The disastrous leveraged-buyouts (LBOs) that wrecked a host of companies in the late 1980s and early 1990s were supposed to be a thing of the past. LBOs took on a bad name after about half of the companies acquired in the 1980s feeding frenzy eventually collapsed. The most notorious of these cases was perhaps Kohlberg Kravis Roberts & Co.’s $31.1 billion buyout of RJR Nabisco in 1988, a saga that was captured in the book Barbarians at the Gate. At the time, the deal was the largest LBO ever mounted and marked the peak of the 1980s LBO frenzy. (The deal would not be surpassed in size for seventeen years.)
But LBOs didn’t disappear. Instead, the corporate raiders went on a PR campaign and pretended to clean up their image. In fact, they came up with a new name for the same game: “private equity.” In recent years—right up to the emergence of the credit crisis—these firms went on a voracious buying spree, one that may lead to a painful day of reckoning yet to come.
Between 2001 and 2008, private equity firms completed nearly 3,200 buyouts in the United States, amounting to almost $1.2 trillion. There is more than $1 trillion in debt stemming from these buyouts. (An equally large wave of buying occurred in Europe.) This debt could precipitate the next wave of the credit crisis. In addition, private equity firms own companies that employ about 7.5 million Americans and perhaps 25 percent of the jobs could be lost through the course of liquidations or restructurings. Those are the central contentions of Josh Kosman’s The Buyout of America.
Kosman has covered the financial industry for more than a decade and is currently a business reporter at the New York Post. Prior to that, Kosman covered private equity and mergers for several other business publications. Kosman’s text examines the wave of buying that occurred in the 2000s and raises troubling questions about the private equity model.
The book goes through numerous examples of companies—including retailers, technology firms, and mattress makers—acquired in private equity deals where mismanagement occurred, products or services declined or employees were forced to take pay cuts or lose their jobs entirely. The most enraging section is one that looks at how private equity takeovers of hospitals and subsequent cost cutting led to a decline in health care standards and more dangerous working conditions. In these cases, private equity tactics led to avoidable deaths.
Private equity deals are riddled with problems. They rely on the massive use of debt to finance acquisitions. Banks went along with the game because the acquisition loans were unlikely to stay on bank balance sheets for long. In most cases, buyout debt ended up getting securitized in the shadow financial system as collateralized loan obligations, which are very similar to the toxic collateralized debt obligations that subprime mortgages ended up in.
After acquiring firms, private equity buyers typically move quickly to trim costs and cut staff in order to generate quick short term bursts of profits and cash reserves. Kosman even documents cases where firms entirely dismantled research and development operations because short-term windfalls were prioritized over long-term planning. In addition, he points to a study from the University of Chicago that shows that from 1980 to 2001, the firms private-equity acquired had higher rates of layoffs than other firms.
The short-term profits and assets generated by private equity tactics, in turn, are used as collateral for another wave of borrowing in the name of the acquired company. (This debt, too, is securitized.) The money that is borrowed, however, is not used to invest back in the companies. Instead, it is used to pay down the loans that financed the original acquisition of the company—and to shower private equity managers with huge fees. Initial multimillion dollar investments can be paid back many times over in short order even while the acquired company quickly deteriorates.
In this process, the acquired company is saddled with a substantial debt bill that it may not be able to pay. A huge problem is what happens when all this debt cannot be paid. Private equity firms—by spurring on excessive borrowing—have precipitated a scenario in which many of the firms they acquired will have debts coming due in the next few years that will not be able to be refinanced or paid down. This is what Kosman speculates will precipitate a new wave of the credit crisis.
While debts mount for the acquired firms, private equity firms themselves lose no money. At the end of the cycle—after they’ve flipped the firm to another buyer, taken it public or forced it to file for bankruptcy or liquidate—the private equity firms have made huge returns on their investments while the firms they buy end up in much worse shape. Even if an acquired firm is forced to shut its doors, the private equity firm has already reaped its return and is not on the hook itself for the debts its acquired firm has amassed.
In addition to crippling companies, private equity as a business is built on exploiting tax loopholes. On the acquisition side, the buyouts take advantage of the fact that interest payments are tax deductible—a regulation that was created to encourage companies to borrow in order to reinvest in their own businesses, not to fund the rapid trading of companies. Moreover, any gains that private equity firms post as a result of their deals are treated as “carried interest” rather than as capital gains. As a result, private equity firms pay a tax rate of 15 percent rather than 39.6 percent.
Although Kosman does not draw this conclusion, the study of private equity illustrates perfectly the waste endemic to capitalism and particularly to the financial system. Private equity firms are parasites. They buy companies not to invest in them and to expand production, but only to make money on money. This is why private equity firms seem almost ambivalent about improving underlying operations of the firms they acquire.
The productive capacity of people is wasted so a few super-wealthy can make even more money, with devastating consequences for society at large. And lives are destroyed as workers—in some cases after spending their whole lives working for a company—end up with no severance and no pension.
While The Buyout of America is limited in scope, it does elucidate how finance has destabilized and damaged sections of the economy. It is a small piece in showing why the quest for profits above all else ultimately does not lead to the betterment of society. As a result, it’s a book worth checking out for anyone trying to get their head around the mess the Wall Street wizards have created.