Private Equity and the Next Credit Crisis
My September Book Lust column included a preview of Josh Kosman’s book, The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis, which was released this month.
Monday I heard Kosman interviewed by Fresh Air’s Terry Gross (on NPR affiliates everywhere).
FASCINATING STUFF, including:
- How interest tax deductibility allows private equity (PE) firms to dodge about $70b in federal taxes
- Why you can’t buy a two-sided mattress any longer
- Why PE likes the hospital industry (and what it could mean to you if your local provider is bought by PE)
- PE firms (including the companies they own) are the largest employers in the country; even larger than Walmart (by a mile)
- Four of eight former treasury secretaries now in PE. John Snow (under G. W. Bush) is now at Cerberus which finagled bailout funds for its company, GMAC, by turning it into a bank (even though it didn’t have capital reserve requirements of “real” banks)
- Buyouts are facilitated by Collateralized Loan Obligations (CLOs), the private equity version of the mortgage industry’s Collaterelized Debt Obligations (CDOs)
- Returns to PE investors are below that of the S&P 500
SCARY STUFF, including:
- The conservative Boston Consulting Group estimates that half the companies owned by PE will default on their loans or go into bankruptcy
- If these companies lay off half their employees (which is reasonable) another 1.9m people will be out of work, which will ripple through the economy in consumer spending, mortgage foreclosures and so forth
- The trillion in bad debt will freeze lending everywhere
- Of the current 11% corporate loan default rate, 50% has PE involvement. Tsunami of defaults has begun
Prescription
Kosman would like to eliminate interest tax deductibility for corporate takeovers. This would make LBOs unprofitable and end the industry.
Why is the end of private equity considered a good thing? Don’t buyout firms improve companies? According to Kosman, PE firms only put down about 20% of the purchase price, then use CLOs to fund the remaining 80%. The acquired company has to service the debt out of profits instead of spending that money on R&D and other capital expenditures. PE has a 4-5 year horizon on its exit, so they’re not running companies for the long haul. Theoretically, everyone’s supposed to win with PE, but the record shows that few do.
The Obama administration is reportedly looking into this. Paul Volker is charged with considering the whole tax code, including tax deductibility of interest for buyouts.
Writing Prompts for Blogs and Newsletters:
- Here’s your chance to defend PE, and the enabling triumvirate of i-bankers, hedge funds and ratings agencies!
- Do you work for a pension fund that invested in CLOs? How will you assure participants that YOUR CLOs will perform in spite of the 11% corporate loan default rate Kosman cites?
- GMAC fired its CEO this week. Do you regret giving TARP money to this non-diversified auto lender-cum-bank?
- Do you have a better idea for recouping the estimated $70b in federal taxes lost to PE deals than dis-allowing interest deductibility? Are we in for a national value-added tax or sales tax?
A great example of how vulture capitalism has turned the US into the great short-term society it has become, where looking to the tip of one’s nose has become “strategic planning”. Of course, with the financial lobby owning Congress, what do you expect anyway? A government which actually believes in representing the people? What a fascinating idea that would be!
I find Mr. Kosman’s views to be fairly shallow. I have not read the book, but did listen to a big chunk of the interview.
The private equity industry is much more diverse than he gives it credit. Private equity is not just about buying companies using more debt. It was just a cheaper source of capital. (Capital always carry a cost.)
He is right that private equity over-indulged on cheap credit in 2006 and 2007. But they are not alone. The debt was cheap and lots of industries jumped on the cheap debt wagon. It will come due over the next few years.
There is certainly a lot of arguments on whether to allow the interest deduction for businesses, just as there is for the home mortgage interest deduction.
Think that there are several issues here. At the core, is that a larger group of people were “taught” that they should seek higher returns from their investment and retirement money. Since they were not smart enough to do this themselves, they had to turn to financial firms to do this, whether investment banks, private equity, etc. CNBC and other business channels and magazines fed this media frenzy and bonfire.
In order to satisfy this demand, investment banks took more firms public, while PE firms sought to squeeze greater “efficiency” (actually short-term returns) from other companies. The result is a US economy which has had maximum value squeezed out of it for the short-term, with little to no money left over for investment and R&D.
In the meantime, Americans will gradually come to realize that going public is not the answer to everything; some better-run firms are in fact private. Going public is not the answer to everything, and while some PE and VC firms can offer high returns, they are, and always will be, i n the minority. Higher returns of 50%+ always should be in the minority, even for rapidly developing new sectors.
finance is a game with no fixed rules designed solely for the benefit of the players. they eat each other, and everything around them. regulation is not possible. we live with viruses. and adjust around them.
