The US Democratic politician Elizabeth Warren recently published a piece of draft legislation with the eye-catching title of the “Stop Wall Street Looting Act”. Sounds a touch light-hearted? Well, actually it is deadly serious.
The “looters” in the title are private equity funds; specialist investors that buy companies using large amounts of debt. Once a minority activity, private equity has grown mightily over the past four decades on both sides of the Atlantic. As of 2017, there were around 8,000 private-equity owned businesses in the US. That is nearly twice as many as there were listed firms.
Quite how this expansion has been accomplished lies at the heart of the story. Private equity executives insist their practices have spread because they run these companies better. That may be true in some cases — perhaps many. But there is a more questionable side to the buyout industry’s astonishing, Triffid-like growth.
It stems from the way that private equity deals are structured. When buyout firms acquire a business, they fund the transaction primarily with borrowed money. This is then pushed down on to the portfolio company, which has to service those heavy debts.
The result is a company that may be leaner because of the so-called “discipline of debt”. Remember, financial engineering is a core skill for private equity. But it’s also far less resilient to business downturns or idiosyncratic problems. Its main recourse when these strike is simply to sell assets, cut back on staff numbers or squeeze the amount the business invests.
Ms Warren’s biggest problem is with the incentives that drive this exercise. By raising debt levels, buyout insiders increase the gearing on the call option that equity ownership of any company represents. This gives them an incentive to shuffle collateral out of the reach of creditors, whether by taking fat fees for such marginal activities as “monitoring”, or extracting assets in the form of leveraged dividends. If the deal ultimately flourishes; great. But if it doesn’t, well, they’re fine too.
“Heads I win, tails you lose” capitalism may be great for buyout insiders, egging them on to pay ever more extravagant prices for targets. But it hurts the taxpayers who must meet the social costs of closures. And the biggest losers are of course employees and retirees, who have no ability to diversify their exposure to the financial game that’s under way.
If you think those fees are peanuts, think again. When Toys “R” Us collapsed last year after the debts from a $6.6bn buyout in 2006 finally felled the US retailer, it turned out its private equity backers had collected fee income worth $470m. The outcome for the workers: some 33,000 lost their jobs.
The concern is that private equity is presiding over a systemic abuse of limited liability. Safe in the knowledge that their own downside is capped at their equity contribution, buyout bosses are heedless of the havoc they create for others.
And while in theory, the pension funds that are the main backers of buyouts should be mindful of the temptations they’re dangling before insiders (and the hefty fees they are paying), in practice they are too conflicted and return-hungry to trouble themselves that much.
Ms Warren’s answer is simple and decisive. She would whip away the most harmful incentives, withdrawing the privilege of limited liability for private equity investments, and making the acquiring firm liable for the debts of its portfolio companies.
If a private equity business went bust, the creditors would be able to go after the assets of the fund sponsor, as well as the personal wealth of its general partners. The bill would also capture transfers that shifted collateral out of the reach of lenders. These would all be fraudulent, unless proven otherwise.
Private equity would also be restricted in its ability to scoop out all those juicy monitoring fees and special dividends.
Despite its unlikelihood of passing into law, Ms Warren’s bill has provoked predictable outrage among the industry. The American Investment Council (AIC), a trade body, calls its provisions “oppressive” and “extreme” and warns that it “would make it next to impossible for investors to invest in struggling businesses that need capital”.
But, of course, Ms Warren’s proposals would do nothing to harm responsible private equity firms — most of whose investments (as the AIC attests) never enter bankruptcy. What they would do is to limit the ability of buyout bosses to use their privileged position to milk portfolio companies unduly, and pay ever more extravagant prices for firms using other people’s money.
These practices mean that private equity is increasingly gambling with the real economy. A sensible society would not allow it to rig the odds.