The Private-Equity Time Bomb

The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis

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by Josh Kosman, Portfolio, 280 pages, $26.95

You may recall a front-page New York Times story from last October about Simmons Bedding Company. The 133-year-old Wisconsin firm was entering Chapter 11 bankruptcy, having been bought and sold by private-equity companies four times since 1986. The private-equity owners sucked out capital from a perfectly viable operating company and loaded it up with debt so that they could extract more money; when it collapsed under the weight, they took it into bankruptcy. Altogether, the private-equity owners made an estimated $750 million in profits, while the company's debt went from $164 million in 1991 to more than $1.3 billion in 2009. In the bankruptcy, bondholders alone will lose some $575 million, and more than a thousand workers have already lost their jobs.

What happened to Simmons has happened to hundreds of other companies, and worse is yet to come. Some iconic American brands are now speculative playthings of private equity, which has become a Madoff-scale scam, albeit a perfectly lawful one. The practice is not only legal but encouraged by our tax, securities, and bankruptcy laws. By giving financial engineers a deduction against taxes otherwise owed for the interest paid on borrowed money, the tax code creates an incentive for private--equity artists to rely heavily on borrowing. Neither tax nor regulatory law distinguishes between productive borrowing and abusive borrowing, and the bankruptcy code allows a corporation to wipe off old debts, no matter how abusively or corruptly they were incurred. And because the securities laws are designed primarily to protect investors rather than the integrity of the system, private-equity companies are exempt because they do not have shareholders in the usual sense of the term. The companies' shares do not trade on exchanges, though they have limited partners who are akin to shareholders.

Private equity, as financial journalist Josh Kosman explains in this brilliant and necessary book, is misnamed. It might better be named private debt. Unlike a bona fide venture capitalist, a private-equity company does not add net equity capital. Mainly, it adds debt, which in turn finances windfall extractions, often at the expense of the operating company, as in the case of Simmons. "The idea that PE firms put cash into companies was a widely held misconception," he writes. The victims are workers (whose wages, benefits, and pensions are squeezed), suppliers, creditors, communities, and the very existence of once proud and viable American corporations. And warns Kosman, as these companies increasingly enter bankruptcy, private equity will cause yet another credit crisis comparable to the sub-prime disaster.

The fable told by the private-equity industry, Kosman explains, is that many companies are poorly managed and sources of cost-savings could be wrung out by new management brought in by new owners. Alternatively, the story holds that their share price undervalues the parts of an enterprise that could be more profitably deployed if reconfigured or broken up. But in reality, very few private-equity owners are willing to play the role of both disruptive innovators and patient capitalists. They are interested in quick windfalls. What makes the entire business model viable is that companies, or their parts, can be bought and sold several times with borrowed money, using the subsidy of a tax break on the interest each time.

If this tale sounds vaguely familiar, it's the story of the leveraged-buyout (LBO) craze of the 1980s. When the LBO business crashed and burned, Kosman explains, LBO operators rebranded their industry as "private equity," which sounded so much more dignified. Many of the players, such as KKR, are the same. True venture capitalists, Kosman writes, "invest in growing companies, and they maintain an active oversight role as these companies grow and change." Private-equity firms, by contrast, make their big bucks on buying, loading up the company with debt, and selling -- sometimes to each other so that tax breaks can be used each time. In addition, they pay themselves exorbitant "special dividends" and "management fees," looting the cash flow that the operating company needs for its ordinary operations, not to mention investment in innovation.

There have been other books on abuses of the leveraged buyout game, but Kosman's is the first to comprehensively describe the modern private-equity industry as it has evolved over the past two decades, and its risks and costs to the economy. He had a particularly good perch to cover this story. Beginning in 1996, as a young journalist, he took a job for the Buyouts Newsletter and then at the Daily Deal newspaper, which covers the industry for a business audience. He knows private equity as well as any financial journalist. Over the years, he became appalled at what he was covering but stayed on the beat. "I decided to learn as much as I could about private equity to write a book about the industry aimed at a general readership," he writes.

The stories are grimly familiar. Thomas H. Lee Partners, one of the biggest private-equity firms, buys Warner Music, the world's fourth-biggest music company, and loads up the company with debt to finance the buyout and to pay itself $1.2 billion in dividends. One-third of the work force is fired. KKR, Merrill Lynch, and Bain Capital team up to buy Hospital Corporation of America, a long-troubled company with 170 hospitals. Staffing is thinned, standards erode, complaints increase. CD&R, The Carlyle Group, and Merrill Lynch buy Hertz, the nation's largest auto-rental company, putting up $2.3 billion in cash out of a $15 billion deal. The private-equity owners quickly recoup more than half of their down payment by loading up the company with even more debt. Funds for rental operations are cut by 39 percent, and Hertz's market share falls. Bain Capital, the company that made Mitt Romney rich, invests just $18.5 million in KB Toys, extracts $85 million in dividends, then takes the company into bankruptcy, stiffing employees, investors, and creditors.

Early in the last decade, private equity thrived on the same bubble that pumped up housing prices and created the sub-prime boom and the general illusion of prosperity. And the entire game was eerily reminiscent of sub-prime. Like much of the rest of the bubble, private equity's windfall gains were based on borrowed money. Buyout volume, Kosman reports, peaked in 2007, at $486 billion. Between 2000 and 2008, there were a total of 3,188 such deals. Like sub-prime, private equity was one of the schemes that generated enormous fees for Wall Street firms that arranged the takeovers and the financing. The biggest financiers, not surprisingly, were JPMorgan Chase, Goldman Sachs, and Citigroup. Most of the debt, in precisely the fashion of the sub-prime disaster, was turned into securities and bought by pension funds, hedge funds, and ordinary investors. And like the rest of the economy, private equity is facing a day of reckoning -- but one that has been slightly delayed because the collapse of the overburdened operating companies is not happening all at once. Kosman reports that private-equity firms own companies that employ some 7.5 million Americans, and he estimates that half of them will go bankrupt between 2012 and 2015, leaving a trillion dollars worth of debt in their wake and costing close to 2 million jobs.

There have been efforts over the years to prohibit these abuses, and all have failed. In 1987 the chairman of the House Ways and Means Committee, Rep. Dan Rostenkowski, after congressional investigations of the first wave of LBO disasters, proposed to close the tax loophole that rewards takeovers with borrowed money. But that was the year of a stock market crash, and Congress was in a mood more to restore confidence than to reform the abuses. President Barack Obama's plan for broad financial reform has only the most minimal reporting requirements for private-equity and hedge funds. The revolving door between administrations of both parties and the private-equity industry, plus the industry's very efficient use of lobbying and campaign contributions, as Kosman observes, makes substantial reform unlikely any time soon. Kosman's contribution, in an exceptionally clear and careful book, is to shine a bright light on this little-appreciated time bomb to remind us why the current financial crisis is made up of many interconnected parts and that absent radical reform, that crisis is likely to continue detonating.