CalPERS and CalSTRS are both boosting investments in private equity, which includes leveraged buyouts that a new book says bankrupted many companies, eliminated thousands of jobs and may cause a new credit crisis.
“The Buyout of America” by veteran financial reporter Josh Kosman is a full-on assault on private equity firms now said to employ one of every 10 Americans in the private sector and to have produced 17 of the 400 wealthiest Americans.
In the scramble for pension fund money, CalPERS revealed last month that three private equity firms paid more than $50 million in fees to the “placement agent” firm of former CalPERS board member Al Villalobos.
For a typical leveraged buyout, says Kosman, private equity firms put up about 2 percent of the purchase price, pension funds and other investors about 30 percent, and the rest is borrowed by the company being purchased.
The plan is to make the company more efficient, often by bringing in new management, cutting costs by laying off workers and selling parts of the company. Then in about five years the company is sold or taken public through a stock offering.
But Kosman says the private equity firms often seek short-term gains by cutting customer services, raising prices and failing to invest in the company’s infrastructure and research and development, damaging long-term prospects.
He says private equity firms also have the companies borrow not to pay off debt or improve the company but to pay dividends to the investors — a practice pioneered by, among others, Bain Capital under Mitt Romney, the former GOP presidential candidate.
During a previous buyout boom in the 1980s, Kosman says, half of the 25 companies that borrowed $1 billion or more went bankrupt. He contends that of the 10 largest buyouts in the 1990s, six of the companies were made worse not improved.
Now the fate of many of the more than 3,000 companies purchased by private equity firms from 2000 to 2008 during another buyout boom is predicted in the subtitle of the book: “How private equity will cause the next great credit crisis.”
About $1 trillion worth of loans from banks and other lenders were used to buy companies, Kosman says. Often the loans were sliced up and resold in bundled pieces, like the subprime mortgages at the center of the financial crisis last fall.
The principal on many of the loans comes due in 2012 through 2014. There are predictions that about half of the private equity-owned companies will not be able to repay their loans and default.
Most notably, the Boston Consulting Group reported last December that new research indicates “most private equity firms portfolio companies are expected to default on their debts, which are estimated at about $1 trillion.”
Kosman says that if half of the private equity-owned firms collapse between 2012 and 2015, file for bankruptcy and fire half of their workers, about 1.875 million jobs will be lost.
Will the credit markets recover and allow the loans to be refinanced? Will the private equity firms, said to be sitting on about $450 billion, make investments to bolster their companies?
Kosman acknowledges that there are unanswered questions. But he is not optimistic, predicting that many of the companies will collapse because of the “greed and grossly short-sighted management policies of their private-equity owners.”
The book published this month has been getting national attention in Time magazine and on National Public Radio. A review in the Wall Street Journal by another veteran financial reporter, Randall Smith, is generally favorable.
“Mr. Kosman brings to the subject a relentlessly critical approach that is refreshing, simply because so many stories about the buyout firms are the sort of puff pieces that result from delicate negotiations for access,” wrote Smith.
“He documents dozens of companies acquired in buyouts—such as hospitals, mattress manufacturers and a car-parts makers—whose service or products went downhill, whose employees suffered pay cuts or layoffs, and whose fortunes plummeted, sometimes ending in bankruptcy.
A large union with members in the public and private sectors, the Service Employees International Union, criticizes private equity on its website, Behindthebuyouts.org.
The Private Equity Council, on the other hand, has posted a rebuttal of the Kosman book on its website.
“Kosman demonstrates a sharp bias against the private equity industry as he distorts facts, misquotes research and ignores evidence that does not support his thesis,” says the council.
A case in point: the Boston Consulting Group report said the large number of defaults should not trigger an economic “shock wave” and that the companies owned by private equity firms have the same chances of survival as other companies.
The Boston report said “the private equity model is here to stay,” but predicted that 20 to 40 percent of the current private equity firms may disappear in the shakeout following the financial crisis last year.
“It is also likely that the winners will consolidate the market, lay the foundations for superior long-term returns by investing in cheap assets during the downturns, and emerge with an even greater focus on operational value creation,” said the report.
A chance to pick some winners would be good news for the California Public Employees Retirement System and the California State Teachers Retirement System, which both increased their private equity investment allocation this year.
CalPERS boosted its private equity target from 10 to 14 percent of its total investments, CalSTRS from 9 to 12 percent. Both are expecting to get about a 12 percent return from private equity, more than from publicly traded stocks.
“Private equity” is usually a broad term that covers about a half dozen things, including venture capital that is invested in a startup or expanding firm. But most of the big gains in recent years have been in leveraged buyouts.
It was a triumph of rebranding, says Kosman, when leveraged buyouts, which triggered congressional hearings after excesses during the Michael Milken junk-bond era of the 1980s, resurfaced as private equity.
One chapter in the book, “A Different Approach,” chronicles a buyout, General Instruments in 1990, that arguably improved the company, despite missteps such as the loss of lucrative fiber optic patents.
Kosman advocates the closure of private equity “tax loopholes” that allow deductions for interest payments on company loans and apply low capital gains rates to commissions, rather than much higher income tax rates.
“What is the downside of enacting tougher new laws and closing loopholes? Not a lot,” wrote Kosman.
“Those small number of PE firms that really improve companies could continue with little interference because they can earn money without debt financing,” he said. “Such changes would hurt only the majority of PE firms that make fortunes by starving businesses while saddling them with big debt burdens.”
Reporter Ed Mendel, long considered the state’s premier budget reporter, covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. His stories can be seen at his blog, CalPensions.