There is good PE and bad PE. The opacity of current disclosures makes it difficult to tell which is which.
Public pension funds have been under pressure to seek greater returns on their investments for a long time now. Many of them have taken to allocating more of their portfolios to so-called, “alternative” assets, that have reported higher returns compared to what the pension fund can earn by investing in public equity and public debt markets. Most of these alternative assets usually involve investing in private equity funds. Bloomberg reports that public pensions make up 31.3% of all investors to private equity funds and contribute 67% of their capital as LPs (limited partners). In that sense, “private” equity is not merely a private contract between the manager and investor given that so much of the capital that funds that industry is from citizens’ pension money. On top of that, private equity is economically important in many ways: as of June 30, 2022, as per McKinsey, PE’s global AUM (assets under management) was approximately $11.2 trillion. The number of portfolio firms under PE management is reported to be double that of publicly listed firms.
Public pensions funds have also been vocal about ESG concerns in the public equity industry. Some, including me, have argued that this dynamic ironically creates a market for reporting arbitrage. Public companies, who hold assets with dubious ESG characteristics (greater carbon emissions or labor hidden in private entities with no public audit trails), have incentives to sell these assets to private equity to escape reporting pressures. On top of that, concerns have been raised by Brendan Ballou, Eileen Appelbaum and Rosemary Batt and Ludovic Phalippou questioning whether the returns claimed to be delivered by private equity are real and even if they are real, are these excess returns in private equity earned by one or more of the following dubious techniques: (i) excess leverage; (ii) sale-leasebacks; (iii) dividend recapitalizations; (iv) onerous management fees; (v) related party transactions; (vi) socializing costs by exploiting bankruptcy law or by tax avoidance; and (vii) poor customer outcomes in industries with large social footprint.
Before we go to the details of these shenanigans, it is worth mentioning that some of the concerns seem distinctly bipartisan. For instance, conservative think tanks such as American Compass are also concerned about these issues relating to financialization of the real economy and PE.
Next, I will elaborate on these techniques in plain English. These activities involve complex legal maneuvers and investment terms that can be hard to explain. Consider these as the essence, not the exact legal description, of what reportedly happens.
(i) The IRR problem:
PE portfolio companies are not traded on the stock market. The pension fund invests say $100 into a portfolio company and realizes say $150 when the portfolio company is sold or otherwise liquidated say five years later. Roughly speaking, the return on investment was 50% over a five-year period. But investors need more timely information about the company’s performance. To satisfy that need, PE sponsors report the so-called “IRR” or the internal rate of return, which, the ILPA (Institutional Limited Partners Association), an interest group representing LPs, defines as “when the net present value of the cash outflows (the cost of the investment) and the cash inflows (returns on the investment) equal zero, …the discount rate is equal to the IRR.” In effect, the PE sponsor comes up with a fair value of the portfolio company and reports an IRR. Fair values, especially in relatively illiquid markets, are unreliable and there is always an incentive for the sponsor to goose up the IRR, given that the valuations are not necessarily audited in all cases. IRRs reported by PE firms are subject to numerous other biases that are beyond the scope of this article. PE advocates have argued that these objections are baseless.
The inflated IRR hypothesis is somewhat hard to systematically verify because transparent data on an unbiased sample of PE portfolio firms’ performance, leverage, and fees are not widely available. The pension fund investing in PE funds hopefully knows whether the IRRs reported to them truly reflect their return on the fund that pension constituents could access and the alpha relative to the next best alternative. If not, they would do well to invest time and resources to verify the returns reported to them.
Even if the IRR numbers were fully accurate, we must grapple with an inherent contradiction underlying IRRs. IRRs will be higher when the portfolio company is sold or liquidated earlier, all else constant. Paying out early, by definition, encourages a short investment horizon, which is arguably the root cause for so many of the other problems listed next.
(ii) Excess leverage:
The claim is that the PE firm buys out the market value of the equity of a company from existing shareholders. Most of the PE firm’s investment is financed by debt that it has borrowed, perhaps from public pension funds. An important point is that debt is structured to stay on the company’s balance sheet. Hence, public pension funds could become the “residual” claimants if the company were to go under and does not have assets or profits to pay off its obligations.
The annual interest payment on the newly borrowed debt pressures the annual operating profits of the company. Companies sometimes may have such high debt burdens that they can’t afford to offer quality jobs and affordable goods and services. Some must restructure under the burden of debt if interest rates rise unexpectedly. This burden can lead to cost-cutting and hence loss of quality jobs, environmental investments, or compromised quality of goods and services offered, especially if the customer base is reasonably captive as in prisons and nursing homes. These considerations become more complicated if pension funds invest in PE as GPs but also hold debt issued by the PE or the PE sponsored company as pension funds benefit and lose from being on both sides of the transaction – owning the equity via its PE portfolio, but the debt through its fixed income portfolio.
