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