Private equity is finally getting some long overdue official scrutiny via a series of Congressional moves. One is the full House Financial Services Committee meeting today, at 10:00 AM, America for Sale? An Examination of the Practices of Private Funds. You will find the live webcast at that link, as well as links on that page to the written testimony of each of the witnesses. This is a meaty topic, plus AOC should be on deck, so I hope you can catch at least some of the hearings and comment here if you are so moved.
In addition to this hearing, other measures underway are the bipartisan bills in the House and Senate to prevent surprise billing (which as we’ve discussed, is in large measure the result of private equity buying, consolidating, and exploiting various physicians’ practices that provide outsourced services to hospitals). The hard-ball lobbying against the bill generated a backlash, with the Energy and Commerce committee as well as Senator Elizabeth Warren and Representatives Mark Pocan and Lloyd Doggett all seeking pricing information from the major private equity firms engaged in these practices.
The big question may be, “Why now?” We’ve been writing about private equity’s dodgy practices for years, and we are not alone. The testimony provides an answer. The short version is that it is finally becoming obvious to too many people that for the most part, private equity’s profits come at the expense of everyone else. (For convenience, we are referring to private equity, but bear in mind that some hedge funds also will buy companies)
Private equity firms also seem rattled by Elizabeth Warren’s “Stop Wall Street Looting Act,” which would make private equity general partners and their control persons jointly and severally liable for all liabilities of the companies they acquire, as well as of the investment fund. Georgetown law professor Adam Levitin explains why, contrary to what the industry would have you believe, this is not an outlandish idea (in fact, the “heads I win, tails you lose” arrangement that private equity firms have created is what ought to be regarded as outlandish).
In a post last week, Levitin shreds the “Chicken Little” claims of the damage that the Warren bill would supposedly do, seeing them as a measure of industry worry. Another indicator of the industry’s diminished stature: the number of critical articles, even within the normally deferential financial press. For instance, Mark Hulbert’s MarketWatch op-ed last week used the proposed KKR leveraged buyout of Walgreens as a point of departure for a broad-ranging critique of private equity’s underwhelming returns. The damning subhead: “No evidence that public companies perform better after being taken private”
The lead witness, Eileen Appelbaum, has with her research/writing partner Rosemary Batt, been dogging this industry for a very long time. Their publication of the seminal book Private Equity at Work meticulously documented numerous private equity practices that were not widely known, plus gave careful readings of academic research. Appelbaum and Batt painstakings demonstrated that findings that were presented in the papers themselves as favorable to the industry regularly didn’t hold up when you read the study methodology and results. It was revealing to see the efforts soi-disant scholars twist their own results to flatter private equity. But this should come as no surprise since the overwhelming majority of academics who study private equity earn far more from consulting to private equity firms than they do from their day jobs.1
Appelbaum’s written testimony gives a high level but well documented overview of how private equity operates and how many of its practices are destructive. She points out that while smaller deals normally do lead to fundamenal growth of the acquired business,2 the big transactions, which is where most of the private equity dollars go, rely on leverage and financial engineering. And to add insult to injury, the mega funds which make the big deals earn the considerable majority of their income from risk-free fees, as opposed to profit participations.
Appelbaum focuses on two hot topics. One is retail bankruptcies, exemplified by Toy ‘R” Us. Toy ‘R’ Us clearly failed as a result of excessive leverage, which included selling its real estate and then forcing the stores to lease the properties back. This “op co/prop co” strategy has wrecked many a retailer, since owning their real estate outright would lower their cost base and enable them to ride out downturns. Not only would the private equity firms strip them of this protection, but they would often saddle the retailer with high-cost leases so as to make the sale price of the real estate even higher and allowing them to pull even more cash out of the deal early.
The second focus is private equity’s role in surprise billing. Here Appelbaum deserves to take a star turn since she documented in gory detail how two major firms, KKR and Blackstone, have played major roles in driving up hospital costs (they aren’t alone, mind you; they are just the biggest perps), doing the heavy lifting that the mainstream media re-reported.
Interestingly, the committee is also hearing from a private equity industry limited partner, Wayne Moore, a trustee of the Los Angeles County Employees Retirement Association. And mirable dictu, not only is he not a cheerleader, but he confirms the concerns we’ve been raising for years over excessive fees, lack of transparency and badly aligned incentives. Giovanna De La Rosa, a United for Respect Leader and 20 year veteran of Toys ‘R’ Us, speaks about how much the closures have cost her and other employees.
Despite the lofty consulting fees that the private equity industry lavishes on academics, curiously none of them is coming to defend their meal tickets. The two witnesses making the case for private equity are both from astroturf groups, one the American Investment Council and the other, the Small Business Investor Alliance. Their written submissions are awfully lightweight.
So hope you have time to catch at least some of the proceedings. Again, the link to the webcast is here.
1 One of my colleagues, newly installed in a (believe it or not, non-tenured) chair named for a private equity kingpin was invited to his office and offered a consulting gig. It was pretty close to money for nothing: “Why don’t you come and observe what we do and tell us if you have any ideas for what we could do?” My colleague, who has managed to rise in academia despite his fierce independence, found a way to politely turn down this, erm, opportunity.
2 While Appelbaum’s and Batt’s research does show that smaller deals, of transaction sizes of $50 million or smaller, typically do result in growth of the operation, and Appelbaum may have decided not to argue over these deals because the big ones that consume the bulk of investment dollars are so clearly destructive, that does not necessarily mean the private equity firms are adding enough value to offset their fees. Some members of the industry concede that private equity companies may simply be good at finding “growth-y” companies. That is confirmed by investment strategies that engage in public market replication of private equity, as in buying public companies that have characteristics that would make them attractive to private equity firms. Those strategies deliver returns similar to private equity net returns.