Attempts at turnarounds of failing companies are only a very small portion of private equity investments. 

The distinguishing feature of private equity (PE) buyouts is that they are changes in the ownership and control of operating companies in the later stages of a company's history. The transactions are led by a private equity firm, and the firm sponsors PE funds that purchase operating companies for their portfolios. The PE firm is the general partner (GP) and makes all the decisions; pension funds and other investors are limited partners (LPs). Acquisition of an operating company entails extensive debt financing, with the burden of the debt falling on the acquired company, which is responsible for repaying it. The focus in this post is on the sources of gains to private equity investors from these leveraged buyouts.

Maybe most important, we begin by noting that private equity is not mainly engaged in buying up failing companies and trying to turn them around. The disproportionate emphasis in the media and by PE firms on efforts to turn around failing companies paints a distorted picture of what private equity does. Bill Clinton unfortunately bought into this view when he tried to explain what’s good about private equity on PBS NewsHour: "I’ve got a friend who buys failing companies, and he tries to turn them around. And he’s turned a bunch of them around, but not all of them. So sometimes he tried and failed. The effort was honorable. That’s a good thing."

The reality is that distressed investing makes up only a thin sliver of private equity investments, typically 1 to 2 percent of annual PE investments. Indeed, a study of 3,200 firms and 150,000 establishments found that establishments acquired in private equity buyouts had faster employment growth prior to takeover than comparable establishments not targeted by private equity. Private equity mainly acquires successful companies.

The sweet spot for private equity is a company doing okay in an industry whose fortunes are about to improve dramatically. This can be a source of PE returns, but it is the result of successfully timing the market.  Management fees that PE firms charge limited partners account for about two-thirds of the earnings of PE firms, but this affects the distribution of gains between GPs and LPs, and not the amount.  Net returns to investors of these fees are unclear. Top quartile PE funds are able to beat the S&P 500 index, but results for funds below the 75th percentile are ambiguous. Returns to large pension funds rarely exceed the stock market by more than the premium for holding illiquid assets. Our focus is on the nature of the private equity business model and what this tells us about the sources of aggregate gains to the GP and LP investors.

Several characteristics of the PE business model directly impact the operations of their portfolio companies:

First, private equity investments are illiquid and more highly leveraged than investments in publicly traded companies–hence, more risky. They need to yield high returns to be worth undertaking.

Second, the high debt that portfolio companies must service means they must quickly achieve an increased and predictable cash flow. Cutting costs by squeezing labor is the surest way to accomplish this.

Third, the PE model is the opposite of "patient capital." While limited partners make a long-term commitment to the PE fund, portfolio companies have only a short time to show results.

Fourth, asset stripping is typical in retail. When PE buys a department store chain, it typically splits it into a property company (prop-co) that owns the real estate and facilities that house the stores and an operating company (op-co) that runs the business. The op-co now must pay rent and no longer has a buffer to help it survive in volatile markets. PE sells the prop-co, making a profit on its initial investment regardless of whether the stores prosper.

Finally, PE will not undertake long-term investments in its portfolio companies unless capital markets are efficient and reward such investments with a higher price when the company is sold.

In most cases, top executives in operating companies face perverse incentives. They are handed a debt structure, asked to put up some of their own wealth, and promised great riches if they meet the targets set by the PE firm. If they fail to deliver quickly, they can expect to be fired. One study found that 39 percent of CEOs were replaced in the first 100 days and 69 percent in a four-year period. Like the hangman’s noose, this tends to focus managers’ minds on aggressive cost cutting.

Operational "value add" – the development and implementation of a business strategy that takes an operating company to the next level, and/or improvements in operations (supply chain management, modernization, process improvements, worker engagement) – harnesses the PE owners’ access to superior management skills and capital markets to improve performance. Buyouts of family-owned businesses and acquisitions of hospitals that lack funding to stay abreast of the latest technology are examples, as is distressed investing that rescues companies from bankruptcy. In these instances, private equity creates economic value as well as gains for PE investors. The evidence of these operating gains is thin, however, and even sympathetic academic studies are not persuasive. Greater transparency by this notoriously private industry would help establish how widespread such economic wealth-creating practices are.

The creation of economic value is one source of private equity gains. It is not the only source, however, and is often not the main source.

A second source of gains is a transfer from workers to PE investors, as employees at healthy companies that are performing well are laid off and those that remain are subject to an intensification of work. Wages and benefits may be reduced to increase predictable cash flow. Work may be shifted from union to non-union facilities. While such actions may be necessary in the case of distressed firms in need of a turnaround, the practice is applied far more widely.

