- Paperback: 396 pages
- Publisher: Russell Sage Foundation (May 1, 2014)
- Language: English
- ISBN-10: 0871540398
- ISBN-13: 978-0871540393
- Product Dimensions: 6 x 1.3 x 9 inches
- Shipping Weight: 1.3 pounds (View shipping rates and policies)
- Average Customer Review: 9 customer reviews
- Amazon Best Sellers Rank: #568,870 in Books (See Top 100 in Books)
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Private Equity at Work: When Wall Street Manages Main Street
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Deregulation of the financial markets and investor thirst for higher profits have given an enormous boost to private equity financiers. They buy companies, issue huge debt, and reconfigure or dismantle them for profitable returns, sometimes at the expense of workers, suppliers, customers, and creditors. Yet because they are not publicly owned, private equity firms have little transparency or accountability. Economic scholars Appelbaum and Batt shine some light on the shadowy world of private equity and its high risk-reward profile. They clearly explain how private equity investments differ from publicly traded companies and explore their impact on the broader U.S. economy, particularly because so many pension funds are investors in private equity deals. They explore the impact of private equity deals on the labor market as more and more acquired companies are encouraged to reduce their workforces to give greater return to investors. Finally, Appelbaum and Batt recommend changes in public policy to reduce incentives that overburden companies with debt and to promote greater transparency in such deals. A dense but accessible look at a little-understood sector of the financial markets. --Vanessa Bush
About the Author
EILEEN APPELBAUM is senior economist at the Center for Economic and Policy Research, Washington, D.C. and Visiting Professor in the Management Department, University of Leicester, UK.
ROSEMARY BATT is the Alice Hanson Cook Professor of Women and Work at the Industrial and Labor Relations School, Cornell University.
Top customer reviews
A private equity firm is controlled by the general partners who typically contribute just 1 or 2 percent of the working capital while the remaining equity is provided by limited partners such as pension funds who commit their investments for an extended period which can be up to 10 years. PE funds improve their returns by the aggressive use of leverage whereby they may borrow as much as 94% (in the sad case of KB Toys) of a target company’s purchase price. With a highly leveraged purchase, a small increase in the value of the company can produce a large return to the owners and the general partners are also in the fortunate position of using other peoples’ money to buy a company which may then hire them as highly paid consultants …
"The general partner receives three streams of income: management fees from the limited partners, profits from investments, and fees from the portfolio companies."
Loans are easier to obtain when they can be secured against tangible assets such as property so retailers and restaurant groups have been common acquisition targets and A&B present several case studies where such deals have resulted in bankruptcies and mass layoffs.
"the Wall Street Journal 's analysis of Bain Capital's performance found that of the seventy- seven businesses that Bain invested in from 1984 to early 1999, 22 percent either filed for bankruptcy reorganization or were liquidated by the end of the eighth year."
When a portfolio company defaults on its debt repayment, this does not directly impact the PE owners because of the protections inherent in the status of a limited company …
"… U.S. corporate law recognizes corporations as legal entities separate from their shareholders, officers, and directors. Corporate
obligations are the liability of the corporation, not of the shareholders who own the corporation."
This separation becomes strained when the owner is a PE group which appoints all the company directors and the authors offer a few case studies where the owners have been held liable for debt and at least one other instance where they were asked to underwrite it – and refused to do so.
A&B provide many case studies to support their arguments and there are extensive notes and references which comprise 22% of the Kindle edition. However, the book is somewhat repetitious for the general reader and the same issues – of excessive leverage, moral hazard and perverse tax incentives seem to be raised again and again. The academic style with numerous citations in the text detracts from the clarity of the explanation and footnotes would have been preferable. The exclusive focus on US examples is also somewhat limiting – especially since Applebaum is a UK-based economist. Given the large number of case studies, it would have been helpful to present them in a more uniform format and to list them in a separate index.
Chapter 6 asses the performance of PE funds with a particular focus on the internal rate of return However, the authors neglect to explain how this is calculated – perhaps subscribing to Stephen Hawking’s adage that including the formula would halve their sales – and their largely verbal attempts to explain its limitations are vague and difficult to follow. More worked examples and graphics would have been helpful.
At the time of writing, the Kindle edition is on sale for about $4 and, at that price, it is very good value. If you are just skimming through it, the case studies in chapter 3 are probably the most interesting – particularly that of the medical software supplier, Awarix. Case studies with largely negative outcomes (for stakeholders other than the general partners that is) are so numerous it is not worth singling any out – just open the book at random.