(iii) Sale leasebacks and dividend recapitalizations:
The claim is that certain PE strategies are especially attracted to businesses that have large real estate footprints. The PE firm then arranges for a sale-leaseback of such real estate. In simple terms, this means that the real estate is sold to a buyer or special purpose vehicle (which can also be owned by the PE firm) who pays the company an upfront sum for the purchase and simultaneously makes the company a tenant on the hook for annual rent, which, in turn, places pressure on the company’s net income.
On the surface, this sounds like a good deal for the company, but the devil lies in the detail, of course. First, on the company’s balance sheet, mostly undervalued real estate is substituted by a cash inflow. In case a reader wonders why real estate is under-valued in the books, note that land and buildings cannot be written up in the financial statements, in general, in US companies. Second, the PE firm takes that cash and pays itself as a “dividend recapitalization” or the present value of future dividends from the company. In essence, the PE firm has recouped its equity investment in the company but continues to retain decision rights on how the firm is run. Finally, the math that equates the lumpsum “sale” proceeds to the “lease rent” and over what period needs to be scrutinized to assess the true economic return made by the buyer and the company. One would assume that the company gets a raw deal from the trade.
This is not to say that all sale-leasebacks are extractive. Some may be the right decision for the health of the company. Moreover, all dividend recaps need not occur via sale leasebacks. Some are driven by debt financing. The variety of transactions and questions about whether they are extractive or not depends on the context surrounding the firm. Absent disclosures, it is very hard to judge whether a set of transactions for a specific firm is extractive or not.
(iv) Onerous management fees:
The claim is that the company must pay the PE firm a management fee. This annual fee, on top of leverage, sale lease backs, places further pressure on the profits of the company. Industry insiders tell me that can be lots of different kinds of fees. Not all are annual. In particular, the PE firms charge the LPs onerous fees, as well, especially as AUM grows. Such pressures on the profits of the portfolio companies inevitably lead to layoffs and cost cuts. Cutting fat is efficient but cutting essential slack in systems designed to serve customers in sensitive industries such as health care, nursing, and prisons, as detailed below, leads to socialized costs that cause harm to patients, citizens, and society in general.
(v) Related party transactions:
Any company, in the ordinary course of business, must buy materials and or services from suppliers. The claim is that the PE firm forces the company to buy such materials and services not from “arm’s length” parties but from suppliers, either owned or affiliated with the PE firm. These transactions may or may not occur at “arm’s length” prices and the quality of the products and services bought may be inferior, considering the prices paid.
There is also the issue of PE firms selling portfolio companies to one another, with the same LPs in each fund, so the LPs potentially pay higher valuations in one fund for an asset they owned in another. Then there is the issue of continuation funds, where a single PE firm has multiple funds that buy and sell assets between one another.
(vi) Socializing costs via bankruptcy law or tax avoidance:
The claim is that all the newly imposed annual charges on operating profits of the company, via interest, rent on the sale leaseback transactions, PE management fees, and overpayment for purchased materials and services from related parties pushes companies to the edge of bankruptcy. The books allege that PE tends to get taxpayer funded entities such as Pension Benefit Guaranty Corporation (PBGC) to pay out unfunded pension plans of such bankrupt firms. And, have pension funds pick up the residual loss on the bankruptcy of the enterprise as the PE has already taken out its equity contribution via the dividend recapitalization. Industry insiders tell me that losses have been socialized in bailouts of over levered firms, including interventions undertaken during the pandemic. The tax avoidance claim refers to the oft-discussed carried interest loophole, whereby PE partners’ compensation is taxed as “long term capital gain” with lower tax rates.
(vii) Poor customer outcomes:
The claim is that PE is especially attracted to industries that have real estate or infrastructure assets on their books and whose revenues ideally fetch a steady cash flow with a growth rate that is above the rate of standard inflation. It helps if the state or the government is the customer as default risk is minimal. The ultimate customer is usually captive in that she is unlikely to go seek alternate sellers of the product or the service. These industries often also tend to be ones with a high social footprint including prisons, nursing homes, for-profit colleges, medical practices and the like. The books I referenced list horror stories in PE run companies that are too vivid and scary to even recount here (charging prisoners $25 for a phone call home, supplying prisoners with rotten food, patients dying in nursing firms on account of staff negligence, unemployable graduates of for-profit colleges saddled with debt, dentist and dermatology practices where patients suffer on account of unreasonable cost cutting and payday loan businesses where borrowers are trapped in a long cycle of indebtedness).
I would be remiss if I did not register my shock at the claims in these four books. For a long time, I had completely bought the “rational allocator” model of private equity, often taught in business schools, including by me, that private equity is Capitalism 2.0. It makes America a relentless engine of rational capital allocation by squeezing out inefficiencies in resource usage at poorly managed companies usually via the single-minded focus on efficiency that debt can induce in a manager. My class on managing a firm’s fundamentals emphasizes this “good” aspect of private equity. Indeed, private equity is a popular employer of choice for our MBA students. My belief in that paradigm has been shaken to core.
I am still willing to believe there is “good” private equity and “bad” private equity. I want to believe that the shocking stories in these books are outliers, and not a representative average of how PE works. So, I set out to look for disclosures on how to tell one apart from the other. Part 2 covers that investigation and a list of potential policy fixes.
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