Transfers from portfolio companies to PE owners are a third source of private equity gains. The portfolio company’s private equity shareholders may require it to issue junk bonds or may dip into its cash flow in order to pay them a dividend – a so-called dividend recapitalization. PE takes funds that should be used to improve portfolio company operations and create economic value. Often, this creates financial distress for the portfolio company and may even drive it into bankruptcy.

The op-co/prop-co model in retail also transfers assets from the portfolio company to its PE owners. The PE investors enrich themselves at the expense of the portfolio company, which receives little or none of the proceeds of the sale of the real estate assets. As a result, the risk of bankruptcy of the operating company increases. It may get into financial trouble and have to shutter some stores or close down entirely. As a result, the pace of job destruction in PE-owned retail establishments is far greater than in comparable non-PE owned establishments; over a five-year period, the difference cumulates to 12 percent.                 

A fourth source of gains is a transfer from taxpayers to private equity – what a state economic development officer termed "taxpayer financed capitalism." The leverage used to acquire the portfolio company alters its debt structure, increases its debt, and, because of the favorable tax treatment of debt compared to equity, reduces the company’s tax liabilities. Lower taxes raise the bottom line and increase the value of the company by 4 to 40 percent , thus increasing the returns to private equity without increasing economic value. In addition, the PE firm is more likely to be able to use tax arbitrage to legally avoid taxes. Some acquisitions are made for this purpose rather than to create value.

The final two sources of PE gains were identified in the first wave of leveraged buyouts in the 1980s. Shleifer and Summers identified breach of trust as a possible source of increased returns following an LBO. Stable enterprises depend on implicit contracts between shareholders and other stakeholders. Private equity can get a quick boost to a portfolio company’s bottom line by reneging on implicit contracts. This, however, undermines the trust necessary to the long-term sustainability of the portfolio company. Ackerlof and Romer identified the possibility of bankruptcy for profit. This occurs when a PE firm takes a portfolio company into bankruptcy and then buys it out of bankruptcy. The PE firm is still the owner, but the debts of the company have been slashed and its pension liabilities have been transferred to a government agency, the Pension Benefit Guarantee Corporation. The PE firm comes out ahead, but lenders take a haircut and workers receive reduced pensions.

The goal of public policy is to reduce incentives for rent-seeking activities by PE firms. There are several key policy changes that could have this effect: 

First, we can limit the tax deductibility of interest to remove the incentive to overleverage the acquired company. This will reduce the amount of debt placed on companies acquired by private equity. Highly leveraged companies perform poorly in volatile markets and have high rates of bankruptcy during economic downturns.

Second, we can raise the tax rate on capital gains received by individuals. There is no economic rationale for treating interest payments differently than dividends.

Third, we can tax "carried interest" – the share of the gains claimed by PE general partners, among others – as ordinary income. It is a bonus or pay for good performance and should be taxed as such.

Finally, we can require firms to make severance payments based on years of service when laying off workers. This would make layoffs a last resort rather than the first. 

Eileen Appelbaum is a Senior Economist at the Center for Economic and Policy Research.

Ludger Schuknecht's insistance on continued austerity is merely a discipinarian's argument, which has already been proven wrong time and again. 

The letter in today’s Financial Times, "Jointly Agreed Strategy is Good for Germany and Europe," from Ludger Schuknecht, the Director General of the German Ministry of Finance, will likely live in infamy. In any case, frame it for your children as a symbol of the folly of mankind. In the sternest terms, Mr. Schuknecht chastises Martin Wolf for demanding a reversal of fiscal austerity. Why? “The public and markets have been led to believe in short-term measures for far too long.” Goodbye to Keynes, and even Friedman.

Moreover, he argues, “it is expansionary policies and weak fiscal positions that created the current problems of high debt and low competitiveness.” Of course, the Eurozone deficit was only 0.5 percent of GDP before the crisis. In Spain, fiscal policy was clearly restrained before the crisis. Few could argue the European Central Bank practiced loose monetary policy over these years.  

According to Mr. Schuknecht, we need “a combination of fiscal consolidation and structural reforms.” And all of this with the goal of rebuilding confidence. How can we be hearing this again, after the failure of austerity in country after country?  Now even the conservative Spanish government is admitting failure.

Evidence is not the issue here. Surely the impressive IMF research on the failure of austerity time and again cannot be simply dismissed. But dismiss it Mr. Schuknecht clearly does. Heaven forbid we introduce Eurobonds, which will undermine the confidence being built.

Clearly the German government sees confidence somewhere, but it is surely not in the financial markets.

I long to ask Mr. Schuknecht what he believes caused the Great Depression. He may have written about this somewhere; I assume he thinks uncertainty and government spending were the causes. I wonder if he can point to one credible case where austerity worked without a concurrent devaluation of the currency.

