“A Bad Man’s Guide to Private Equity and Pensions”

Critics of private equity often inveigh against the fact that the general partners (firms like KKR and Blackstone) have strong incentives to borrow heavily against the companies that they buy, since they collect so many fees that they profit whether or not the businesses they buy can survive with the debt load. It has reached the point where the European Union imposed restrictions on how much borrowed money private equity firms could use, out of concern about how many bankruptcies private equity firms were leaving in their wake.

In the US, the objections to private equity financial engineering and asset stripping generally focus on the risk of company failure and job loss. But an important part of the equation often gets second shrift: that of how private equity kingpins use bankruptcy to get rid of pensions. Eileen Appelbaum and Rosemary Batt did address it in their landmark book Private Equity at Work, but the practice still needs broader exposure.

A new paper by Elizabeth Lewis for Harvard’s Safra Center for Ethics, A Bad Man’s Guide to Private Equity and Pensions, helps fill this gap. I’ve embedded it below. From its abstract:

More recently, some private equity firms have honed Chapter 11 as an efficient financial engineering tool for insider sales—and for dumping pensions. Based on partial data from the Pension Benefit Guaranty Corp., at least 51 companies have abandoned pension plans in bankruptcy at the behest of private equity firms since 2001. They’ve dumped $1.592 billion in pension bills onto a government-backed
agency that insures private defined benefit plans. Because pension insurance doesn’t cover all benefits, their actions have left some of the nearly 102,000 workers or retirees with lost benefits amounting to at least $128 million. And they’ve contributed to the chronic deficits at the Pension Benefit Guaranty Corporation.

Other types of businesses, including publicly held companies, have also abandoned pension plans in bankruptcy. But the business model and practices of some private equity firms can make pension-dumping in bankruptcy especially attractive.

The legal and regulatory environments in the U.S. combine with those practices to add up to a form of institutional corruption. In this working paper, I explain how Oliver Wendell Holmes’ hypothetical “bad man” can use bankruptcy as a strategy to profit. So, here is a bad man’s guide to ditching pensions in bankruptcy—legally.

One of the big drivers of private equity bankruptcies is the strategy called dividend recapitalization, in which the private equity buyer borrows heavily for the main, and in some cases, sole purpose of paying a large dividend to investors. In theory, this is just benign financial engineering, making use of excess borrowing capacity. In practice, in too many cases, aggressive dividend recaps lead rapidly to company failure. I’ve long been mystified as to why this isn’t considered a clear cut case of fraudulent conveyance, when consumers who do pretty much the same thing (max out on their credit cards and default within six months to a year) will have a resulting bankruptcy challenged by creditors. Applebaum and Batt did discuss one case that was so egregious that the creditors did sue, and its denouement may explain why creditors stand pat so often: it took years of legal wrangling and high legal costs for the lenders to extract a settlement, and it was markedly less than what they’d lost. So the short answer appears to be that the difficulties in enforce what would seem to be common sense, established creditor rights allows bad men and bad practices to flourish. Lewis elaborates, starting with an illustration, Friendly’s Ice Cream:

Friendly’s is a case that shows how institutional corruption2 lives in the world of bankruptcy, especially for private equity companies that take companies private and wind up in bankruptcy. There is institutional corruption here because of legislative and regulatory inaction, built-in conflicts in the laws, and because of diffident judges unwilling to challenge the ideology of the market. Elements include unregulated shadow banking, the skewed power of secured lenders, and a nearly opaque practice that goes on in the shadows of bankruptcy, called credit-bidding. Institutional corruption has shaped a legal regime where values of protecting employees and retirees lose to practices that exploit American ideals in bankruptcy—ideals of shedding the past to create anew. Here, those practices are used as an efficient means to shed pension plans in insider deals.

As the headline promises, the article sets forth a how-to manual for how to use bankruptcy to dump pensions without wrecking the underlying business. Not to worry, Lewis is merely informing the broader public of how these tricks work. The playbook is already well known to insiders.

