Plunder: Private Equity’s Plan to Pillage America

Yves here. On the one hand, it’s good to see more and more voices criticizing private equity’s looting. In this case, it’s Federal prosecutor and former Special Counsel for Private Equity Bredan Ballou. Understandably, he is particularly sensitive to the way private equity general partners escape liability for their bad acts via a wide range of devices, including getting liability waivers from investors and acting as if they are not responsible for portfolio company actions, when anyone familiar with the industry knows private equity general partners are very much in control of these investees. Those of you who’ve followed our posts on private equity will see that he cites cases we’ve discussed, such as the abuse of sale leasebacks (also called operating co/property co deals), Eileen Appelbaum’s research, and Chris Tobe’s whistleblowing on behalf of Kentucky Retirement Systems.

On the other, I find it striking how modest Ballou’s proposals were in light of the extent of private equity pillaging. Ballou, whether by accident or not, comes off as taking a line similar to that of former SEC head of compliance, Andrew Bowden, who gave a landmark speech criticizing private equity misconduct, but quickly vitiated that by taking the position that the fund managers were people with good intentions. That extremely hard to swallow in light of their persistent execution of strategies that increase their returns while damaging the long-term health of their holdings, including driving them into bankruptcy. Note that nearly 2/3 of private equity fees do not depend on company performance, so they do well even when businesses fail.

More broadly, there is a conflict between serving the interest of any equity holders and serving other corporate obligations. Equity is a residual claim. Equityholders only get what is left over when all other obligations, to employees, to customers (such as product delivery, warranties), to suppliers, to debtholders, and to governments have been met. Private equity is in the business of making sure that those who ought to come last are first. There is nowhere near enough pushback against the legally bogus notion that equityholders have a privileged position, which was first promulgated by Milton Friedman.

Published at the Institute for New Economic Thinking website

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Rob Johnson:

Welcome to Economics and Beyond. I’m Rob Johnson, President of the Institute for New Economic Thinking. I’m here today with Brendan Ballou, who works in the United States government as a prosecutor. He has written a book, what I would say, at a time where people are in a great deal of stress, thinking that we are not in a coherent social structure, about a sector that we call private equity. The title of the book, Plunder: Private Equity’s Plan to Pillage America. Brendan takes you through a lot of things that we’ll talk about today. But my father was a doctor, and as many guests on this podcast know, I would love a good diagnosis. But without a remedy, you’re deepening the despair. And as our previous guest, Martin Wolf talked about, when you’re deep in despair, you create the temptation to authoritarian rule. But he’s taking us on a deeper dive, not only with diagnosis, but what look to be healthy and substantial reforms that affect the wellbeing of many people in many sectors of the economy. Perhaps most profoundly the elders as we’re watching the baby boom age out. Brendan, thanks for being here today.

Brendan Ballou:

Rob, thank you so much for having me.

Rob Johnson:

I really admire. I want to underscore for our young scholars. When somebody sits in a substantial position and they write things as powerfully and vivid as this book, the courage that they’re demonstrating is a very, very excellent example. And that courage is what has to lead us out of this discord. Being mad and fighting doesn’t solve things. Seeing the next North Star is where you got to go. And I thought you did a superb job. I don’t know how we get it all implemented. But I think you got to know what you’re aiming for before you start to move forward. And this is an outstanding book in that regard. And I’ll just put a little note in my son who is involved in startups and venture capital in the digital world, and as some of our guests know, he’s the world champion of Pokemon Go. He heard about this book and ordered it before he knew that you and I were going to meet. The echoes among the young and intelligent are already there, and I’m here to amplify them further today. Thanks for joining us. This is great.

Brendan Ballou:

Well, thank you so much. And that’s extremely exciting to hear.

Rob Johnson:

You yourself are, how do we say, trained in the elite realm. I understand you went to Columbia University, Stanford Law School, nobody’s going to kick the tires and say he’s not well-educated and can’t see what’s going on. You’ve got a lot of experience in the trenches in government. But let’s go to the motivational part first before we take advantage of your insights and training and abilities. What inspired you to stand up right now and make this, what did you see going on? What did you see that you could contribute? Where did your inspiration come from?

Brendan Ballou:

Well, it’s a very kind question of you to ask. I was and I am an attorney at the Department of Justice, and I should say off the bat that I’m speaking purely in a personal capacity and my views don’t necessarily represent those of DOJ. But back in 2020 I was in the antitrust division and antitrust along with the Federal Trade Commission see proposed acquisitions as they come in. When one company wants to buy another they need to submit some paperwork to our agencies and we review it. And I was looking at some of these filings and they were all by companies that I had never heard of, Blackstone, Carlyle, KKR, and so forth.

