Private Equity and Breach of Trust

WASHINGTON - Though private equity firms have garnered much more attention recently, the focus has mainly been on how partners in these firms use tax loopholes to amass vast fortunes in part by not paying their fair share of taxes. Much less is known about the sources of these earnings. A new report from the Center for Economic and Policy Research sheds light on this process.

PE firms raise capital from investors – pension funds, mutual funds, insurance companies, university endowments, foundations and wealthy individuals – to acquire a portfolio of companies. The leveraged buyout of a company entails extensive debt financing, with the acquired company – not the PE firm – required to put up its assets as collateral for these debts and to repay the loan. The overriding goal of private equity is to manage its portfolio of companies to maximize returns for itself and its investors.  Little is known about how the portfolio companies fare. PE firms claim that their profits come from adding value via better business strategies and operational improvements, and then selling these companies for more than they paid to acquire them.  This is one way that PE can create value. But this is not the only, and often not the main, source of PE gains. PE firms have strong incentives to increase their own returns by redistributing wealth from other stakeholders to themselves.

As CEPR economist Eileen Appelbaum, one of the study’s coauthors observes, “Private equity does sometimes use its superior access to capital markets and managerial know-how to improve efficiency in the operating companies it acquires. But often the gains that PE firms reap for themselves and their investors result not from the creation of wealth but from transfers from workers, tax payers, portfolio companies and creditors. Economists criticize this as ‘rent-seeking’ rather than ‘profit-seeking’ behavior. Breach of trust with stakeholders in the companies they acquire undermines the ability of these companies to create value and, in the worst case, threatens the company’s very survival.”

In pursuit of maximum profit, a company’s new PE owners may be willing to default on the implicit contracts with workers, vendors, suppliers, creditors and others that ensured that the acquired company’s stakeholders worked together productively and that were a major source of the economic value created by the company. This breach of trust with other stakeholders was identified as a potential source of shareholder returns in the leveraged buyout wave of the 1980s by Andrei Shleifer and Larry Summers. The report “Implications of Financial Capitalism for Employment Relations Research,” examines four contemporary cases in which the private equity owners sought to quickly increase profits by reneging on implicit contracts. The cases demonstrate how PE firms breach implicit contracts in the context of other strategies PE uses to maximize investor returns. The report examines how this process plays out for stakeholders in very varied settings. The U.S. department store chain Mervyn’s saw vendors, workers, creditors and the firm itself suffer losses after its buyout. When EMI Music Corporation was bought out, artists, managers, creditors and the firm were economically undermined. The New York rent-controlled complexes Stuyvesant Town and Peter Cooper Village saw renters and creditors lose millions. Finally, in the case of British confectioner Cadbury’s, traditional industrial communities face massive layoffs despite assurances to the contrary.  These very different cases show the similarities across industries in the mechanisms PE uses to make money.

The analysis challenges the agency theory view that the high levels of debt levered on portfolio companies leads managers of these companies to make better decisions, and that leveraged buyouts increase the profits of acquired companies through a better alignment of the interests of shareholders and managers. The cases presented in “Implications of Financial Capitalism for Employment Relations Research” illustrate how the use of portfolio companies’ assets as security for these loans exposes these assets and, in turn, employees and former employees to risk in leveraged buyouts. The necessity to service debt or face bankruptcy allows the new owners to break implicit contracts to meet debt obligations, undermining the relationships among managers, workers, suppliers, and local communities. The earnings of PE owners may come at the expense of other stakeholders rather than from an increase in efficiency, and the future of the portfolio company may be put at risk.

An important aspect of the financialization of the U.S. economy has been the rise over the past three decades of new financial intermediaries – private equity firms, hedge fund firms and sovereign wealth funds – that raise private pools of capital and provide an alternative investment mechanism to the traditional banking system.  The growth of these funds and the implications of their business models for firms and employees are examined in another report, “Financial Intermediaries in the United States.” Attitudes of these investors towards unions vary from hostile to pragmatic to indifferent. As long as unions don’t get in the way of making anticipated returns, these financial intermediaries can live with them.  Whether attitudes are hostile or not, however, the lion’s share of the wealth created by the productive enterprises in which these funds invest goes to investors while workers are left with less secure employment and lower pay and benefits.