Public pension funds like CalPERS are the biggest investors in private equity, providing roughly 25% of assets under management. This practice of pension stripping means that public sector retirees pension payments depend in part on looting taxpayers and private sector retirees. Lewis has identified 51 private equity portfolio companies that have used bankruptcy to dump their pension obligations. That means $1.6 billion of additional costs to the general public via the federal Pension Benefit Guaranty Corporation, plus over 101,989 workers or retirees who have lost benefits of at least $128 million.

CalPERS takes particular care to make sure its investments don’t hurt state and local public sector employees; it has a long-standing policy to restrict investments in companies that outsource their jobs. It’s time to demand that state officials require that public pension funds take a tougher against funding private equity looting of the rest of us.

Private-equity-bad-man
Private equity bad man

Disclosure: We have made a private equity whistleblower filing to the SEC

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31 comments

  1. vlade

    There’s a corollary. To sue when a company is brought down by borrowing to pay dividend is not the only choice left to the borrowers. It’s the only one post-fact.

    The creditors could simply not lend to pay out dividends, and covenant around it. But there’s a whole host of incentives not to.

    Incidentally, is the cost to public really 1.6bn? 1.6bn in bills doesn’t mean 1.6bn in costs, as that depends on the assets the pensions had before. The only reason I’m asking is because if 1.6bn ignores assets it opens it to challenge with aim to mislead.

  2. reason

    “I’ve long been mystified as to why this isn’t considered a clear cut case of fraudulent conveyance, when consumers who do pretty much the same thing (max out on their credit cards and default within six months to a year) will have a resulting bankruptcy challenged by creditors. Applebaum and Batt did discuss one case that was so egregious that the creditors did sue, and its denouement may explain why creditors stand pat so often: it took years of legal wrangling and high legal costs for the lenders to extract a settlement, and it was markedly less than what they’d lost.”

    Isn’t the real question – why is this a civil case and not a criminal case?

  3. MikeNY

    A major driver of div-recaps is the desire for PE firms to recoup most or all of their equity investment while still keeping control (or “the option”) on the asset (the company). I’ve seen div-recaps within 6 or 8 months of the original deal. I’ve also seen cases of three div-recaps on the same asset, with the PE firm recouping well in excess of its investment, and still owning the company. It’s the perfect example of “other people’s money”.

    The private bank market goes along because typically they don’t want to lose their asset (i.e., the earning loan). This is especially true in hot markets, where managers are issuing new vehicles (CLOs) that need assets. In my experience, if there’s push-back, it is more often on pricing than structure.

    People talk about “fraudulent conveyance” sometimes in BK, but I can only recall one instance that lenders even tried to establish it. Lending professionals as much as PE firms have an interest in establishing the “Whocouldanode?” defense in BK. Personal careers ride on it. And of course there are always financial projections that show how the company could support the debt load. FWIW.

    The usual assumption is that in BK, any unfunded pension liability is unsecured, and subordinate to secured debt.

    1. steelhead23

      The usual assumption is that in BK, any unfunded pension liability is unsecured, and subordinate to secured debt.

      Ah, there’s the problem. Let us assume that banksters aren’t idiots (seriously, stop laughing) and that a PE loan officer is not also a PE GP – that is, let’s assume, just for giggles, that the bank really intends to profit off its loans to a PE-controlled company. If the unfunded pension liabilities were considered superior to secured debt in BK, the company would have to show much, much more collateral to secure a loan and there’s no way on God’s green earth a PE firm could BK a company for profit. Since this is a known strategy, let’s protect those sweet innocent banksters from the evil depredations of PE firms intentionally defaulting and change the BK rules – pensioners first – banksters get what’s left. This is the first time in my life where I have considered it possible to get a win-win for banksters and pensioners. Obviously an unworkable idea.

  4. Mary Wehrheim

    Millions of people due to a lifetime of stagnant or low wages, access to no or crappy pension plans, bankruptcies etc will have very little to retire on. As destitution gets worse, the goal of congress is to privatize to the vultures the one piece of the whole sorry equation that works….social security. You don’t have enough funds to retire…that is your bad. You should have gone into a career that enabled you to fleece so many people you end up with plenty of money to fend for your self. There seems to be some truth behind that saying, “Behind every fortune is a great crime.”

