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?

Dwight’s Death

Dwight was new to my small business, but had worked for a similar company doing the kind of work we did and he was good at it.  He’d been with me about a month when he asked for an aspirin to suck on.  He had a bad tooth and his dental appointment, at a public clinic for the poor and un-insured, was weeks away.  Unlike many of his co-workers, Dwight’s tooth didn’t get in the way of a good day’s work.

I nearly fell down that Sunday afternoon when his young daughter called my cell phone to tell me that Dwight had died. I was buying some tools and supplies for the next week’s work and probably made a scene on the floor of the hardware store when I burst into tears and repeatedly screeched “What?  How?”

Officially, we’ll never know the answer since the family couldn’t afford an autopsy.  We all speculate that the tooth was worse than Dwight had let on and that it had poisoned his bloodstream and led to organ failure — a condition called sepsis.  According to estimates by the University of Rochester Medical Center 750,000 cases of severe sepsis occur each year, more than congestive heart failure, or breast cancer, colon cancer and AIDS combined. It begins with an infection that triggers an inflammation response throughout a person’s entire body. This whole-body response to infection – termed sepsis – produces changes in temperature, blood pressure, heart rate, white blood cell count, and lung function. Half of all people diagnosed with sepsis will die.

At that point in time I could afford to offer my employees medical insurance but Dwight hadn’t passed the 90-day waiting period.  Truth is I don’t know if he could have passed the medical questionnaire required to qualify for coverage.

Since employee life insurance was bundled with medical, his family had to postpone his funeral twice while they raised money to bury him.  Everything I had (and then some) was already in the business or I’d have written the check myself.

Seeing both sides of the fence

Health care reform gets very personal to me as a result of being a small business owner who used to be an insurance company executive.  I have a view from both sides of the fence.

Dwight’s story tells the personal side. From the insurance side, I remind readers that the American courts have decided a corporation’s primary LEGAL responsibility is to its shareholders, therefore insurance companies must put their profit motive first — before quality of care, before anything. Regulations are in place to mitigate this profit motive, but they’re just speed bumps.

Blood money

We set private insurers in the business of earning “money gotten at the expense of others’ lives or suffering,” which is blood money by definition.  We Americans do this because we worship the market.  We don’t have a healthcare system in this country, we have a market for it.

Author Thomas Frank’s book One Market Under God walks us through the development of our cultural ethos that says we must leave everything to the markets. The mantra “Markets are good, government is bad” is why we’re in this healthcare jam.  After all, markets are interested in profits and profits only; service, quality and general affluence are different functions altogether.

According to Frank, here’s what Americans have come to believe: “You must liquidate the past; you must privatize, deregulate, and de-unionize; you must trust the market implicitly and allow the market to dictate every aspect of your existence. Only when you commit yourself fully, when you give it all to the market, will your voice be heard; only then will the little guy be empowered.”

He then reminds us what happens when the markets rule: “The market will give you a voice, empower you to do whatever you want to do – and if you have any doubts about that, then the market will crush you and everything you’ve ever known.”  Didn’t Lehman Brothers a year ago illustrate that?

In last year’s PBS Frontline special Sick Around The World, journalist TR Reid walked through how parts of the US healthcare “market” resemble the “systems” of other countries:

• VeteransAdministration = British NHS
• Medicare = Taiwanese system
• Employed people with workplace insurance = German system
• Any poor country = Americans not covered in one of the above

Limits on the magic of markets

If the crash of 2008 taught us anything it’s that we don’t REALLY trust markets.  If we did we wouldn’t have bailed anyone out and fallen into a Depression that would have made the 1930′s look downright prosperous.

Time to carve out an exception to the wisdom of the markets in this healthcare debate.  The market is just a market, not an omniscient, benevolent diety, and certainly not a responsible government guided by a collective conscience.

Corporate Bankruptcy Word Cloud

Here’s a free word cloud maker:  www.wordle.net

Simply copy-paste your text or give Wordle an RSS feed and let it work its magic.  When it spits out your custom image, you can play with the layout, fonts and colors to your heart’s content.