And the more these filings I looked at, the more I thought, “Boy, whatever these institutions are, they’re buying everything.” And I started to do some research and learned about this concept of private equity. And then learned about how private equity was expanding to just about every area of the economy. And I think it’s a story that people are just starting to really become aware of. But explaining how pervasive the industry of private equity is, how it’s transforming the economy and what to do about it was a story that I didn’t think had been told yet.

Rob Johnson:

When you look, I guess when you get started, the story you tell is in the context of some kind of sense of incoherence. In other words, it felt to me as I was reading the book, like there’s something happening here. What it is ain’t exactly clear. How would I say, I’m not Crosby, Stills, Nash & Young, but there’s a sense in which you were intuiting that what you were watching wasn’t for the broad-based good. That there was something about it that was going to be detrimental to some or many.

Brendan Ballou:

I think that’s right. And your music executive background is showing with the quotes, I love it. I can talk about that first example, because I think it illustrates the problem. But maybe it would be worthwhile to just set a baseline of terms here about what we mean when we talk about private equity. Because I know you worked in finance, this is a term that you’re familiar with. I confess as a humble lawyer that I really didn’t understand what private equity was until I was pretty deep into this project. But the basic idea is very simple. Private equity firms take a little bit of their own money, some investor money, and a whole lot of borrowed money to buy up companies. They then try to make operational and financial improvements on the company or changes on the company with the aim of selling it for a profit a few years later. And that is a very simple idea, but it has a couple of problems.

One is that private equity firms tend to just invest only for a few years, so they need to make a return very quickly. Another is that private equity firms tend to load up companies with a lot of debt and extract a lot of fees. And then the third is that companies tend to be … Private equity firms tend to be insulated from liability for the consequences of their own actions. And for me as a lawyer, that last part was the problem that was most interesting to me. And to go back to your original question, this example of illustrating what’s the challenge with the private equity business model?

If I can tell this story, Carlyle, which is one of the leading private equity firms, bought up a nursing home chain, HCR ManorCare, which was once one of the largest nursing home chains in America. They executed a lot of tactics that essentially drained ManorCare of resources. They sold the underlying assets of the nursing home chain. They executed what’s called a dividend recapitalization to essentially give the private equity firm money, and cut staff. As a result, complaints by resident spiked health code violation spiked. And at least one person in one of these facilities actually died. She needed assistance going to the bathroom. She didn’t get it. She went by herself, hit her head on a bathroom fixture and ultimately died. But when her family sued for wrongful death, Carlyle, the private equity firm was able to get the case against it dismissed. And what they said was, “Oh no, no, we are not technically the owners of the nursing home facility. Rather, we merely advise a series of funds whose limited partners through a series of shell companies ultimately own the nursing home.”

And that legal slight of hand was enough to essentially confuse the court and get the case against Carlyle, the private equity firm dismissed. And that’s a long answer to a short question, but what I hope it illustrates is that private equity firms can often control the companies they buy without actually having responsibility for their actions once they do so.

Rob Johnson:

I mean, in my own life, which was in that hedge fund chapter, the notion that there’s a free market out there and you’re just following all the different things going on in the private sector. Well, we could say very obviously you got to pay attention to the Federal Reserve because they set interest rates. But my reading of your book and looking at private equity executives tells me they’re very immersed in and knowledgeable about the legislature, the legal system. In other words, they understand the nature of the playing field as they formulate their strategies and which you might call try to mitigate their liabilities.

Brendan Ballou:

I think that’s exactly right. I think private equity’s success is lessen actually operating businesses. If you look at who runs private equity firms, it’s rarely people who are engineers, or marketing experts, or sales experts, or logistics experts. They’re finance people, understandably. And so their expertise comes not from necessarily making deep operational improvements to the companies they buy, but from using, and in some cases abusing the financial and legal system. To put a pin on that, private equity I think is probably as an industry one of the most successful in lobbying the federal and state governments. Private equity and investment firms have spent something like $900 million on federal candidates and elected officials since 1990. They have hired just untold numbers of senior government officials.

We’re talking about secretaries of Treasury and the Obama and Bush administrations, secretaries of defense and state, two speakers of the house, Paul Ryan and Newt Gingrich, any number of senators and Congress people. They have a very deep bench for when it comes to essentially advocating for themselves on legislation. And they have had enormous success, whether you’re talking about issues like the carried interest loophole, surprise medical billing, or a whole bunch else.