    1. Dr Tom Schmidt

      social Security doesn’t work for anyone born after 1960. I have been denuded of hundreds of thousands of dollars, with no hope of ever returning that money in a real fashion, let alone nominal dollars. “invested” in government bonds I would have enough money to retire on, if in my own account.

      It is a great deal if you were born in 1935, as a part of a generation that will pay no net taxes to the Federal Government. A group whose maximum “annual contribution” was $60 for years; a group that did not pay for Medicare until 1965; a group that will collect 4x out what was paid in. That I will give you.

      1. John Zelnicker

        True that workers only began paying for Medicare in 1965. That’s because there was no Medicare before then.

    2. sufferinsuccotash

      “Behind every fortune is a great crime.” — Not Chaucer, not Rabelais, but Balzac!

  5. diptherio

    Been re-watching Adam Curtis’s The Mayfair Set. One of the episodes looks at how Milken and his ilk used pension-fund money to squeeze workers via hostile take-overs and downsizing. This has been going on for quite awhile now.

    No wonder the WS a-holes think we’re all a bunch of muppets–we allow them to use our pension money to run a scam that enriches them at the expense of future pensioners (i.e. OUR KIDS). We are a bunch of idiots to let this go on, and every Pension Fund manager who is implicated should be ashamed of themselves. This idiocy has been going on my whole lifetime, and it doesn’t look like it’s going to stop any time soon. Muppets indeed…

  6. cnchal

    . . . This practice of pension stripping means that public sector retirees pension payments depend in part on looting taxpayers and private sector retirees.

    The public sector loots the private sector twice, once when taxes are paid to fund generous government employee pensions that no one in the private sector has, and then when the returns to the public sector pensions are not high enough to cover expenses, public sector pensions directly provide the funds to enable Pirate Equity to loot the portfolio companies, and strip the meager pensions of their employees.

    The public sector pension managers wash their hands of this by pointing to their contract with the pirates, and that the pirates have full control and decision making when it comes to portfolio companies.

    It is as if public sector pensions put up the cash to enable a criminal gang to run around robbing people.

    1. RUKidding

      You make some very good points about Pirate Equity and government pensions. I feel compelled to point out, however, that the majority of government pensions are not all that “generous.” They are fair, imo. The media constantly regales us with the outlier pensions that ARE, indeed, overly generous, but those pensions are the exceptions not the rule.

      I don’t have links handy, but I do believe that the average government worker’s pension is somewhere in the neighborhood of $30k per year, and sometimes, depending on various circumstances, the pension pay outs are taxed – as in, while the government worker obtained their pension funds via taxes or other fees, then the government worker *pays back* some of those taxes into the general funds upon receiving their pension.

      A lot of these little details are often lost in the rush to make it seem like all govt workers get amazingly salubrious pensions. They don’t.

      Plus why should govt workers NOT get pensions? My father, recently deceased, got a pension for over 30 years, after working over 30 years in the private sector. My dad was not in a union, yet he enjoyed his pension. Why should workers not get pensions? When did the notion of a pension become something that’s disgusting, evil or worse?

      Those latter questions are not asked of the prior commenter, but in general. Food for thought.

      Everyone loves to diss govt workers as some kind of parasitical blight on society. I posit it’s the 1% and their various minions who are.

      1. Felix_47

        The pension situation is outrageous. We have E4s who have served in the military for a couple of years who are getting out with lifetime pensions, then getting SSI, and VA disability pensions for things like backache, “stress” and whatever…..largely fraudulent or exaggerated. The average you quote includes those who have worked but a few years. Why don’t you comment on the average total income of a fireman or police officer in California or Illinois? The average number is very misleading. The median might be a lot better. Government pensions and disability are terribly abused. Just because the numbers are lower than the banker pigs feeding at the public trough does not make the crime any less. Bottom line….if we want a free society we need to stop sucking at the tit of the government…..meaning those who are working and paying taxes. Why do you think the average earner hates paying taxes?

        1. Brian M

          Given how expensive California is, why shouldn;t California firemen be paid decent wages?

  7. Stephen Rhodes

    Reminder of U S Steel case:

    “…In one such case, the investment banker Wilbur Ross, a man with a reputation for working with unions, joined forces with the United Steelworkers in 2002 to buy several shuttered steel mills out of bankruptcy. Ross persuaded the unions to cut wages and benefits, and restored the mills to profitability.