I took the two (so far) responses to “Corporate vs Personal Bankruptcy Attitudes” and fed them through Wordle and got this result:

Sink AND Swim

Yesterday I asked a question about attitudes toward individuals filing for bankruptcy protection.

Today I want to point to an article in The Atlantic’s June 2009 edition titled, “Sink and Swim” wherein the magazine’s business and economics editor Megan McArdle argues that a relatively lenient American system of debt forgiveness is actually good for our economy:

“America leads the developed world in bankruptcies because for more than a century, we’ve worked hard to build the best—and, not coincidentally, the most generous—bankruptcy code in existence. We didn’t do it by design, but in fits and starts; the hodgepodge of innovations that have helped systematically ensure that debtors get a fresh beginning were as much the brainchildren of grasping creditors as of beleaguered debtors. Nonetheless, our system works so well that other nations are trying to move away from their harshly punitive treatment of insolvent debtors, and closer to our free-and-easy, all-is-forgiven model.

“Our leniency toward those with unsustainable debts helps not only profligate debtors, but the rest of us as well. Less onerous bankruptcy procedures boost rates of entrepreneurship: reduce the cost of failure, and people become more willing to take risks. America’s business environment is much more dynamic than that of Europe or Japan, for many reasons—and our generosity to capitalism’s losers is one of them.”

Debtor’s prison, anyone?

It seems most people want at least a pound of flesh from the insolvent.  Let’s see how that works by looking at Dubai, a country with no concept of bankruptcy.  As soon as you leave your job in Dubai, your employer has to inform your bank. If you have any outstanding debts that aren’t covered by your savings, then all your accounts are frozen, you are forbidden to leave the country and they throw you in prison.

Yep, that’s just what we need — more people in prison sucking up public monies for their upkeep instead of trying to start businesses and raise their families on the outside.

Prompts for financial and legal professionals:

• Based on what you’ve seen with your clientele, are we each just a job loss or serious illness away from insolvency?
• Are any of your clients asking if they should liquidate their 401-ks to stave off a bankruptcy filing?  Under what circumstances do you think this is a viable strategy?
• What should our schools do about the lack of financial literacy in America?  What can be done about the financial  illiteracy of adults?
• Has this recession in any way made you re-examine your professional views on the Bankruptcy Reform Act of 2005?

Corporate vs Personal Bankruptcy Attitudes

Blame the victim?

I ghostwrite a bankruptcy practice’s blogsite and moderate the comments.  Got an interesting comment last week. The commenter wanted to be on record that bankruptcy attorneys are devil’s spawn who enable the deadbeat insolvent to saddle the piously solvent with their mistakes.

The commenter isn’t the only one with this attitude, which is why I bring it up.

When a company declares bankruptcy the angry mob doesn’t break out the pitchforks and go after the management team or board (with a nod to the quasi-exceptional case of former GM head Rick Wagoner).  But the screeds about people in foreclosure and those who seek bankruptcy protection proliferate like melanoma cells.

Upside-down logic

According to the Institute for Financial Literacy, the four most common causes of financial distress include overextension on credit, unexpected expenses, reduction of income and job loss.  These are essentially the same reasons corporations file for protection (income and job loss more logically rolled together in the case of businesses).

So when it’s the masters of the universe and captains of industry at the helm of corporations making short-sighted decisions that drive their companies into financial distress, why are we so hard on the employees and small business owners whose personal misfortunes are tied to corporate failure?

Welfare Queens?

Those of us alive during the 1980′s remember the famous stories/urban legends of the woman paying for groceries with food stamps, then carrying them out to her new Cadillac.  In other words, gaming the system and thumbing her nose at the rest of us.

Is there a bit of that same belief about individuals who go bankrupt?  That they use bankruptcy as a personal money management strategy like Donald Trump uses it as a business strategy?  Hrumph, even The Donald gets his own TV show and multi-level marketing network of millions.  What gives with our idol worship of this guy and our disgust for the little guys?

I’d really like to know what’s behind the difference in attitude here.  Please weigh in.