But such arguments do not seem to turn on evidence or theory.  They come from the stern gut of a schoolmaster, and they come from a nation that has yet to suffer the consequences of the current crisis. The inability or refusal to see ahead is the sure sign of an ideologue. But I think this is not even ideology; it is the instinct of the disciplinarian. And it is mixed with a desire to diminish government. Another rap on the knuckles with the ruler will bring confidence, confidence will bring investment, and investment, prosperity. We were told the same in the 1930s, but never mind all that.  

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

Private equity disproportionately rewards privatization companies while others are burdened with the risks. 

I wanted to wait a few days before commenting on Newark Mayor Cory Booker’s spontaneous criticism of Barack Obama for picking on Mitt Romney's experience at Bain Capital. Booker doesn’t know much of anything about private equity, but many financial services donors have his ear. He took in nearly half a million dollars in campaign donations from the industry over the last nine months, and he frankly sounded like its mouthpiece.

Booker backtracked, but it would be nice if he knew something about the private equity business before he spoke publicly about it. This expectation of knowledge should also apply to widely read columnists like David Brooks, who, as usual, reflexively defended the Wall Street practice without presenting evidence. He issued a piece of public relations diatribe that no doubt soothed the right but contributed nothing to our understanding. The contention is that these buyouts turned fat American companies into lean and productive ones since the 1970s. Other pundits less well known for their conservative reflex responses have also given partial defense of private equity.

So let’s begin with one point: there is a place for private equity. In a privatization or leveraged buyout, a company is bought by an investment partnership with moneys borrowed against the company itself. The new money can be used productively even when levels of debt against the company’s assets and profits soar. A smaller company that cannot raise adequate equity can raise money by being bought by a private equity partnership. A company that is doing poorly can benefit from added capital and new management. Sometimes trimming labor costs in the process makes sense, of course. 

But the record of leveraged buyouts and private equity reflects its excesses, and most importantly, the lopsided nature of the financial incentives for doing the deals in the first place. Companies like Romney’s Bain or Steve Schwartz’s Blackstone or Kohlberg Kravis Roberts, the early industry leader when privatizations were called leverage buyouts (LBO), take advantage of a major government-provided benefit. The interest on debt is tax-deductible, and high levels of debt are the source of profits in these transactions. It is just like buying a house with a small down payment; if you can sell as the value goes up, the return on the down payment is high and the interest was deductible all along. In the meantime, the house is collateral for the loan. Similarly, partners are rarely if ever on the line for the debt; the company being privatized is. The one difference is that if the collateral value of the house falls, as it has recently, the homeowner is on the line. This is usually not so with privatizers.  

Great deal? You bet. The owners of the privatizing firm put up very little capital; it is their limited partners who put up more.  Then they borrow like mad from banks, pension funds, hedge funds and so on. If the new company can be sold or brought to market again at a higher price, they make a bundle compared to their equity down payment. The CEOs of the company, or the new executives brought in, are given huge amounts of stock. They too make a bundle. Are these incentives conducive to good business decisions?

Most likely, the investment decision is based not on how much the company can be improved, but how much can be borrowed against its assets. The second concern is the interest rate on the debt. There is no evidence that privatizers mostly buy struggling companies to resuscitate them.

Moreover, companies with high levels of debt are subject to great risk of bankruptcy. Macy’s did one of the first leveraged buyouts of its size, the CEO made out wonderfully, and soon Macy’s was in bankruptcy. It reorganized and reemerged successfully due to its retailing skills, but these were not enhanced by the LBO partners.  

Data shows the newly bought firms create fewer new jobs—or result in more lost jobs—than firms that are not subject to private takeover. But what about the much-lauded productivity gains? On balance, these target firms mostly increase productivity by selling or closing low-productivity units. Arguably, they also make their employees work harder. The fear of lay-offs can enhance productivity. There is no evidence that these firms improve productivity mostly by investing in new technologies, new managerial methods, and so on, which is often their claim.

And of course what productivity gains they have had (overall they are small) did not reinvigorate the American economy. The two main sources of productivity gains in the U.S. were high-tech companies and the retailing behemoths led by WalMart. Many retailing targets of privatizations eventually went bankrupt.

The best recent paper on private equity was written by Eileen Appelbaum of the Center for Economic and Policy Research and Rosemary Batt of Cornell University. The David Brookses of the world will cry that these researchers are of a liberal bent. But read the paper to see how carefully it is done. The exegeses of much of the right in defense of private equity are essentially outright propaganda.   

