As private equity deals grow, so does public anxiety
IN America, financial success is supposed to be admired, not held in contempt.
Unless, of course, you make your money in a way that is distasteful or downright illegal.
Private equity investment firms, which are buying up companies worldwide at a heady pace, haven’t been charged with breaking any laws. But the bigger and richer these investment titans become, there’s a natural suspicion that private equity’s gains may come at the expense of others -- average investors as well as workers, lenders and perhaps the economy as a whole.
The public-to-private movement has an inescapable aura of exclusivity to it, because, well, that’s the point: Some of the most brilliant financiers on Wall Street take money from well-heeled investors, borrow on top of that, buy up businesses, remake them out of the public eye and eventually sell them for what all parties involved hope is far more than the purchase price.
In a landmark moment for the privatization wave, Cerberus Capital Management struck a deal last week to take control of Chrysler from DaimlerChrysler.
The iconic American auto company will be in the hands of a notoriously publicity-averse investment firm that also owns such disparate businesses as retailer Mervyn’s, countertop maker Formica and movie producer Spyglass Entertainment.
In a sense, history is repeating. Cerberus and some of its private equity rivals are beginning to look like throwbacks to the 1960s, the age of conglomerates such as Gulf & Western -- nicknamed Engulf & Devour for its rabid pace of acquisitions of unrelated businesses.
But in that era, small investors could buy into Gulf & Western, ITT Corp. and other publicly traded conglomerates, and the companies’ finances were open books. Now, public investors are bought out, and the curtain is drawn.
As of last week, Standard & Poor’s counted 12 companies within the blue-chip S&P; 500 stock index that had buyout offers on the table from private investment groups. The list includes utility company TXU Corp., retailer Dollar General Corp. and eye-care company Bausch & Lomb Inc.
So what’s not to like about that? The public-to-private wave has helped push the stock market to record highs and is a bonanza if you own stock in a buyout target. Bausch & Lomb stock was at $49 two months ago. Last week, private equity firm Warburg Pincus agreed to buy it for $65 a share. The stock went even higher, closing Friday at $67.10, on the expectation that a better bid would surface.
But here’s the question that Jeffrey Bronchick, who helps oversee $3.7 billion at money manager Reed Conner & Birdwell in Los Angeles, wishes more of us would ask: What are we giving up in future returns by selling out today?
A private equity buyout that includes existing company management as participants (as is typical) is riddled with conflicts of interest from the get-go, Bronchick asserts. He notes that it’s in the interest of management, and the private equity investors, to buy a company for the lowest price they can get away with, because that will enhance their future returns.
When private equity seals a deal, Bronchick says, “they’re buying my upside” -- meaning what he might have earned if the company had remained public and prospered.
That also was the knock on the leveraged buyouts of the late 1980s. The key distinction often made between that privatization boom and the current one is that today’s private equity investors say they’re interested in building up the firms they buy, not stripping them down, breaking them up and selling the pieces.
The Private Equity Council, a lobbying group formed five months ago by Apollo Management, Bain Capital, Carlyle Group and other buyout leaders, has been touting a recent study by consulting firm A.T. Kearney that bolsters the argument that private equity ownership aids companies’ growth and job creation.
“Contrary to popular belief, there is no evidence that private equity destroys companies and employment,” the study said. In fact, firms owned by private equity investors created about 600,000 jobs in the U.S. from 2000 to 2003, according to Kearney.
(Of course, there’s no way to know how many jobs the purchased companies might have created had they not been brought into the private equity fold.)
Douglas Lowenstein, president of the Private Equity Council, told Congress last week that private equity “is about hundreds of thriving companies contributing to the economy in numerous positive ways.”
Testifying at a hearing held by Rep. Barney Frank (D-Mass.) to assess the effect of private equity deals on workers and companies, Lowenstein also stressed the high returns that private equity managers reap for their investors -- including many pension funds -- as companies are sold or taken public again via stock offerings. That’s good for the pension funds and good for the economy, he said.
The California Public Employees’ Retirement System says it has earned a compounded return of 18% a year on private equity investments that have fully cashed out.
But there’s a danger in telling people how well off you are. The Service Employees International Union, which also testified at Frank’s hearing, declared that rank-and-file workers were being shortchanged while private equity magnates and their investors rolled in dough.
“For all the hundreds of millions of dollars in fees and billions in profits taken out in these deals by the private equity firms, the workers at most of the portfolio companies receive no increases in pay or benefits,” said Andrew Stern, the union’s president -- although it wasn’t clear how the SEIU could know that.
Another party that believes it is being shortchanged in the private equity boom didn’t have a seat at the table at Frank’s hearing: the bond investors who are helping to finance the public-to-private wave.
Bond investors have for months bemoaned the private equity industry’s increasing use of creative financing that essentially gives lenders fewer rights if a buyout company begins to have trouble paying its debts.
That complaint hasn’t kept bond investors from buying up this dicey debt, so if they’re about to be taken to the cleaners by private equity investors it’s the bond buyers’ own fault. And none of them should be surprised if, well before any debt problems arise, many private equity investors are able to extract handsome cash returns from their companies.
“If the bottom fell out, they’d still walk away with huge amounts of money,” David Dreman, a veteran investor who heads Dreman Value Management in Jersey City, N.J., says of the private equity players. They’re paid to watch out for their investors, not their creditors.
But Federal Reserve Chairman Ben S. Bernanke is paid to watch out for creditors, and last week he warned that financing for private equity deals posed “significant risks” for banks and that the central bank was taking a closer look.
Shareholders may feel that private equity investors are stealing their companies, and workers may believe they aren’t fairly sharing in the wealth. But Bernanke raised the most serious risk of all: that the private equity mania could be sowing the seeds of the next major U.S. debt crisis.