Rob Johnson:

My sense is that their influence, particularly through the book. Some people say democracy, governance, capitalism, and therefore it’s morally legitimate. But the currency of money is competing with the currency of votes. And the problem that many people cite is that the big donors can influence who’s elected, who’s appointed, what laws are enacted, what supervision and regulation looks like, how would you say, what’s enforced, there can be things that are law, but they’re not enforced. And how we create that balance between the currency of votes and the currency of donations and where we are on that pendulum becomes very important to what I would call the cohesion or coherence of society. Now, I may be speaking from a painful past, because I grew up in Detroit. People used to say when I was a kid, I was seen in the ’60s, ’70s, early through the late ’70s, what I will call diseases of despair. Lots of suicides, alcoholism and things like that.

I saw the distress, but many adults said, “We can’t trust the government.” I mean, when Lyndon Johnson came during the Detroit riots, they were talking about the National Guard wouldn’t be deployed unless Governor George Romney agreed not to run against him for president. And people were appalled by that. But the distrust was, one of my dad’s friends and one of our neighbors said in our backyard one night, “The United States of America has divorced Detroit, Michigan. They aren’t giving us any help.” Now, a lot of people will say, “The Voting Rights Act and the Civil Rights Act and keeping the Democrats from the south on the coalition made it hard to create adjustment assistance for a northern black majority city, 70 some percent of the population.” But watching that, I guess what I would say, scarred my telescope in watching things profoundly, even as a youngster before I went to college.

And I guess I think we should talk a little bit about how it’s affecting the different sectors, but talk about the reforms that you recommend. And then talk about how in the realm of this unbridled money politics and which you might call some recent Supreme Court decisions and things like Citizens United, how do we inspire people to take action as citizens to get things back on track? That’s what I see as a meta course for our conversation.

Brendan Ballou:

Absolutely. No, I think that makes a lot of sense. And I think you use the word inspiration, which is really important. Which is when we talk about problems like the private equity business model, it’s very easy to become very pessimistic, almost nihilistic. And I think that that’s counterproductive. It’s helpful to talk about not just what’s wrong, but what are the specific things that we can do to try to address it.

Rob Johnson:

Let’s start with, you mentioned a little bit about a nursing home. What sectors do you see most profoundly affecting the American population because of the influence of private equity?

Brendan Ballou:

It’s really interesting. One of the surprising things that I saw in researching this book is, private equity firms often target industries that service not rich people, but rather poor people. And I found that rather counterintuitive. Because if you’re in the business of making money, you sort of figured you’d go towards the rich people. But it turns out that industries that service working class people are often very attractive to private equity firms. Because working class people often don’t have alternatives. And so it’s very easy to raise the price of a given product or to lower the quality care, knowing that people really don’t have other options. I think the most extreme form of this is prison services, where private equity has really been dominant. They have bought up prison phone companies, prison healthcare companies, prison food companies, and a whole bunch of ancillary services. And the results have been more or less what you would expect given the problems of the business model that we’ve been talking about.

With prison phone companies there’s been complaints about exorbitant rates. I can’t attribute this to a specific company, but complaints that a 15-minute call could cost $25. With prison healthcare there’s complaints about having so few medications that prison hospitals have to take “a drug holiday.” That a woman has to give birth alone in her cell because there’s insufficient staff. That people are dying because of lack of care. And then in prison food services, there’s complaints that people are given so little food that they are on the verge of starvation according to some. Allegations that food services are using meat that’s literally labeled on the box, not fit for human consumption.

You talked about growing up in Detroit, Michigan experimented with privatizing its food services to a private equity owned company. Ultimately that led to one of the first prison riots in the state in several decades. And the state ultimately had to abandon the project, I believe, in part because it didn’t even save any money. Private equity is extremely active in that area, but that’s illustrative, not exhaustive. And I don’t want to spend too long and take too long answering your question, but whether it’s nursing homes, healthcare, housing, single family rentals and mobile homes, retail services, private equity is expanding in just about every direction to such an extent that the industry spent $1.2 trillion on acquisitions in 2021. And just for context, the entire U.S. GDP is about 25 or 26 trillion dollars, so it’s not an insignificant part of our overall economy.

Rob Johnson:

Well, I agree with you. We shouldn’t exhaustively go through everything, because I want people to read your book.

Brendan Ballou:

It’s kind of you.

Rob Johnson:

You can’t take all the secrets out. By the way, I believe the book is being released this week, is it not?

Brendan Ballou:

We end up, it’s ultimately going to be May 2nd, but for listeners, it is available for pre-order now on Kindle hardcover-

Rob Johnson:

Excellent.

Brendan Ballou:

… and Audible.

