Andrew Dittmer: Eileen Appelbaum and Rosemary Batt on How Private Equity Really Works

Yves here. Naked Capitalism contributor Andrew Dittmer, perhaps best known for his series on libertarianism (see Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, and his responses to reader comments) has returned from his overlong hiatus to interview the authors of the highly respected new book, Private Equity at Work.

Eileen Appelbaum and Rosemary Batt have produced a comprehensive, meticulously researched, scrupulously fairminded, and therefore even more devastating assessment of how the private equity industry operates, including its deal and tax structuring methods, its impact on employment, and whether its returns are all they are purported to be. Their work was reviewed in the New York Review of Books; we also discussed it in this post.

Earlier this year, Andrew spoke with Appelbaum and Batt, and the first part of their discussion covers the problematic relationship between private equity funds (general partners) and their investors (limited partners) and how private equity affects other businesses.

In some cases, Appelbaum and Batt bending over backwards to be evenhanded. For instance, they attribute the explosion in CEO pay not to the leveraged buyouts industry (private equity before it was rebranded in the 1990s) but to an article by Michael Jensen in the Harvard Business Review that argued for paying CEOs like entrepreneurs. While narrowly true that the Jensen article was the proximate cause of the shift in big corporate pay models, having lived through the 1980s and the way that LBOs captured the attention of the business press, it is hard to imagine Jensen’s thesis being taken seriously in the absence of the LBO boom. The “maximize shareholder value” theory of corporate governance was first presented in a Milton Friedman New York Times op-ed in 1970 and had not gotten traction with the mainstream. It was the wave of takeovers of overly-diversified conglomerates in the 1980s and the easy profits garnered by breaking them up and selling off the pieces that seemed to prove the idea that too many CEOs didn’t have the right incentives to run their businesses well (and in fact, it’s also true that the business press of the 1970s decried American management as hidebound and much less good at working with labor than the Japanese or Germans). But as we’ve seen since then, equity-linked pay has produced rampant short-termism and facilitated looting by executives. Even if the old pay model was problematic, its replacement has performed even worse, save for the CEOs themselves.

By Andrew Dittmer, who recently finished his PhD in mathematics at Harvard and is currently continuing work on his thesis topic as well as teaching undergraduates. He also taught mathematics at a local elementary school. Andrew enjoys explaining the recent history of the financial sector to a popular audience

Interactions of General Partners (GPs) with Limited Partners (LPs)

Eileen Appelbaum: Rose and I did a briefing at the AFL for the investment group. We had investment people from both union confederations who are concerned about the fact pension funds are putting so much money into private equity. They told us that they had never been able to see a limited partner agreement until Yves Smith published them. The pension fund people are so afraid of losing the opportunity to invest in PE. Some general partner could cut them off for having shared the limited partner agreement. Unbelievable.

Andrew Dittmer: In general, LPs seem to have a pretty submissive attitude toward GPs. Where do you think this attitude comes from?

Rosemary Batt: One cause is the difference in information and power. Many pension funds don’t have the resources to hire managers who are sophisticated in their knowledge of private equity firms. They don’t have the resources to do due diligence to the extent they would like to, so they need to rely on the PE fund, essentially deferring to them in what they say. 

Eileen Appelbaum: I think that there is a reluctance to question this information or to share it with other knowledgeable people – they are afraid that if they do, they will not be allowed to invest in the fund because the general partners will turn them away.

I attended a lunchtime lecture recently, the title of which was “How is it that private equity is the only industry in which 70% of the firms are top-quartile?”The general partners have found ways to persuade their investors that they are the top-quartile funds, that “you will make out best if you invest with us,”and “we’re very particular – if you can’t protect our secret sauce, we aren’t going to do business with you.”

The other side of it is that some of the pension funds have their own in-house experts, and some of them believe they’re smarter than the average bear – there’s a certain pride in their ability to get the best possible deal, better than other LPs can get.

It’s the lack of transparency. With more transparency we’d have a lot less of these problems.

Rosemary Batt: Another issue is yield – often they’re thinking, “We need to be investing in private equity or alternative investment funds because this is the only way to get higher yields.” There’s a kind of halo effect, if you will, around the private equity model – many people think it really does produce higher returns without really having the knowledge. In some cases, there are political battles that have to be fought to get legislators to make a decision not to invest in these funds.

Eileen Appelbaum: Often the person who is appointed to make the decisions about private equity investments comes from Wall Street, maybe even from a PE background.