    Ross himself contributed only $90 million in cash; the rest of the multibillion-dollar purchase and upgrading was financed by debt and investment capital contributed by limited partners. Thousands of jobs were saved at reduced wages, but when Ross cashed out in 2005, his personal profit was fourteen times the money he’d invested. Appelbaum and Batt note that “his three year investment netted him $4.5 billion—just equal to what retirees lost in their health and pension plans.”

    Ross’s story, it should be made clear, is private equity at its best. More typical are the dozens of cases recounted by the authors where private equity has no interest in preserving a potentially profitable company or workers’ jobs, but simply seeks to extract as much profit as quickly as possible…”
    Why Work Is More and More Debased
    Robert Kuttner in NYRB Oct 23 2014

    1. MikeNY

      to extract as much profit as quickly as possible

      Otherwise known as the IRR. Absolutely true: this is the absolute standard on which PE funds measure (and market) themselves. I neglected to note that as another attraction of the div-recap in my post above.

  8. Buckaroo

    “We are a bunch of idiots to let this go on, and every Pension Fund manager who is implicated should be ashamed of themselves.”

    Why?

    “We have the best government that money can buy.” -Mark Twain

  9. Jim A

    It is my understanding that in many cases the PE firms sell their stake in the businesses after they have “turned them around” (loaded them with unsupportable levels of debt). So the real question is WHO are they selling these “dead men walking” zombie companies to and WHY are they overpaying?

    1. JTMcPhee

      Why do state pension funds, municipal pension funds, various state and local government agencies, and elected representative bodies like city and county councils, end up buying the shitty end of so many of these sticks?

      Maybe venality, corruption and stupidity? Along with cupidity and that old log-rolling impulse. And don’t the shit-sticks get re-packaged and re-branded and handed over to the really slick salespeople for the Great Houses of Finance to unload on the unsuspecting, ignorant and trusting?

    2. Vatch

      Others more knowledgeable than I am will no doubt provide answers, but I suspect that pension funds are among the buyers of zombie stocks.

  10. casino implosion

    “One of the big drivers of private equity bankruptcies is the strategy called dividend recapitalization, in which the private equity buyer borrows heavily for the main, and in some cases, sole purpose of paying a large dividend to investors.”

    Just like the transcontinental railroads that dominated 19th c American finance. Nothing changes.

  11. Ray Phenicie

    “Elements include unregulated shadow banking,”
    Just so happens I am reading one of the research papers at the Levy Institute “Reforming the Fed’s Policy Response in the Era of Shadow Banking.” I find amazing facts in here everyday: the most interesting being that the Federal Reserve had.no.clue. as to what the Shadow Banking industry was up to in 2007-08.
    Not. A. Clue. Have they picked up anything yet as to how to regulate? Of course that’s really the SEC’s job-actually the two together.

    1. abynormal

      interesting you bring up this regulation at this particular time…

      from 2013: ‘Shadow’ banks face 2015 deadline to comply with first global rules
      http://www.reuters.com/article/2013/08/29/us-g20-shadowbanking-rules-idUSBRE97S0TX20130829
      “Actual implementation won’t start until market conditions are right and authorities and industry have enough time to adjust their systems, the FSB said.”

      timing/the shadow spks: GE’s Jeff Immelt sounds off on Europe and ‘more regulation’
      http://fortune.com/2015/06/15/ge-immelt-regulation-europe/
      Immelt went on to critique Europe’s approach to wooing businesses. “They don’t have a single digital market,” he said, referring to Europe’s fractured system. “They don’t have a single power market. There is no community like Silicon Valley that’s matched in Europe. And so, young people like you who are living your dreams here, they don’t have that opportunity in Europe.[for me to germinate toxins via HFT, to reach to big to fail]

  12. Knute Rife

    Stripping off pension liabilities is perhaps the biggest reason to file a Chapter 11. Any other liability, including collective bargaining agreements, have a possibility of being negotiated away outside bankruptcy, but the only real way to get rid of a pension and keep operating is a Chapter 11.

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