Rob Johnson:

Excellent. And I think, you talk about these things like the prison services and so forth. I just want to use an economic term. Suppliers can take advantage when demand is inelastic. And what inelastic means is, like you said, you don’t have alternatives. They can reduce the quality and you can’t get out because you still need it, whatever it is. They can raise the price. Let’s say you need a shot to stop a critical illness that could kill you. You get a vaccination for $42 if you’re in Italy and it’s $1,700 here. Why is that? Because there’s nothing that allows you to do an alternative. And so what economists call inelastic demand is part of the structure that allows this exploitation. And inelastic demand is probably more of a feature of really extreme things related to your health and wellbeing, perhaps to age, because your mobility to go look around, find something else is diminished.

And I guess for the people who are more highly educated, they can go shopping and what I’ll call create their own flexibility through their curiosity, that some people just don’t have the time or the perspective to be able to achieve. But that exploitation of inelastic demand is, which you might call bouncing off that currency called votes. Because not only the people who are affected, but those who love them can be quite offended by what they see. And that despair is … I watched Donald Trump that weekend before the election in Michigan running around and putting on TV ads, talking about how the system was rigged. And all kinds of my even well-educated friends in Michigan were voting for him, because they felt like he was calling out a system that was rigged. Whether he seduced and abandoned them or not is another question. But I think you’re really describing something in that one episode that’s very powerful and very important for what you might call understanding how these exploitations can be manifest.

When you think about what to do, is it like a sector by sector by sector thing? I saw there were some explorations of which you might call institutionally sophisticated awareness of what to do. But is there some kind of big picture or meta thing that either precedes or augments those particulars that you think is at the, which you might call at the essence here of the changes that are needed?

Brendan Ballou:

It’s a great question. And at core, the three things that we need to do are get … I mentioned the three problems with the private equity business model. We need to change those so that private equity firms, think for the long term, don’t load up companies with a lot of debt and extract a ton of fees, and hold themselves responsible for their own actions. And if you do those three things, private equity will become a lot less interesting in a sense, and a lot more useful. Because as long as factories need to get built and employees need to get hired, there’s a role for capital to play in our economy. The challenge that we’ve got is, one of the primary institutions for providing capital right now, private equity is doing it in a way that really is divorced from consequence or from long-term thinking. Those are the three things that we need to change.

Now, how do we do that? Historically, people have really looked to Congress for these big changes. And I absolutely think that that’s part of the solution here. And there’s been important legislative proposals in Congress to address exactly some of these problems. But as we’ve seen, Congress has struggled to address a lot of things related to private equity. Whether it’s surprise medical billing or the carried interest loophole, which I mentioned earlier. I think for people that are passionate about these issues, I think it would be helpful to look at what are the other levers of power that can be used to improve the private equity business model. And here I think we should be looking to federal regulators. There are things that the SEC, the Treasury Department Federal Reserve can be doing. On specific issues, there are things that Health and Human Services, the Federal Communications Commission and so forth can be doing.

There’s a lot that can happen at the federal level. There’s also things that can happen at the state level. States and localities should be thinking about legislation where if a business is headquartered in their jurisdiction and a private equity firm buys it and ultimately eviscerates the business, passing legislation so that the PE firm is held responsible for that action. That’s something that states can do. There’s even roles for ordinary litigants and activists to play. Part of the challenge that we’ve got is, a lot of decision makers, maybe I’m being naive here. But I think a lot of decision makers want to do the right thing, especially on technical issues around things like the bankruptcy law for instance. But really don’t understand how the arguments that they’re seeing by private equity firms might affect real people. And so part of the work is just helping to educate decision makers in bankruptcy court, administrative law judges through rulemaking, helping them understand what the impact of these decisions are going to be and how they might consider the impact on ordinary people in their actions.

Rob Johnson:

And so in other words, in that area between codified legislation and doing nothing at all, the discretion of these local officials can perhaps tilt the balance in a healthier direction of public policy?

Brendan Ballou:

Absolutely, and I will say, this has actually already been happening on some specific issues. We were talking earlier about prison phone services. Bianca Tylek and Worth Rises to name just a few of many people and organizers that have been working on this have really successfully pushed state, local and ultimately federal legislation to cap extraordinary prison phone call costs. And it’s really changed the entire business model for prison phone services and made it much less attractive to private equity. Those organizations I think have been astoundingly successful on that. And I think there have been similar movements on other areas where private equity has been active. Nursing homes we were talking about earlier, for instance. It’s not just that change is possible, change has actually happened, it just needs to keep happening.

Rob Johnson:

How would you see … Let’s talk about the role of the SEC or the FED. Are they under current, which I might call, jurisdiction, able to influence what’s happening in this sector? Or is this something that would need regulatory or legislative initiative to say, put them under that lens?

