THE BILLION DOLLAR QUESTION:What is the impact of private equity

on companies and workers?

Eileen Appelbaum, PhD.Center for Economic and Policy Research

www.cepr.netSUPER RETURN U.S. 2012

June 7, 2012Boston, MA

Key Characteristics of PE Model That Affect Operating Companies and Workers

• PE investments illiquid, more highly leveraged

Use of leverage => must yield predictable cash flow

PE model is opposite of ‘patient capital’

Op-co, Prop-co model in retail, restaurants, nursing

Financial markets may not recognize negative effects of dividend recaps and failure to invest

Top Executives in Operating Companies Face Perverse Incentives

Top executives:• Handed debt structure• Put up some of own wealth, promised great riches • Must meet shareholder targets• Fired if they fail to deliver quickly –> aggressive cost cutting

– Acharya & Kehoe 2008 found 39% of CEOs replaced in first 100 days, 69% in four-year period

– Like hangman’s noose, focuses mind on short-term profit maximizing

Sources of PE Gains

1. Operational engineering– Improve business strategy, access to superior management – Invest in capital, technology, worker skills; engage work force– Company grows organically, employment increases

– PE firm has greater access to capital to finance investment in technology or strategic acquisitions• Examples: hospitals, family-owned businesses• Distressed investing may rescue companies from bankruptcy

– Evidence on operating gains is thin – need to know more• Bankruptcy filings, press reports provide info on failures• Even sympathetic academic studies are not persuasive

Sources of PE Gains1. x

2. Transfer from workers to shareholders– Layoff workers, intensify work for those that remain– Reduce wages and benefits to increase predictable cash flow– Shift work from union to non-union facilities

3. Transfer from portfolio company to PE owners– Dividend recaps transfer resources, don’t enhance value

– Op-co/Prop-co: Op-co pays rent, Prop-co sells real estate to REIT • Asset stripping => Op-co unable to weather economic volatility

Sources of PE Gains

4. Transfer from taxpayers to PE – taxpayer financed capitalism– Leverage alters debt structure, reduces tax liabilities– Magnifies returns, but increases risk of financial distress/bankruptcy– Use of tax arbitrage reduces state, federal tax payments

(Badertscher/Katz/Rego 2011)

5. Breach of trust (Schleifer and Summers 1988)– Stable enterprises depend on implicit contracts shareholders/stakeholders – Reneging on implicit contracts gives quick boost to bottom line– But undermines trust necessary to long-term sustainability

6. Bankruptcy for profit (Ackerlof and Romer 1993)– PE firm takes portfolio company through bankruptcy, emerges as owner– But with write down of debt, transfer of pension responsibility to PBGC

PE and Jobs: (Davis, Haltiwanger, Jarmin, Lerner, & Miranda 2011 )

Impact on Establishments – Employment grows faster in PE targets prior to acquisition

– “…clear pattern of slower growth at targets post buyout … differentials cumulate to 3.2% of employment in the first two years post buyout and 6.4% over five years.” (p. 17)

– “Slower employment growth at PE targets post buyout entirely reflects a greater pace of job destruction” -- half due to closings (pp. 17-18)

– In retail, employment falls by nearly 12% in PE targets relative to controls – effect of prop-co/op-co model and asset stripping

PE and Jobs: Results from 2011 Study

Impact on Firms – Continuers and deaths: “Summing these two components yields a two-

year employment growth rate differential of -5.49 percentage points for PE targets, a large difference” (p. 23)

– Adding in greater job growth for targets than controls at greenfield establishments (+1.87) ”yields a differential of -3.62 percentage points for targets” (p.23)

– Only when acquisitions are included does the employment growth differential shrink to less than 1%

– “Finally, bringing in the role of acquisitions and divestitures reduces this differential to -0.81 points” (p. 23)

Risk of Bankruptcy

Strömberg 2008: Compares PE and publicly traded firms– For LBOs completed between 1970 and 2002 (before financial crisis)

• 7% became bankrupt while in PE hands• Twice annual bankruptcy rate of publicly traded: 1.2% vs. 0.6%

– 1980s boom: Many LBOs ended in default or bankruptcy (Kaplan & Strömberg 2009, Wright et al. 2007)

Hotchkiss/Smith/Strömberg 2011: Highly leveraged firms – 2,156 firms, half PE-owned and half not, Jan 1997-Apr 2010– Quarter of sample had a default between 2007 and 2010 (p. 9-10)

• 12.3% for 2001 LBOs, 31.6% for 1997 LBOs• 25% default rate: 2007 – 2010Q1

Conclusion

• PE has potential to improve portfolio company performance– Better access to capital markets and managerial know-how

• But laser-like focus on maximizing short-run shareholder returns, high leverage, short time horizon to exit– Leads to decisions that enrich investors and company execs without

due regard for long-term competitiveness of companies

• Regulation + reform of tax code can reduce risk of financial distress and incentives for opportunism & self-dealing

References• Acharya, V. and C. Kehoe (2008). “Corporate Gevernance and Value Creation: Evidence from Private Equity.”

http://www.ecgi.org/competitions/roi/files/Acharya_Kehoe_v5.pdf • Ackerlof, G. A. and P.M. Romer. (1993). “Looting: The Economic Underworld of Bankruptcy for Profit.” Brookings

Papers on Economic Activity, 24:1-74.• Appelbaum, E., R. Batt and I. Clark (2012). “Financial Capitalism, Breach of Trust and Collateral Damage,” paper

presented at Across Boundaries: An Interdisciplinary Conference on the Global Challenges Facing Workers and Employment Research, London School of Economics, December 13, 2011. http://www.cepr.net/index.php/publications/reports/financial-capitalism-breach-of-trust-and-collateral-damage

• Badertscher, B., S.P. Katz & S.O. Rego (2011). “The Impact of Private Equity Ownership on Portfolio Firms’ Corporate Tax Avoidance,” Manuscript.

• Davis, S., J. Haltiwanger,, R. Jarmin, J. Lerner, and J. Miranda. (2011). “Private Equity and Employment.” NBER Working Paper 17399. Cambridge. MA: National Bureau of Economic Research. Available at http://www.nber.org/papers/w17399

• Hotchkiss, E., D.C. Smith, & P. Strömberg (2011). “Private Equity and the Resolution of Financial Distress,” Manuscript.

• Schleifer, A. and L. H. Summers (1988). “Breach of Trust in Hostile Takeovers,” in A. J. Auerbach, ed., Corporate Takeovers: Causes and Consequences: 33-68. Cambridge, MA: National Bureau of Economic Research.

• Strömberg, P. (2008). “The New Demography of Private, Equity.” The Globalization of Alternative Investments Working Papers Volume 1: The Global Economic Impact of Private Equity Report 2008, World Economic Forum, January: 3-26.

• Wright, M., A. Burrows, R.. Ball, L. Scholes, M. Meneleman & K. Arness (2007). “The Implications of Alternative Investment Vehicles for Corporate Governance,” Cited in A. Watt (2008). “The Impact of Private Equity on European Companies and Workers: Key Issues and a Review of the Evidence,” Industrial Relations Journal 39(6): 548-568.