Yves here. This is the third part of an interview by Andrew Dittmer with the authors of an important new book on private equity, Private Equity at Work (see Part 1, Part 2, and Part 3).
This final post focuses on the question of whether private equity can be reformed. Even though there is a long list of possible curbs and fixes, Appelbaum and Batt single out the critical ones that they believe will have the most impact.
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
Andrew Dittmer: Your last chapter contained a lot of proposals for how to make positive changes in private equity. If you had to choose just three of these ideas to implement, what would they be?
Rosemary Batt: Curb the high use of debt. I think that’s our number one policy priority.
Leverage is the lifeblood of private equity. We do have examples in the book of smaller companies that are taken over by private equity in which there’s much less use of debt because there’s less collateral available. In many of those cases we don’t see the same negative effects on the company.
Eileen Appelbaum: Another reason we would like to curb it is that PE advertises itself as bringing investment and managerial know-how to the companies that it takes over. If you limit the amount of debt, then the principal way they would be able to make money is by doing what they claim they do. We would like to see them do this, and curbing leverage would definitely encourage them to move in that direction.
Rosemary Batt: We have three different ideas about how you might do that. One is an explicit cap on leverage. There’s some precedent for that – after the Depression, there was an SEC regulation putting limits on how much an individual could borrow in order to purchase a security. But of course whether this would pass is doubtful.
Another thing to think about is how to eliminate or at least reduce the tax deductibility of debt, thereby making debt less attractive.
Still another, probably more politically acceptable idea has been developed by the EU. They have an alternative investment fund manager directive requiring PE firms to assess liquidity and risk issues regarding any given investment, and to set a maximum leverage limit based on a series of conditions: the risk involved, the condition of the company, the size of the company, etc. So this moves away from a one-size-fits-all approach.
Eileen Appelbaum: Right now, Dodd-Frank has the private equity fund general partners talking about what the PE firms are doing, what the general partners are doing, who they’re consulting with, what fees they’re collecting and are they sharing that revenue with their limited partners, and so on, but the SEC does not collect any information or data on the portfolio companies in the PE fund. I think a first step would be to begin to collect that information so that the SEC could then ask questions like, “Is that a reasonable amount of debt to have loaded onto that company? What were you thinking?”
I wonder if Dodd-Frank provides any space for requiring this information to be collected. I don’t know, but if it were possible, it would be a useful and relatively easy first step: Let’s just have the PE fund general partners report the level of debt loaded onto the portfolio companies they manage.
Rosemary Batt: The interagency guidelines on leveraged lending for banks suggest that banks should not make loans to borrowers in which the debt exceeds 6 times earnings (EBITDA). Those guidelines went into effect in March 2013, and in recent reporting we seem to be seeing, as a result, some curbing of bank lending behavior.
Eileen Appelbaum: Now of course the PE companies can go into the shadow banking system and borrow there instead, so it isn’t a complete curb. But the guidelines on bank lending certainly have made it more difficult for PE to do what it likes to do: borrow as much as it wants, load as much debt as it wants onto the portfolio companies. As Rose said, we now have some examples of banks refusing to make loans with that degree of leverage.
Andrew Dittmer: That was still all in the category of curbing the use of debt.
Rosemary Batt: Our second priority is to curb excessive compensation. The 2 and 20 model creates perverse incentives to use debt in order to multiply returns. PE general partners really have very little skin in the game. They put in maybe 1-2% of the 30% equity of the entire purchase price, but they’re getting 20% returns. It’s a classic case of moral hazard, and they have a lot of incentive to load a company with debt.
This model could be revised and reformed. A related issue is the tax loophole for carried interest – PE firm partners pay the capital gains tax rate on the 20% returns they get from their investments. Curbing that loophole would indirectly reduce the perverse incentives for risk-taking embedded in the current model.
Eileen Appelbaum: For third place, there’s a tie depending on whether you worry most about investors or about workers.