Brendan Ballou:

Obviously legislation is always helpful on these things, but under existing authorities there’s a lot that these agencies can do. The SEC for instance is already looking at rule making to ensure that private equity firms act in the fiduciary interests of their investors, which surprisingly they don’t necessarily have to do. The Federal Reserve could designate certain private equity firms as systemically important, given that if they could fail it could have huge ripple effects on the economy. They could potentially with banking regulators even cap loans that are used for excessive leverage buyouts. There’s a lot that these institutions could do if they had the energy to do it. And I think that there are a lot of public-spirited people in these departments and agencies that want to. But I think we need to fill the gap so that the public understands how important these things are and pushes these agencies to act.

And I’ll just say, as a government employee, I can tell you, outside voices really have an impact. And can really empower people inside agencies to do the right thing, and can really help people understand just how important what they’re working on is. All of which is to say, I don’t think people that care about this issue should underestimate their own power.

Rob Johnson:

The research community. That’s where the Institute for New Economic Thinking is how you say, centered on influencing what the people a little bit upstream from policy start to analyze. Do you see interesting scholarly work examining the things that are in your book? Or is this something that, how you say, is inspired through your own proximity that might be the seed corn for further scholarly research?

Brendan Ballou:

I think that there is so much important research that needs to be done here. And the research community can be so helpful. I’ll shout out within INET, Bill Lazonick, Lenore Palladino have been working on related issues around shareholder supremacy that I think has been incredibly valuable. Lynn Parramore has been doing important stuff. Outside of INET, I would be remiss if I didn’t mention Eileen Appelbaum, who is really, I think the dean of sort of private equity research and is absolutely wonderful. And there have been a lot of wonderful journalists as well. I think some of the key research questions that need to get answered. One is an open question about whether private equity is even profitable for investors. There has been really interesting research about whether PE firms actually get higher returns than the market.

Now, the private equity firm itself seems to do rather well, but the limited partners that invest in it may or may not. And there’s been some research questioning that. I wouldn’t weigh in because I’m a lawyer, I’m not an economist. I think that’s one question. I think the second big question is. Getting a better sense of tactics that private equity firms use that can be beneficial to the PE firm, but ultimately damaging to the companies they buy. And I’ll mention just two. One would be what are called sale leasebacks. Where the firm buys the company, sells the real estate or the assets, and then has the company lease those things back. And that can make the private equity firm a quick buck but may hurt the company in the long term.

And then another example would be dividend recapitalization. Where a firm essentially requires the company it buys to borrow money to pay the firm a dividend. These are tactics that we have good anecdotal reporting on, but very little systemic research on. And even less on what the long-term effects are on companies. Those are just two examples, but there’s so much that I think researchers could do here.

Rob Johnson:

Let me, as I’m listening to you, I’m seeing a vision. Starting with, in the realm of financial investment, a phrase I’ve often used is that the bailouts and the guarantees from the central bank to provide liquidity, may become what I call the mother of all moral hazards. In other words, if you are too big to fail, then your funding costs go down because the bankruptcy risk premium is gone. And that means you take more risk because it costs you less to fund things. And furthermore, in a heads I win, tails I get bailed out and the public supports me, it’s like creating an option where you have upside, but very little downside.

Transferring that vision of how central bank guarantees can actually exacerbate the size and scale of the bailouts that they ultimately have to do and affect the market share where the two big to fail banks gain market share because they’re “safer” than the smaller banks in the regions and so forth. Let’s transfer that to private equity. It sounds like you’re telling me that the managements of private equity with their limited partners with all the actions they advise, are trying to create an option for themselves. Where they use other people’s money, they come in on the top, induce or direct transactions that benefit them, but leave the others with what you might call more burden. And so they’re extracting wealth from their co-investors who are different than the principal architect, say the firm, like the big brand names you talked about. They take money for themselves and they leave other people to service it, or they keep charging and diminish the quality of the product the ultimate customer gets. Am I on the right track there?

Brendan Ballou:

I think that’s exactly the concern, and I’ll give you two examples. One and just sort of an ordinary purchase and then some more strategic ones. When a firm like Sun Capital by ShopKo, which was a great Midwest retailer. It was one step up from Walmart and one step below Target. I went there a lot as a kid. They bought ShopKo but then did a lot of the tactics that I just mentioned. They executed a sale lease back so that they sold the buildings of ShopKo and required ShopKo to lease it back, which gave Sun Capital a quick influx of cash. Then executed a dividend recapitalization so that ShopKo had to borrow money, which it gave to Sun Capital and its investors, and then ultimately executed a series of layoffs and were unable to keep the business functioning. And I believe it ceased operating as a going concern. But essentially Sun Capital was able to do all this without having any of that money clawed back through the bankruptcy process.

