Corporate Research E-Letter No. 64, March-April 2007
PRIVATE INEQUITY: HOW MAMMOTH BUYOUTS
ARE CHANGING BUSINESS FOR THE WORSE
By Philip Mattera
Millions of people worry each day about the ups and downs of the Dow Jones Industrial Average, but the real action in big business is increasingly taking place not in public stock markets but in an arena known as private equity. What sounds like a topic of interest only to accountants is actually a trend with widespread consequences for us all. Buyouts of large companies are making a few people fabulously rich but are also weakening parts of the economy, eroding job security and limiting the ability of society to exercise oversight of Corporate America.
Fueled by low interest rates and a steady flow of capital from large investors, private equity deals have been popping up everywhere in the business world during the past few years. Well-known companies such as Hertz, Toys “R” Us, Dunkin’ Donuts and Madame Tussauds waxworks museums have been subjected to buyouts. Former CEOs of major publicly traded companies, such as Jack Welch of General Electric and Louis Gerstner of IBM, are now in the buyout game. Singer/humanitarian Bono moonlights as a principal in a private equity firm that specializes in media and entertainment deals.
In 2006 there were more than 1,000 private-equity buyouts worldwide with a total value of $500-$700 billion (depending on who’s counting). Last November, a leading private equity firm called Blackstone Group agreed to pay $32 billion for a commercial real estate business called Equity Office Properties Trust in what was then the largest private equity deal ever. The previous record holder was the $31 billion buyout of private hospital operator HCA four months earlier. Only a few months into the new year, a new record has been set. Private equity pioneer Kohlberg Kravis Roberts & Co. (KKR) and another buyout firm called Texas Pacific Group agreed to pay $45 billion to take over electric power company TXU Corporation.
Proponents of buyouts argue that they free companies from the tyranny of short-term earnings expectations, the burdensome requirements of the Sarbanes-Oxley corporate reform law and pressures exerted by big investors such as hedge funds. That may be fine for management, but it ignores the fact that large privately held companies tend to be less responsive to concerns about their impact on labor and the well-being of communities in which they operate.
The private equity boom of recent years can be seen as a revival of the takeover dramas of the 1980s—with some of the same actors. Back then, people rarely used the genteel phrase “private equity.” Instead, the talk was of leveraged buyouts (LBOs)—the process by which a group of investors, often including top management, took a firm private by purchasing the publicly held shares with funds borrowed using the assets of the company as collateral. Investor groups were able to raise large sums of money—usually through the use of high-risk junk bonds—while investing little cash of their own. This process reached its height—or its depth, according to critics—in the controverial $25 billion buyout of RJR Nabisco by KKR, a deal immortalized in the book Barbarians at the Gate.
WHAT'S WRONG WITH BUYOUTS
With the resurgence of buyouts in recent years, the objections voiced to LBOs in the 1980s take on a new relevance. The criticisms can be divided into two categories, the first relating to their direct business impact:
They milk the companies they buy. Private equity firms are supposed to make their money when they resell the companies they acquire. But these days they also reward themselves well before that sale takes place—by extracting lavish dividends and management fees out of the revenues of the companies in their portfolio. A private equity group led by Texas Pacific collected a total of $448 million in dividends and fees from Burger King, which it acquired in 2002. That was about the amount the group paid to gain control of the fast-food chain in the first place. When 26 percent of Burger King was sold to the public in 2006, the group’s remaining stake grew in value to $1.8 billion. In other words, it recouped its entire cash outlay and still had a property worth four times its original investment.
The dividends and fees are so attractive that in some cases they become more important than increasing the value of the company. Whereas buyout firms used to spend years restructuring companies, many now take their payments and quickly resell. “An ethos of instant gratification has started to spread through the business,” warned Business Week.
They load up companies with massive amounts of debt. Debt, of course, is at the heart of leveraged buyouts, but today’s takeover firms often force their companies to continue borrowing large sums even after the transaction is completed. Sometimes the loans are not for operations but to pay the dividends demanded by private equity owners themselves. In 2004 nutrition-bar maker Nellson Nutraceutical, which had been bought out for $300 million by Fremont Partners, was forced to borrow $100 million in part to pay a dividend of $55 million to Fremont. This helped push the company into bankruptcy.
They pay obscene amounts of money to top executives. One way to soften up a company for a takeover is to neutralize opposition from its top executives. Buyout firms often do this by including those executives in the investor group buying the company and by keeping those executives in place after the sale. This way they enjoy a windfall often in the hundreds of millions of dollars and get a huge boost in their salary and bonus.
They micromanage the firms they buy. Corporate executives enjoy the payday from buyouts but they find that their new owners may interfere in management much more than big investors did when the company was public. Buyout firms put their own people on the board of companies they buy, and those directors often interfere in decisions that are normally left to management in public companies.
All these tendencies also contribute to the other set of issues surrounding buyouts—those relating to the social impact of companies that have been taken private:
The risks for workers. The need of buyout firms to pay off debt and increase the value of the companies they buy often means the selling off of assets, a reduction of jobs and a squeeze on those workers who remain. Such concerns have prompted a backlash against private equity among unions in places such as Britain, South Africa and Australia. Just last week, a group of international unions issued a call for an investigation by the G8 group of rich countries on the threat of private equity and hedge funds to the stability of the global financial system.
The response among U.S. unions had been more subdued, which some observers attribute to the fact that many pension funds, especially in the public sector, have been major investors in private equity firms and thus have profited greatly from the trend. This attitude could change if a buyout is launched at a heavily unionized company such as Chrysler.
The risks for public oversight. Two of the things that make private equity so appealing for the buyout firms—escaping disclosure requirements and pesky investors—are a source of frustration for those monitoring corporate behavior. Publicly traded companies have to reveal a fair amount of information about their finances and operations, the compensation paid to their executives and the major legal proceedings in which they are involved. Watchdog groups continuously push for more extensive data on social impacts, but there is enough information (especially in the United States) to mount a critique. That information largely disappears when a company goes private.
Also eliminated are the possibilities for using shareholder activism to influence corporate policies on labor, environmental, human rights and other social issues. The TXU buyout has been lauded because it includes a scaling back of controversial plans by the company to build a slew of coal-fired power plants, but that situation is an anomaly.
Buyouts do not relieve a company of the obligation to comply with government rules relating to issues such as toxic releases, workplace health, product safety and fair competition. In fact, there have been reports that some private equity firms are being investigated for violations of antitrust laws. Overall, however, the secrecy in which these firms operate makes it much more difficult for outside critics to press them to do the right thing. The recent announcement that Blackstone Group is planning to sell a stake in itself to the public may lead to more disclosure of its finances, but little is likely to be revealed about the operations of the many companies in its portfolio.
In short, the rise of private equity makes large corporations a vehicle for enriching the few while reducing their level of public accountability.
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