If you’re thinking of the investors, then probably transparency is what you would be interested in. We don’t really have any good way of telling limited partners what the real returns are relative to other asset classes because every study that’s done uses a biased sample, and we don’t know which way the biases go.
If you’re thinking of the workers, you may find the example of Sweden interesting. In Sweden, private equity operates pretty much the way it operates here: it takes over companies, loads them up with debt, and then tries to make a lot of money on the exit.
But Sweden has very strong employment protection laws and unions, so you don’t see the kind of wholesale downsizing and layoffs and cuts in compensation and benefits that frequently accompany PE buyouts in this country. As a result, the model is the same, but the results are different. If you can’t lay off workers so easily, you have to think about how you’re going to make the enterprises more productive in a way that better uses the talents of the workers that you have.
We have a number of ideas for how to better protect the investments that workers make in a company. The academic literature clearly shows that nearly all PE investing is in companies that are quite healthy, in which employment is growing more rapidly than in comparable companies, in which wages tend to be higher, and in which productivity tends to be higher. This means that they are taking over companies in which the currently existing workforce has put in a tremendous investment. These employees have made it the great company that it is, but once the PE firm takes over the company, well, in this country you can fire workers for pretty much any reason. Best if you don’t give a reason because then it can’t be contested.
When you fire these workers, there’s no severance. There’s no golden parachute for all of those workers who invested so much of their lives and their energy in making that company successful. So we think there should be severance pay for workers so that a company that wants to acquire a company and then lay off its workers would have to think twice about it.
The severance should be related to years of prior service with the company, and there should also be provisions along the lines of the WARN Act: in the event of a mass layoff or a facility closure, workers should have 60 days of notice or draw 60 days of pay and benefits and the PE fund should be liable for these payments. Along similar lines, if the PE fund wants to exit the pension fund obligations of the acquired company, the PE fund should have to make appropriate payments. In general, we think it would be worthwhile to provide better protections for the workers who create the companies that PE so badly wants to buy.
Rosemary Batt: There’s one more thing I’ll throw in. A particularly egregious activity is dividend recapitalizations. Even Wall Street people (who are not in private equity) tend to see this as questionable.
Eileen Appelbaum: If the company you’ve taken over is generating profit then you should allow it to reinvest that profit in itself and increase its value down the line. What you should not do is to take a company you’ve already loaded up with debt and then load it with even more debt just to allow it to pay you a dividend. That’s what the term “dividend recapitalization” means.
Rosemary Batt: We’ve found that they usually take place in the first two or three years after the PE firm acquires the company. The company already has a lot of debt after the buyout itself, so by this time its debt is at junk status, and then you require it to take on more debt! I think that if there were public discussion around this sort of thing, it could get some traction.
Dividend recaps skyrocketed after the tax code change in 2003 which lowered the tax rate on dividends to 15%. The value of dividend payments dropped during the recession, but then it doubled between 2011 and 2012. The reason is that the PE firms were not able to exit their portfolio companies in the 2010 – 2012 period. The LPs were getting itchy and frustrated about not getting any returns, and so the PE funds started doing more dividend recaps simply in order to extract money they could hand over to themselves and their investors.
Eileen Appelbaum: The financial reform in Europe limits the ability of PE funds to take any kind of dividends in the early years of owning a company for precisely this reason. So limiting dividend recaps, in at least the early years, is something that can and should be done.
There is another reason why PE likes doing dividend recaps. It has to do with the fact that PE likes to present its performance in terms of the internal rate of return (IRR). Well, it happens that payments to limited partners early in the history of a takeover may do a lot more to raise the IRR than more profitable exits later on. So if you have an opportunity in the second year to take a high dividend recap, or even to sell the company prematurely, then IRR creates an incentive to do this. And still, despite all of the weaknesses of the IRR, despite the fact that everyone in finance knows that it’s not a good measure, it remains the gold standard for private equity fund performance.
Andrew Dittmer: Thanks for talking with me. I really enjoyed reading your book.
Rosemary Batt: Thank you for your very careful read of the book. I’m glad to know that people are actually reading it.