The Kindle edition is reasonably well presented. Figures can be expanded to full page and there is a comprehensive index with hyperlinks. However, the publishers should be aware that it is not possible to flip through a long index on a Kindle so it really needs to have a ‘thumb index’ with a hyperlink to the start of each letter.
To their credit, Ms. Appelbaum and Ms. Batt don't characterize all PE firms as uniformly harmful to the acquired companies and their stakeholders. Some PE firms - especially those that buy and sell small or mid-market companies with enterprise values lower than $300 million - may undertake profit-seeking activities by creating value and increasing wealth not just for themselves, but also for the acquired companies and their stakeholders.
Unfortunately, all too often PE firms undertake rent-seeking activities that maximize their own returns while putting operating companies and their stakeholders at risk. Both authors examine financial engineering activities such as high leverage, the sale of assets, tax arbitrage, dividend recapitalizations, and the use of bankruptcy proceedings under rent-seeking activities.
Ms. Appelbaum and Ms. Batt call for thirteen policies to rein in the PE excesses that they documented in the book under review:
1) Curb private equity compensation to reduce moral hazard and risky behavior. The current legislation on this subject does not have real teeth to reduce the incentives for excessive risk-taking for financial institutions, including PE firms.
2) End preferential tax treatment of carried interest. Both authors argue that the general partners of PE firms are similar to real estate developers and should be taxed accordingly.
3) Reduce incentives to load portfolio companies with excessive debt. The tax advantages of debt amount to a subsidy from taxpayers, contributing substantially to the PE funds' returns.
4) Limit debt. Ms. Appelbaum and Ms. Batt contend that legally binding regulations would be a more effective enforcement mechanism than existing guidelines on this subject.
5) Discourage further PE's contribution to the growth of the shadow banking system. Both authors note that the current reporting is a necessary but insufficient step in the right direction. They call for a legal framework that establishes limits on the use of leverage, subject to review by regulators.
6) Reduce incentives for asset stripping. Removing the limited liability protections of PE shareholders in cases where the assets of a newly acquired portfolio company are sold off would reduce the incentives to engage in such behavior when it is contrary to the company's interest.
7) Prohibit dividend payments to PE investors in the first two years. That moratorium would curb the most reckless use of dividend payments to PE shareholders.
8) Increase transparency. The Institutional Limited Partners Association (ILPA) principles should propose that PE funds report quarterly, using final public market equivalent (PME) values as a more accurate guide to fund performance compared to the internal rate of return (IRR).
9) Update the Worker Adjustment and Retraining Notification (WARN) Act to recognize the role of PE owners as employers. Recognizing the liability of PE owners who exercise de facto control over decisions regarding mass layoffs and facility closings would assure workers and communities of the protections that the US Congress intended when it required employers to provide sixty days' advance notice of shutdowns.
10) Hold PE equity owners accountable for portfolio companies' pension liabilities. The authors argue that the Employee Retirement Income Security Act (ERISA) and certain provisions of the bankruptcy code do not offer enough protection to the deferred income that workers earn during their working years and receive when they retire.
11) Update ERISA. Against this backdrop, the US Congress should act to remove any doubt about the obligations of PE funds for employee pensions.
12) Update the bankruptcy code. Ms. Appelbaum and Ms. Batt contend that the US Congress should restore a fair and equitable balance among the competing interests of a bankrupt company's secured and unsecured creditors.
13) Require severance pay for employees linked to years of service. Analogous to the "golden parachutes" that companies typically provide to executives, such severance packages would give lower-level employees comparable protection against the negative effects of job dislocation.
To their credit, both authors recognize that it will be challenging to achieve these policy reforms for four reasons:
1) The financial services industry spends much on campaign contributions and lobbying to defend its interests.
2) "Regulatory arbitrage" can lead to sub-optimal regulations.
3) The "revolving door" between employment in the financial services industry and public-sector employment in regulatory agencies can be shut to politicians and regulators who push "too hard" on this subject.
4) This "revolving door" can lead to "cognitive capture" of regulators who tend to embrace the perspective of their (former) industry rather than that of the public.
Ms. Appelbaum and Ms. Batt contend that PE firms that make their money as advertised by the Private Equity Growth Capital Council (PEGCC) and other industry advocates, by adding value to the portfolio companies they acquire, will see little difference as a result of the policies mentioned above.
In summary, the book under review, especially the policies advocated in chapter 9, is guaranteed to generate controversy.