Can Private Equity Cause the Next Big Credit Crisis?
Four of the past eight Treasury Secretaries now lead PE firms. New York Senator Chuck Schumer, the “senator from Wall Street”, raises buckets of money from PE firms. Efforts to modify interest deductibility have gone nowhere. So, should citizens play by their rules or totally change the game to geonomics? We trim, blend, and append this 2010 review of a new book by Josh Kosman from the blog Econoamici on August 6.
by Polly Cleveland
In The Buyout of America Josh Kosman introduces us to the private equity or PE firms. They are a major force behind what Barry Lynn called “the economics of destruction.”
PE firms. You haven’t heard of most of them, and they like to keep it that way. A few better-known ones are the Carlyle Group, Goldman Sachs, Kohlberg Kravis Roberts, and the Blackstone Group. They are the descendants of the notorious leveraged buyout operators of the 1970s.
Target corporations. These are typically midsize to largish corporations, steadily profitable but not exciting. Often, like hospital chains, they are not especially well-managed.
Investors. These are mostly pension funds, desperate for higher returns to compensate for prior underinvestment. They include public pension funds, like the giant California Public Employees Retirement System.
Banks. These are mostly the big banks, like JP Morgan Chase or Citicorp, eager for loans that they can “securitize” and sell off.
Purchasers of securitized loans. These are also mostly pension funds, seeking super-safe passive investments for the bulk of their portfolios.
US federal and state taxpayers.
Step one. A PE firm lines up investors, who typically commit to supply funds over a period of up to 10 years. The PE firm promises spectacular returns.
Step two. The PE firm bids for a target corporation. It may put up 5% of the bid while its investors supply the rest. For the balance of the purchase price, some 70% to 80% of the total, it arranges a huge bank loan, which it puts on the target’s books. The target essentially assumes the debt to buy itself out. Under terms of the deal, the target may pay interest only on the loan for five or six years, before the principal becomes due.
Step three. Because interest on the loan is deductible, federal and state taxpayers pick up a big piece of the loan interest, 35% federal, plus whatever state tax piggybacks on the federal.
Step four. The bank securitizes the loan, combining it with other loans to create what are called “collateralized loan obligations,” or CLO’s. CLO’s are equivalent to the “collateralized debt obligations”, or CDO’s, which banks created from mortgages. As with the CDO’s, the bank divides the CLO’s into “tranches”, gets Standard & Poor’s or Moody’s to rate the top tranches AAA, and sells them to further investors.
Step five. The PE firm installs its own management, which starts raising prices and cutting costs, including laying off employees and scaling back R&D. The PE firm has three objectives here: first, it must enable the target to pay the interest on its debt. Second, it must make the target look profitable in the short run so it can sell it when the debt principal comes due in a few years. Third, it seeks to liberate cash to reward itself and its investors during the few years it owns the target.
Step six. The PE firm starts extracting money. It charges its investors a 2% annual fee. It charges the target a 15% “management fee.” It may pay itself a huge dividend. Cerberus Capital Management, which bought Mervyn’s department stores, split the company in two: a real estate division and a Mervyn’s store division. The real estate division promptly jacked up the rent on the store division.
Step seven. The PE firm sells the target, now crippled by debt and underinvestment. Or the target goes bankrupt, like Mervyn’s.
Within a few years, fees and dividends have earned the PE firm many times its original small investment. The PE firm’s investors sometimes do well, but often not, especially when the target goes bankrupt. The buyers of CLO’s from the banks also lose when the target goes bankrupt. Employees lose, both during initial cutbacks and eventual bankruptcy. Customers lose vital services, as when PE-owned hospitals cut nursing staff. The whole economy loses, as once-competitive firms are weakened or destroyed.
But there’s worse to come. The PE firms went on a feeding frenzy during the bubble years leading up to 2008. They now own over 2000 target companies whose loan principal comes due around 2012. If half these go bankrupt, Kosman estimates, some 2 million of the 7.5 million PE firm employees could lose their jobs. And the collapse of CLO’s could wreak further havoc on the banking system.
An end to interest deductibility, or at least deductibility for buyout loans, would stop PE firms in their tracks. So would limits on corporate debt, or requirements that buyers of corporations hold them for at least five years. Eliminating the “carried interest” loophole, which allows financial managers to pay only the 15% capital gains rate, would also weaken PE firm’s tax advantages.
JJS: But could all these shenanigans go on in a geonomy? In a geonomy, all the money we spend for the land and resources that we all use would go into the public treasury (to fund useful services or dividends or both). But the point is, this flow of rent would benefit us all equally, not just a few owners or speculators. So they’d no longer have any reason to speculate in land.
Further, banks would have much less money to lend to speculators, because now banks get most of their money from mortgages, and mortgages would be much smaller. Why? Because the loan would not include the land. The value of the land would be the rent that individuals would pay to their community, and you can’t get a mortgage to pay rent.
Also, in a geonomy there’s no tax on earnings, so there are no tax loopholes. Once again, if you want a real reform, forget addressing symptoms and confront transforming the whole system. Establish geonomics.