It is a standard moral hazard challenge in that they got the upside of the sale, selling the assets and so forth, but didn’t experience the downside when the business actually failed. One broader example that I think is really interesting is, private equity firms are getting very excited about insurance companies. The idea here is that private equity firms buy life insurance companies, which policy holders send the insurance company money every month that the private equity firm can then use to invest in its various projects, leverage buyouts or whatever it happens to be. And there is some reporting out there saying that these private equity firms are actually shifting a lot of these policies to shell companies in Bermuda that have lower capital requirements. And you’re a finance person, you know that gives them more money to work with but gives them less cushion if things go battling.

Now to get back to your point about moral hazard. The really interesting thing about this business model is that if the insurance company fails, most likely the private equity firm won’t have to pay for the policies that collapse. Rather those policies will be absorbed by state guarantee organizations. Which are these state entities that are paid for by other more responsible insurers. It’s a situation where the private equity owners are going to be able to invest more money in riskier projects, but if those projects fail, the bailout will ultimately be by other insurance companies and ultimately other policy holders and probably not themselves.

Rob Johnson:

So, you privatize the games and socialize the losses and-

Brendan Ballou:

Exactly.

Rob Johnson:

Yeah, because it concerns me. I mean, for instance, right now people are talking about the Silicon Valley Bank. Once things erupt, you can’t not stabilize the system. Because that hurts everybody. What economists will call the externalities, the side effects of the panic have to be mitigated. But ex-ante, if you know those things will be mitigated, that moral hazard is enacted and you take too much risk. It sounds to me like in private equity isn’t quite like what you might call the liquidity system in the markets. It’s more related to the legal system, about what structures are considered acceptable and do you need to have modification to the law which stops them from doing things where they extract money and then leave the burden with other parts of the capital structure.

Brendan Ballou:

And maybe an economist would have written a different book. But as a lawyer, I’m particularly interested in what you just said, as the legal incentives that we’ve created for private equity. If I can give one more example on that. One of the stories that really interests me is how private equity firms can use the bankruptcy system to their advantage. PE-owned portfolio companies are by one study 10 times as likely to go bankrupt as non-private equity owned businesses. And PE firms will say, “Well, that’s because we invest in riskier companies and so forth.” But there are actually instances where private equity firms can profit through the bankruptcy process. So, the example that I think of is Friendlies, the diner chain in the northeast. Sun Capital, which we were talking about earlier, bought up Friendlies, executed a lot of the tactics we were talking about a sale lease back and dividend recap and ultimately pushed the business into bankruptcy.

But in bankruptcy, Sun Capital was both the owner of Friendlies and its largest lender. And with that dual position, it was able to sell Friendlies from itself to itself. And the reason it did that is by making that sort of slight of hand, it was able to offload the pension obligations of Friendlies onto a quasi-government agency called the Pension Benefit Guarantee Corporation. And that’s a tactic that by one study has been executed at least 50 times by private equity firms. What’s going on here is private equity firms have essentially figured out this legal gap that allows them to offload pension responsibilities onto other more responsible companies and ultimately the government, without having to pay a cost. And it goes back to your original point about what are the legal incentives that we’ve created for these businesses.

Rob Johnson:

Yeah, I’m reminded of years ago I was involved in analysis of the Detroit bankruptcy. And a gentleman sent me a book, his name is Chris Tobe, T-O-B-E. It was called Kentucky Fried Pensions, and I think the second edition was called the Worst than Detroit Edition or something. But he tells a story about how whistleblowers had to come in. Because private equity firms would come, they would give financial support to the local legislature in the State of Kentucky. The people in the State of Kentucky have a pension and that private equity firm gets to take it over. But then what they did was they bought businesses in Kentucky for too much money. But they did that, which hurt the pensioners. But when they overpaid the people who they bought the businesses from made a pledge that they would invest with the private equity firm personally.

And so there was this pension wealth extraction system that eventually there was a whistleblower. And Tobe describes that. He also talks about a similar situation related to the hedge fund industry in the state of Rhode Island. And seeing what you might call that relation between money politics and these burden sharings is, how do I say? A little bit scary, a little bit demoralizing. There was a professor whose name I don’t recall at the moment, who’s done a lot of work on pensions. He was at Stanford University for many years. And he talked about how when a company was hired in Illinois, their investments in the pension were producing much lower returns than their other investments in Illinois. And that their investments in any sector through the pension had lower returns than their investments in the sector out of state. And it all had to do with these transfers and inside politics games.

