharge debt through Chapter 7 bankruptcy. Hence, college grads that have not yet found that high-paying professional job the glossy college brochure enticed them with, yet have huge tuition debt, will find themselves in debt peonage for decades. Yet, high-rolling PE general partners can discharge their obligation to pensioners for the sole purpose of increasing their lucre.

    This is so blatantly immoral I am stunned that it remains legal. Paging Ms Warren. Paging Mr. Merkley. Get on the ball guys and fix this – or make it one of your campaign issues for 2016. Please.

  6. susan the other

    Pension funds cannibalizing pension funds. Hey, there’s no such thing as retirement in a capitalist economy. It’s eat or be eaten.

  7. Fool

    Strange, the numbers show mediocre returns, and yet the pension funds keep coming back. Could it be that the money is being managed in such a way that’s not in the best interest of the pensioners? Now, if only the data — including LP agreements and investment data from the pension funds themselves — were publicly available, this wouldn’t be such a mystery….

  8. mrD

    I deal with a bunch of PE companies, biz to biz stuff. Eighty percent suck at running a business Lterm. Competitors pick pockets clean, former customers bad mouth them, most PE firms slowly frozen out. A few are really good though.

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