However, the basic point comes back to government and regulation. A major tax advantage gives rise to these buyouts. The privatization partnerships are lightly regulated. After-fee returns to the limited partners seem to be below average. But as for their benefits to society, privatization rewards investors by cutting short-term costs. For a long time, the stock market pushed up the stock prices of companies that kept short-term earnings growing. The influence of such corporate governance has been to keep downward pressure on wages and stoke fear in employees for three decades.

Let’s be clear; some private equity investments were healthy and some of these partnerships do a good job. But all in all, it is clear most are simply exploitations of tax law, market fashions, and their power to borrow money. There is no reason America should reward these investors with a tax break on their huge loans.   

Privatizers didn’t rebuild America. They were rarely the people who planted the garden, watered it, or designed it.  They were by and large the ones who weeded it, sometimes recklessly, throwing out the gorgeous roses in the process. Gardens do need to be weeded, but should those who do the weeding, often heedlessly, make so much more money than those who do the planting? And with the added help of government tax breaks?

In the end, Romney’s Bain made money even though its takeover target, American Pad & Paper, went out of business. Consult Appelbaum and Batt on how some of these strategies work, involving mortgaging real estate holdings and transfer pricing to reduce taxes. Privatization was mostly, if not entirely, about working the system, not building capitalism.  On balance, evidence suggests it hurt more than helped. Any way you read the evidence, it is clear the rewards for private equity firms clearly exceeded the risks. That’s not good for free markets.  

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

The inherent problems and contradictions of Wall Street trading make government intervention a necessity.  

The fiasco at JPMorgan Chase is most disturbing because it reflects the inherent riskiness of modern financial trading. Few articles have pinpointed this as the problem. It is the reason strong regulations and high capital requirements are necessary; you can’t outsmart these inherent contradictions.

JPMorgan ran its trading operation out of its risk management group, which was supposed to offset risk, not take on new ones. But even if you are trying to implement a pure hedge—that is, minimize risk—there are two big issues here. One is the inefficiency of markets and the lack of adequate information. You can buy or sell a security—usually a derivative, or a leveraged security based on the ups and downs of another security—to hedge a position, such as a portfolio of bonds you think might readily fall in value. This was the Chase situation. 

However, the first problem with this is that the hedge is not necessarily properly priced, because the markets are inefficient and prices are not transparent to all. It is often too cheap. Second, the counter-party—the seller or buyer on the other side of the transaction—may not meet his or her commitment. This is what happened when AIG sold insurance (credit default swaps) to Goldman Sachs and then couldn’t pay it off without a government bailout when markets collapsed.

The next big issue is the human one. Judging from press accounts, JPMorgan wasn’t trying merely to hedge. In truth, there are no pure hedges or people wouldn’t make money at all. Nothing can eradicate risk completely. Rather, JPMorgan looked like they were taking long and short positions on balance—that is, trying to win bigger by guessing the direction of the markets, not just hedge.   

Again, there are two problems within this larger issue. First is the inalterable human temptation to make a big killing, especially when the individual bankers are being paid big bonuses to do so and suffer relatively little if they guess wrong. Call this asymmetric incentive. They may even have changed their own yardstick, or value at risk, to seem like they were taking less risk. No doubt they had some kind of argument to do so.

The second is a more subtle one. Traders usually believe that at some point securities prices will revert to their long-term values compared to each other. This was the philosophy behind the hedge fund Long-Term Capital Management (LTCM). It is very likely the traders at JPMorgan doubled down rather than try to unwind their positions, believing that markets would soon adjust to some historical averages and prove them right. The people at LTCM bought when others were selling, certain that they could hold on until markets adjusted. They could not.

These basic facts of Wall Street life are inescapable. Thus, the JPMorgan fiasco is a repeat of what happened time and again in 2007 and 2008, such as with AIG, and what happened in the 1990s with LTCM, and many others.   

Why did Jamie Dimon think he knew better? The repetition even extends to the fact that the risk manager and the trader were friends. The same was true at Citigroup before it lost a ton of money, to the surprise of its own management, as mortgage markets began to crack a few years ago.

These are fundamental, baked-in problems for Wall Street trading. Some, like today’s Wall Street Journal, will say losses are a part of capitalism and capitalists learn from their errors. The main lesson here is that they don’t learn and they can’t.

This is a job for government. Tough regulations are needed. If these firms and their employees had to absorb their own losses, perhaps there would be justification for some of these risks. That banks like JPMorgan are supported by FDIC-insured funds, that they have shareholders, and that they are so big their losses will always be guaranteed by the taxpayers, are all reasons that strong regulations are necessary. Their losses were a failure of regulation once again, reflecting the continued need for strong capital requirements, a broader Volcker rule, and transparency and margin requirements in derivatives trading. Some of that is coming. Clearly, it is not here yet and may not be here at all.

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.