I think, I say for our listeners and watchers, there are some episodes like the Kentucky Fried Pensions or what’s happened with the Illinois pension system that reinforce the framework that you’re sharing with us today and which is contained in your book. But I feel you’re more systematically integrating things. They could smell the rat. You’re looking at the whole zoo, and it’s really interesting.

Brendan Ballou:

That’s sweet of you to say. And you mentioned Kentucky, it’s really interesting. Some pension holders, some retirees actually sued Blackstone in Kentucky claiming that the pension was systemically underfunded and wasn’t getting the returns that needed to survive. And Blackstone did some pretty extraordinary legal moves within the state to get the case against it dismissed. They’ve been very successful in maintaining their involvement in that pension system. One of the interesting trends that’s going on right now is, private equity firms have in a lot of ways exhausted pension funds as a source of new money, and they’ve been looking for new places to go. And one of them is 401(k)s. Historically 401(k) fund managers have not invested in private equity for fear of getting sued for irresponsible or imprudent investments.

But in 2019, 2020, the Department of Labor in conjunction with the Securities and Exchange Commission issued a letter that essentially insulated fund managers from liability if they ultimately invest in private equity. And that letter has been partially walked back, but not entirely. And what it means is there’s really an arms race going on for private equity firms to convince fund managers to give them 401(k) money to fund their projects. That’s the next frontier of private equity investment.

Rob Johnson:

This is quite haunting. Because you look at people who’ve been keeping a 401(k) or other forms of savings. And all of a sudden as they age they become more anxious and they sense that people are playing all these games, which I might call with the returns. How did they defend themselves? It’s very, very, how do you say? You can sense when we talked at the outset about some of the political discord, some of the fear and dissatisfaction with politics, talk about a place where apparently, from my understanding of the statistics, until perhaps very recently older people tend to participate more in elections, their voter turnout rates are higher. Maybe it’s because they’re trying to protect themselves from these manipulations by using the currency of votes to the extent that they can. But it’s very haunting to think that your retirement security and your health security, when you’re vulnerable and fragile, are in play at this game.

Brendan Ballou:

Well, it’s potentially dangerous for ordinary retirees and it’s potentially dangerous for companies. Because the more money that private equity firms have, the more that they’re going to spend buying the companies, which means that they’re going to load it up with more debt, which creates systemic risk for the economy. I mean, the good thing is, as you said, older Americans vote. And this is an issue that really affects older Americans. And unlike a lot of challenges that you have with the PE business model, this is a relatively simple fix. You just need to withdraw one letter from one agency. And I think if there’s concerted energy around that, it could actually happen.

Rob Johnson:

Well, I remember when the Detroit bankruptcy happened, there were all these people, particularly women who had worked 40 years in the municipal government in administration for the city. And essentially the rescheduling was not to go raise taxes on the residents of the State of Michigan and pay these people after 40 years of work, it was to reduce their healthcare and their pensions. And at one point a gentleman, his last name was Ora, was the special, which I might call leader or whatever, who was appointed. And he apparently went to a French sewage and water company to try to buy Detroit sewage and water, which was I believe the largest freshwater publicly owned water company in the United States. But the reason for that strategy was, a publicly owned water company had to pay its pensions, whereas the privately owned acquire could lay people off and negate the pensions, and then get a windfall.

But they didn’t get a windfall to help the city out of its bankruptcy. They got a windfall for themselves and their private profit further at the expense of the population in Detroit. And the judge who was presiding was mindful of this. And how would you say it? That transaction was never realized. But it was a very contentious set of, how you say? Powers and pressures and so forth on who was going to bear the burden of that bankruptcy.

Brendan Ballou:

Well, it’s interesting that you talk about water systems and trying to sell them. That’s another area where private equity firms have gotten interested. PE firms have been taking over a host of government responsibilities. In water in particular two cities, Bayonne, New Jersey and Middletown, Pennsylvania, both were facing financial hardship and sold their water systems to a joint partnership led by KKR and actually a French company, perhaps the same, Suez. And I don’t think it would be overstating and say it was a disaster for the cities in that they essentially gave up the right to set prices for the water. And the joint venture immediately raised them to such an extent that there was public reporting saying that residents would say like, “I’m a water Nazi, I only buy flowers that don’t require much watering. I time our family members about how long their showers take.”

And despite efforts, these cities are essentially locked into these contracts for 30 years or more. It’s a problem that they’re going to be facing literally for generations. Meanwhile, KKR exited the partnership, I think in under four years and pocketed, I think somewhere north of a $100 million through the project. It was very successful for KKR and its partner, obviously not so much for the cities and the residents.