What continues to annoy me about the regulators (another very long list of mine, but this one is near the top) is that while they are fully cognisant (e.g. here) of the risks incurred on what I’ll broadly term society by PE, we still get nothin’ but a load of handwringing. The Bank of England’s report in the above link cites in its conclusions (with evidence) that by increasing leverage, you get increased fragility (e.g. refinancing risk, interconnectivity risk, information hiding risk — the bit in the report about increased forbearance by lenders to PE is interesting, but we simply have no way of telling how much of it might be going on, for instance).
But you’d struggle to recognise that report was written by a regulator. The problems with PE are acknowledged, but no-one seems to think that anything should be done about it. The whole tone of the report comes across as if it was written by a disinterested bystander. “PE slashing and burning might be destabilising whole companies, many of them of strategic or systemic importance ? Oh, really, how terrible. More tea, vicar ?”
It’d be a cold day in Hell before PE reforms itself. If the regulatory bodies won’t hasten that reform, it’s not something we should hold our breaths about.
Thanks, Clive. I think that generalizes to all of the Financial Industry (including Insurance).
Agree. I’m so horrified by what private equity is able to do, all legally, to destroy companies that could make it just fine if they took out much smaller loans and did a few other things to improve their business. And then there is always the company – most companies – that are not meant to be eternal capitalist powerhouses. They have short productive lives, after which they should liquidate, more or less. But PE comes riding in with guns blazing to “save the company” and then just stuffs its own pockets. The whole PE business model is appalling. And a disgraceful lie.
To me, the worst thing, after the employee wage/benefit cuts and/or terminations, is the dividend recaps. They are the epitome of rentier extraction.
One of the better articles of the above behavior, was an article by NYT of how a 100 year old company was loaded with debt bankrupting the company.
A basic question regarding your concerns about private equity: Why do you care? If wealthy private investors want to make risky investments with their own money, why is it any of your business? Unless their losses are socialized to taxpayers, why do you care? A basic tenet of the free-market system is that failing businesses be allowed to fail. The assets of the failed businesses can be acquired by other entrepreneurs for use in new ventures.
The problem comes with the Too-Big-To-Fail banks, banks which are believed by regulators to be too systemically-critical to be allowed to fail. Then we have a “heads I (the banks) win and tails you (the taxpayers) lose.” The solution to the problem is simple. We need to reestablish the separation of commercial banking from investment banking, a new Smoot-Hawley-type regulatory regime.
Let’s put the blame where it belongs: with the politicians in Washington who repealed Smoot-Hawley and with the regulators who sat by fat, dumb, and happy while TBTF banks took very imprudent risks. Anyone who knew where to look, and many analysts did, could have seen the risks building.
The OCC publishes a quarterly derivatives report which is available for free on their website. If you start looking at the reports in the early 2000s, you can easily track the huge increase in derivatives, particularly credit-default swaps. It was those derivatives that were most responsible for the 2008 banking blowup. The credit-default swaps grew at a rate that was many times greater than the growth of the real economy. The extreme leverage was there to see for anyone who cared to look. But who wanted to be a spoilsport? Not the people who were supposed to be protecting and ensuring the integrity of the US financial system.
Private equity isn’t used solely by private investors. They get big slices of their business from entities like state and union pension systems. This allocation of power and money is ironic but true. In my opinion pe should be abolished , but reform always comes first.
Now we’re getting somewhere. Why do you think that private equity should be abolished?
Do you mean Glass-Steagall instead of Smoot-Hawley? Glass-Steagall was the regulatory regime that kept the commercial deposit-taking bank separate from the casino-gambling investment bank, which prevented the bank from using insured deposits to make risky bets. It was compromised beginning in the eighties and was finally repealed in the nineties by the Clinton cohort to legitimize the acquisition of Citibank by Traveler’s Insurance after the fact.
Smoot-Hawley was a tariff regime that raised the prices of thousands of imported goods in a vain attempt to protect US industry. It contributed greatly to the continuing misery of the Great Depression.