This is an accurate assessment of the LBO prolem. I worked (past tense) for an advertising circular that went through two rounds of LBO’s
Upshot: The publication never invested the requisite captipal to create an Internet presence, even a novice observer could see the need for this investment around 1997, as the Internet appeared as a superior information channel for help wanted, auto, and Ebay-ish sales of personal property, not to mention personal ads.
The second LBO group has created a huge loss in value, essentailly reducing the value of the business by 65%.
I really think a non-LBO buyer would have managed the company for the long haul with much better results.
Mr. Kosman has performed a great and long-overdue service with this book. While I would award him high marks for effort, I’m afraid he sees only a small part of the horrendous macro picture.
The tax structure was radically changed back in the late ’70s and throughout the ’80s, purposely designed for debt leveraging, i.e., interest tax deductibility and providing tax advantages to structured financing of securitized pools — that is further encouraging the self-destructive force of securitization.
Those leveraged buyouts (LBOs) greatly enrich the pirates of private equity, while destroying employment, productive companies, and future opportunities for the American worker and innovator.
The three prongs of the trident, leveraged buyouts, labor arbitrage (the offshoring of American jobs and foreign job creation by American-based transnationals) and securitized financial instruments of mass destruction, are the force for the disassembling of the American economy.
Great for the Plutocrat Class, while turning the rest of us into the Serf Class.
With the Bush/Obama Administration appointments (that is, the recent appoints with Brand Obama in place) principally coming from either Goldman Sachs and/or Private Equity, this nation is truly in a world of trouble.
And while I support Mr. Kosman’s predictions, I would also state that private equity misdadventures make up a portion of the meltdown already, with those $633.8 billion of strucutured loans from the top banks (GAO-08-885 Private Equity report) along with the investments from the top pension funds (80% of those with greater than $5 billion in assets) going to those private equity funds of funds.
I think the statistics Mr. Kosman uses point to some deficiencies in the PE space, but fundamentally, I think there are two real issues that get at the root of the matter: 1) valuations and 2) leverage.
The valuations that were used in pricing these deals must have come out of some text they must have used at Hogwarts because they didn’t make sense to me 3 years ago. Whether you wanted to use Debt/EBITDA, Debt/CF, the valuations sounded out of whack and the growth forecasts assumed growth rates that simply didn’t exist.
Which leads to my next point: leverage. With interest rates at all-time lows globally (1% rates here & in Europe, 0% in Japan), there was a lot of cash that was just begging & pleading for as much excess yield as it could find. So if a CLO was getting shopped around and offered an extra 200 basis points in yield on what everyone thought would be “safe deals” (I never remember these things as being that safe), everyone would jump on with no questions asked.
The “scary stuff” you point out is bound to get here, it’s just a question of when. Those horses were out of the barn during the credit boom, so closing the door now is a tad late. Plus, you can always find a way to do these deals, taxes or not. If the cost of financing is cheap enough and if the legal structures/jurisdictions used have more flexible tax codes, you can find a way around most (if not all) of the reforms.
Maybe I’m just more risk averse than a lot of folks out there, but I called these things “dead men walking” deals as they were announced because I just couldn’t imagine doing them for the prices they paid and the required cost saves. Maybe we just need some attitude adjustments when it comes to taking risk.
Professor,
I really love the Hogwarts valuation reference.
I take your point about getting deals done without the tax code, especially with states and locales giving economic development incentives like the money was free.
As for risk aversion, I think Mr. Kosman’s point is that the manipulation of the tax code canceled out what would normally have been a deal-breaking risk premium on most of these transactions. Once again, the tax payer, who has no voice, foots the bill for financial folly.
Looking forward to your continued comments on this and other posts. (And good luck with that CFA).
Sergeant,
You have a real way with words (I notice these things). If you coined “three prongs of the trident…” my hat is truly off to you.
You mention plutocrats and serfs, which reminds me of the Gettysburg Address. “Of,” “by” and “for” the people, our republic is not. Reining in corporate influence and their ability to outright purchase legislators tops my list of constitutional reforms.
Thanks for reading & responding. Looking forward to more from you in the future.
Thank you for giving us a view from the trenches. I’m glad you’re a reader.
Doug,
I take your points. Would you like to expand on them in light of subsequent responses?
Thanks for reading and commenting.
Amazing as always
Tamela,
Point taken on the tax rate making these deals undoable. I guess if you sit back & think about it, very few of these deals made any sense through the years, so if you’re doing them just because there’s a tax advantage, it’s probably not a sound strategy for putting the deals together.
The bankers that structured them would argue differently, I know. But at the end of the day, can you tell me a deal like Hilton being taken private by Blackstone really had a value add? No, not really. It just Blackstone a lot more hotels to work with. But who wants to be a Dubai World subsidiary with Cracker Barrels (I’m talking about you, Hampton Inn.)?
Cheers.