Rob Johnson:

Let’s, how do I say, we’ve been touching on it, but the last part of your book, A Call to Action, you’ve got a section of what I’ll call a diagnosis. First of all, you describe what’s going on and how they get their way out the sector. But how to stop them is the meta title of the last section of the book. What’s the agenda for reform and what must we do? Start with broad, generic things and then zoom in on each sector.

Brendan Ballou:

Sure. As I mentioned, there are three basic problems with private equity. Investing for the short term, loading companies up with debt and fees, and insulation from liability. And the basic project is to stop those three problems in the PE business model. Private equity firms don’t need to stop existing, they just need to be more responsible or have their incentives changed in a way that they think for the long term and take responsibility. As I mentioned, Congress can be part of the answer in this, but Congress has historically struggled on issues related to private equity. There are things that we can do across the federal government, whether it’s some of the solutions that we mentioned with the Securities and Exchange Commission and the Federal Reserve. Looking critically at the bankruptcy code to try to make sure that some of the more abusive tactics that some private equity firms use aren’t accepted. And that’s really just an education project for bankruptcy judges.

And then on specific issues, when we’re talking about nursing homes and private equity activity there. Getting HHS to establish minimum staffing hours, which they’re in the process of doing. Getting the FCC to regulate prison phone services, which they’re starting to do. Getting Fannie and Freddie, the housing regulators to ensure that foreclosed homes are actually going to individuals and not to private equity firms that can flip them into single family rentals. And then, at the state level we need to be talking about how can we make sure that companies that are headquartered in those jurisdictions aren’t abused by private equity firms. And I think the short version of this is basically, if a private equity firm buys a company in their jurisdiction and executes a short-term tactic like a sale leaseback or a dividend recapitalization, and ultimately jobs are lost or the company goes bankrupt, the private equity firm should be held responsible. It’s a simple idea. If private equity firms are able to make decisions on behalf of the companies, they should be responsible for the consequences of those decisions.

The last thing that I’d say is there’s really a role for litigants here. Whether it’s challenging specific PE practices like their purchases of physician staffing companies that might violate state corporate practice and medicine laws. Or veterinary clinics that might violate the veterinary analogy, to also just an education process. I think that part of the challenge that we’ve got is that private equity just sounds so boring. It sounds so obscure and technical. And helping regular people who are affected by this understand just how private equity is shaping their lives, I think can be really transformative. Because I think that will filter down to bureaucrats like me in government and have a positive change. I think that this is a huge challenge that we’re facing, but I think that there are a lot of levers of power for us to do things.

Rob Johnson:

But that’s encouraging. And I think that’s how do you say, very important. I’m very inspired that given your position, given the knowledge that you’ve accumulated and demonstrated in this book, that there is something within you that might be called a purpose. Muhammad Ali’s famous poem, Me We. Your pendulum’s on the we side. And I know given your credentials, given your experience, given the quality of the writing of this book, you could have become a very wealthy, private equity executive in the next chapter of your life. And by writing this book you’ve chosen another path. And I really I want particularly our young people to understand that the courage that you’ve demonstrated, and the sense of what matters that your example shows is very important if we’re trying to imagine a coherent and cohesive society that does not, which I might call, fall back to that totalitarian what some have called second civil war type of outcome. Thank you for the efforts you made, but thank you for the example you set. It’s really, really powerful.

Brendan Ballou:

That’s incredibly generous of you to say, and I’m not sure it’s deserved, but I appreciate it. And my thanks likewise to INET, which I think is just doing just incredibly important research, not just on private equity, but sort of a whole host of economic justice issues. I think that organizations like yours fill just an incredibly important gap connecting policy folks to academics and activists and everybody in between, so I’m really grateful for the time.

Rob Johnson:

Well, I’m grateful for the ability to connect you to all of those channels, because I think you have a tremendous amount to offer. And I hope that this is the first chapter of what will be several in this podcast between you and I. And how do I say? We’re clearly, I think our Young Scholars initiative will certainly want to invite you to come give a talk to them and how do I say, deepen their awareness and understanding both through reading and through interaction with you. But for now, it’s been a great pleasure to have you on. And I’m now, how do we say? I am, you know the word encourage. If you go back to the Latin, courage, core is heart and that the core age was to tell the story of your time with your whole heart. And that’s in part what I think you’ve done in this book. But to encourage is to inspire other people to tell that story with their whole heart. And that’s what I would call the crown jewel of this experience that I’m having today in talking with you.

Brendan Ballou:

Well, that’s incredibly eloquent and I take it to heart, so thank you again.

Rob Johnson:

Thank you. To be continued. And check out more from the Institute for New Economic Thinking at ineteconomics.org.