Yes, thank you. I meant Glass-Steagall.
The losses are socialized. When people are laid off they get unemployment, and possibly food stamps. There is a loss of taxes paid by all those people laid off. The wage rates in those areas goes down, so more taxes are lost, and less income is generated throughout the communities. Worker’s lose pensions, which makes them more dependent on Social Security and Medicare.
But if you have to ask the question why do people care, I suggest you re-read this series until you get it. If that doesn’t happen, then just admit you don’t care about your fellow citizens, while others do, and leave it at that.
I do care about other people, and I believe that the free market is the best way to create and distribute wealth equitably. I know that my statement is heresy to socialists and other collectivists, but the free market is based on voluntary, i.e., non-coercive exchange, and socialism is based on coercive economic relationships enforced by government power.
The perfect image of the liberal do-gooder mentality is the cover of Jonah Goldberg’s book Liberal Fascism (http://en.wikipedia.org/wiki/Liberal_Fascism). It shows the iconic smiley face with a Hitler moustache. Have you read it?
It is not “wealthy private investors” who invest in PE. It is overwhelmingly pension funds, public and private 25% and 10% of total assets, respectively), foundations and endowments (another 10% of industry assets) and fund of funds (about 15% of industry asset), whose main investors are all of the preceeding, but smaller ones who need a FoF because they are too small to meet PE fund minimums and get adequate diversification within the PE “strategy.” Sovereign wealth funds and insurers are another 10% or so each. The PE funds themselves hold 3% of fund assets. That means only around 15% is wealthy individuals, pretty much all of them Wall Street denizens.
If you told a self-made businessman the terms of a private equity fund, that the have capital calls with 5-10 days notice, don’t tell you what they are investing in, don’t let you see how those investee companies are doing, charge tons of fees in addition to the management fee and carry, and don’t tell you when you get your money back, they’d never consider it.
A large chunk of the industry, well over 50% of industry assets, is fiduciaries who are not even coming close to doing their job. They are not competent to invest in PE.
‘probably transparency is what you would be interested in’
That was essentially the conclusion of the Securities Exchange Act of 1934. Congress couldn’t tell investors whether stocks were fairly priced or not. However, the law could insist that companies fully disclose results and risks, so that investors could make informed decisions.
Private equity gets round these restrictions because it’s not publicly traded. However, public pension funds could certainly be used as a wedge to force greater disclosure, via state laws requiring them to disclose partnership agreements, fund holdings, cash flows, dividends and the like.
If the result is that PE partnerships freeze out public pension funds — great. It’ll save the taxpayers money, and put a stop to using public funds to finance leveraged speculation and predatory fees.
An era of low returns exerts relentless pressure to lower management fees. 2/20 fees are not an acceptable business model anymore. 2/20 is dying dodo bird, flopping in the muck beside the tar pit.
Thanks for promoting this book – one of the best academic books of the millenium.
But, while I get that academic policy books always end with the recommendations, it is not possible to take them seriously.
BTW, in response to TMM above, one reason to limit debt is that the other stakeholders in the business, esp the people who work there, usually get crushed first, before the owners. Most working people, if their job isn’t total shite, will go to great lengths to hold onto the job they have, including taking massive wage cuts trying to keep a business being bled dry by PE alive. Workers take wage cuts so absentee owners can extract more. Call it the US economy.
Yves & others have made the point several times that PE is just the ’80s Barbarians-at-the-gate leverage buyout mania rebranded; Private Equity sounds so much more genteel & refaned.
Perhaps we should really go further back to the ’70s when it went by the cruder but much more descriptively honest title of asset-stripping, the perfect description for “dividend recapitalisation”.
The lipstick changes but the pig remains the same.
You are entitled to your opinions but as someone who has a Ph.D. in mainstream economics and has spent a life working in the field, with economists of varying perspectives, and having also read extensively about economics, I, and pretty much every professional economist I know, would disagree with your assessment. Only a couple are socialists.