Andrew Dittmer: Portfolio theory plays a role here – it tells people that it’s wise to be invested in alternative assets in order to reach the efficient frontier. But PE is cyclical, and so the idea that it helps diversification seems somewhat questionable.

Eileen Appelbaum: Right. It’s a cyclical industry, and it seems to be correlated with the stock market, so exactly how it’s diversifying your investments is also a problem. Portfolio theory has been very, very powerful. Before it was developed and accepted by regulators, pension funds would not have been able to invest in private equity because they were obligated to evaluate the risk of each individual investment – that would have ruled out most private equity investments. But portfolio theory says that you should evaluate the risk of the portfolio and not of each individual investment, and that’s what allows pension funds to invest in PE.

Rosemary Batt: The idea that you can diversify away risk can leave people with the belief that they don’t have to worry about risk. So it leads to a sense of false security.

Effects of Private Equity on Non-PE Firms

Andrew Dittmer: Could you talk about how private equity affects firms not owned by private equity?

Rosemary Batt: It’s hard, of course, to pinpoint causality given that we don’t know if public corporations have directly copied private equity practices. But one example I think is relevant is the use of debt – the leveraged buyout model beginning in the late 70s and early 80s involved the use of extensive debt, and other companies began to look at this model. And while public companies don’t have nearly the level of debt that companies owned by private equity do, they have certainly increased their use of leverage in the last 20 years.

Eileen Appelbaum: I think tax arbitrage is another example. Private equity excels at figuring out every little loophole and taking advantage of it. I think there was a time in the past when a U.S. company was proud to be a U.S. company and would not have moved its headquarters to Ireland in order to avoid paying taxes. But now it’s pretty widespread for companies to do this, and then you have stateless profits. The idea of tax arbitrage as something that’s perfectly okay for a respectable company to do, I think had its roots here.

Andrew Dittmer: Do you think PE has played a role with the pay of top corporate officers?

Eileen Appelbaum: I think PE is part of a larger move from managerial capital to investor capital. This general trend has been helped along by several things that affect private equity but also affect publicly traded companies. One was the idea that you should tie the returns of a company’s presidents and CEOs to the performance of their companies in the stock market. We see this in the carried interest that PE partners receive; and we also see it in stock options as CEO pay. These are two branches from the same tree, but the tree is investor capital.

Rosemary Batt: CEO compensation really skyrocketed in 1990 after Michael Jensen’s articles encouraged all companies to tie their CEO payment more closely to stock price. That practice just exploded in the 1990s, and was a quite widespread phenomenon. As Eileen said, this is tied to a greater focus on the shareholder model of the firm.

Eileen Appelbaum: On the other hand, it’s possible for trends in the general business world to take hold in a more decisive way in private equity. One element promoting certain practices in PE is the managerial literature: the academic literature urging companies to pursue their core competencies.

You may have an overall profitable company and the subsidiaries of it may be profitable as well. -If there are some branches or some facilities that are less profitable than others, PE advertises itself as investing and making the underperforming facilities more profitable. But often it just sells them off or closes them down – which raises the overall profitability numbers of the company. The emphasis on core competence is used to justify this kind of behavior on the part of PE firms.

One thing to keep in mind is that there are some things that PE firms do that ordinary companies just can’t do, or at least can’t do to the same extent. One of these is the fees that are charged. You can’t be the corporate headquarters of a publicly traded company and then charge your subsidiaries separately for any management advice you give them or any transactions you carry out in their name.

Also, the greater transparency of publicly traded companies and the greater amount of information that the SEC collects and makes public about them places limits on what they can do.

Rosemary Batt: An example of how PE acts differently than public corporations has to do with how they use the bankruptcy laws. Because PE loads companies with more debt, those companies have about twice the rate of bankruptcy as public corporations. But since PE companies are not in the eye of the public in the same way, and don’t have to worry as much about their shareholders, they frequently take advantage of a certain section in the bankruptcy law called the 363 sale.

Under normal bankruptcy procedures, you would need to make a complete plan for reorganization, and the different stakeholders would have some say in that plan. But under the 363 sales, they can accelerate the process of bankruptcy, and in doing so they can more easily rid themselves of pension obligations.

Public corporations know about this loophole and they’ve started using it a little more, but they are much more constrained in their ability to take advantage of this kind of thing due to reputational risk.

Eileen Appelbaum: In our discussions with people from the PBGC [the Pension Benefit Guarantee Corporation, the US agency that provides payments to beneficiaries when a private pension plan fails], we were told that there has been some increase in public firms using the 363 sale, but it’s PE firms that have really taken advantage of it and they are still driving the process.