The dangers of private equity funds

Most Americans -- unless they read the daily financial press -- are probably not fully aware of the influence that private equity funds now have on business in the United States and on the economy as a whole. But perhaps it’s time to start paying attention. With half a trillion dollars in capital, these lightly regulated firms are transforming the lives of millions of people in the United States. The 20 top private equity firms control companies with more than 4 million employees.

The largest of them -- Carlyle Group, Kohlberg Kravis Roberts & Co., Blackstone Group, Bain Capital, Cerberus Capital Management -- are not exactly household names, yet they have purchased some of the most widely recognized companies in the country. Carlyle Group, for instance, has purchased Del Monte Foods and Loews Cineplex Entertainment. And last week, Cerberus obtained the majority interest in Chrysler Group by purchasing that division from DaimlerChrysler. Blackstone now owns Houghton Mifflin Co., one of the premier educational publishing companies, and HCA, the nation’s largest hospital chain, was purchased last year by Bain Capital and Kohlberg Kravis Roberts.

FOR THE RECORD:
Private equity: An article in the Aug. 12 Opinion section on private equity funds buying U.S. companies stated that the Carlyle Group owns Del Monte Foods Co. It does not own the company. —

In recent months, the outside world has begun, slowly, to take notice. The Economist magazine, for instance, ran a cover story three weeks ago on “The Trouble With Private Equity.” The 1.8 million-member Service Employees International Union issued a stinging report about the effect of private equity firms on workers and called for broad regulatory reform. And now, leading Democratic congressional leaders are pushing legislation that would increase taxes on the mega-millions that private equity fund managers receive as compensation.

The way these companies work is that they create enormous private equity funds, often made up of investments from pension funds, insurance companies and endowments. The funds then invest in private companies -- either ones that are not traded on public stock exchanges or ones that are publicly traded but are then taken private.

The primary goal is to make profits that beat what investors can get in the publicly traded stock market. Through various mechanisms -- including management restructuring, selling unprofitable divisions and personnel cuts -- companies are “retooled” and “turned around,” and then often brought back into the public stock markets or sold to another firm. If all goes well, the fund mangers make enormous profits and fees, investors are rewarded with high returns and the new company operates more efficiently and productively. If job losses occur or company pension obligations are jettisoned along the way, then that is the price we must pay -- according to this philosophy -- to sustain a dynamic market economy.

So what’s the problem? For the fund managers there is no problem. Stephen Schwarzman, co-founder of Blackstone Group, has a net worth close to $10 billion. He celebrated his now famous 60th birthday with a $3-million bash and hired rocker Rod Stewart to perform. Blackstone collected $850 million in management fees in 2006, a sum similar to other large private equity firms.

Free-market defenders argue that the fees collected by these fund managers are well worth it. Private equity funds discipline the market, they say, by finding undervalued companies that are transformed into job and wealth creating entities. Capital is thereby deployed more effectively, companies become more efficient and productive, and investors are rewarded for their risk.

But the labor movement and other analysts paint a darker, less beneficent picture. They point out that private equity funds have little oversight from regulators and virtually no input from the workers who are employed by the companies they purchase. While takeover firms argue that their machinations create more jobs in the long term, unions say that the types of jobs created are not always as well paid or do not always offer full-time employment. For instance, after a consortium of private equity firms bought rental car firm Hertz Global Holdings Inc. from Ford Motor Co., the new owners took out loans to give themselves a special dividend payment. After Hertz was taken public again, the company announced a “restructuring” that would eliminate 2,000 of the company’s 31,500 workers.

Moreover, because high amounts of debt are used in buyout strategies, there is a fear that as debt financing becomes more risky -- as it has in recent weeks -- the financial stability of the overall economy will be undermined. If the goal is to strip and flip a company in the shortest time -- not unlike what has happened in the housing market -- the long-term planning, investment and stewardship of businesses will disappear. While fund managers pocket the profits, workers and communities suffer the consequences of these highly leveraged transactions.

Some analysts see private equity mania as reflective of a deeper problem with the evolution of contemporary American capitalism. Robin Blackburn, a journalist and historian, argues in his book “Age Shock: How Finance Is Failing Us,” that modern corporations are seen by the new financiers less as producers of products than as bundles of assets and liabilities that can be manipulated and shaped by ever more complex techniques of financial engineering -- such as risk arbitrage, lease-backs, derivatives and hedging techniques.

Private equity funds have been a boon to institutional investors like pension funds, which these days control a large percentage of the country’s investment capital. At the Los Angeles City Employees’ Retirement System, of which I am one of seven trustees, we have generated significant returns through private equity investing. Our $750-million private equity portfolio (out of an $11-billion total portfolio) has had a three-year investment return of 24%. That is good for our retirees, good for the city and good for taxpayers. A well-run pension fund will make it less likely that taxpayers will have to bail out unfunded pension liabilities.

But beyond investment return, we also have to be cognizant of how our investment strategies help shape the economy. Political and labor leaders are calling for further regulation of private equity investing with an emphasis on worker and community involvement in the opaque decision-making that now rests in the hands of a financial elite. While some argue that privately owned firms should be free from government intrusion, the sheer size and broad social effect of these deals distinguishes them from the mom-and-pop hardware store down the street.

Perhaps it is time for increased oversight to tame these new economic behemoths. It is never a good idea to simply leave capitalism to the capitalists.

Pension funds can help by looking for smart, socially responsible ways to invest. At our pension fund, we have made investments in “worker-friendly” private equity funds that look for companies that can be supported and strengthened. One of these funds -- the Yucaipa American Alliance Fund -- is run by Los Angeles billionaire Ronald Burkle. Of the 10 companies in his portfolio, eight have a unionized workforce. The fund has posted superior returns while avoiding the slash-and-burn strategy of other less socially responsible investors. Front-line workers often see what management overlooks, so Burkle engages unions as partners and strategic allies rather than as adversaries.

If we have to make a decision between two investments with the same risk-and-return profile, it makes economic and social sense to choose the fund manager that will manage our capital in a responsible way.

Trustees of pension funds and foundations are not stock pickers, but we are stewards of a larger investment community -- a community that private equity funds have dramatically affected. It is part of our fiduciary responsibility to follow that money to the end of the trail.

Kelly Candaele is a trustee of the Los Angeles City Employees’ Retirement System.