Illustration by Sarah Angèle Wilson
This article appears in the August 2022 issue of The American Prospect magazine. Subscribe here.
It is genuinely hard to find a more destructive economic force in America today than the private equity industry. It encompasses all of the negative trends that have undermined living standards for the broad mass of citizens since the Reagan era: the escalating share of national income going to finance, the rise of market concentration, the contempt for workers, the yawning gap between rich and poor.
The biggest private equity firms buy up companies with borrowed money and load them with debt. While fund managers extract cash through fees and financial engineering, the companies struggle to pay off these new obligations on their balance sheet. The subsequent cost-cutting of jobs, wages, and pension plans can be seen as a direct transfer from labor to capital, with the financiers growing impossibly rich while everyone else suffers.
The leveraged-buyout era has immiserated labor, dampened productive investment, and degraded the experience of workers, customers, and the larger economy. We should ameliorate this suffering by ending private equity as we know it.
Right now, that seems like a fantasy. The industry is entrenched in housing and health care and energy and retail and restaurants. It’s involved in far more obscure markets, from Nielsen ratings to Smarte Carts at the airport to voting machines to Plan B, the morning-after pill. As of 2020, companies owned by private equity directly employed 11.7 million employees, comprising roughly 1 out of every 13 U.S. workers. Cheap money issued during the pandemic likely expanded that further, producing a record number of buyout deals.
But the market downturn in 2022, the ebbing power of the industry, and the growing awareness of its perverse impact on the economy present an opportunity to rethink how easy America makes it for predatory financiers to thrive. At every level of the private equity experience—from fundraising to acquisitions to exits—we either subsidize the industry’s business model, facilitate its war chest, or allow firms to separate actions from consequences. If we focused attention on turning off the fire hose of money flowing into the biggest firms, the worst elements of private equity could be a thing of the past. Here’s how.
PRIVATE EQUITY FIRMS RAISE funds from several different sources. But after the industry temporarily collapsed amid Michael Milken’s prosecution in the late 1980s, institutional investors like public pension funds and university endowments drove the return to prominence. That support can be traced to one law signed by President Bill Clinton. It’s called the National Securities Markets Improvement Act of 1996 (NSMIA), and its impact has been almost totally forgotten to history.
The Investment Company Act of 1940 required investment funds to register with the Securities and Exchange Commission, with regular reporting requirements, prohibitions on certain transactions, and restrictions on leverage (the use of large amounts of debt). Only investment firms that limited themselves to under 100 investors could avoid the 1940 Act restrictions.
The leverage restrictions alone—investment companies must carry asset coverage of $3 for every $1 of borrowing—would make the private equity business model largely impossible, so firms kept under 100 investors per fund. But Section 209 of NSMIA allowed exceptions for funds with over 100 investors, as long as they were “qualified purchasers,” defined as either individuals with $5 million or more in investments or institutional investors with over $25 million in assets. This opened a new funding base, which happily rushed in, seduced by the prospect of outsized returns. A decade later, in 2006, there was $375 billion in private equity acquisitions, 18 times the amount of just three years earlier.
The tools exist today to stop private equity, in a law written 82 years ago.
So the first way to reduce the involvement of private equity in every aspect of our lives would be to repeal Section 209 of NSMIA. This would both reduce the amount of available capital in each fund and limit private equity’s more attractive options. For example, firms have sought to get their investments into 401(k) plans, offering themselves to small investors for the first time. The Department of Labor has tried to put a stop to this. But if PE funds fall under the 100-investor rule, it wouldn’t be worth it to them to tap retail investors.
The bigger deal here is it would kick most institutional investors out of the private equity game, leaving them much better off. Contrary to private equity’s claims, their long-term performance does not beat the public equity market, as a 2020 study by Ludovic Phalippou showed. The business is good at minting the billionaires who run private equity firms, but less so at enriching its partner investors. Despite this, public pension fund exposure to alternative investments has risen to more than 30 percent. These are the retirement dollars of ordinary workers funding the decimation of ordinary workers. Saving pension funds from themselves should be a public-policy goal.
LIMITING FUTURE FUNDRAISING won’t affect the current cash pile, which surged over the past year. Firms are sitting on an estimated $2.3 trillion in “dry powder,” which refers to money not yet deployed. So in addition to dampening fundraising, there need to be prescriptions for the rest of the private equity cycle.
For instance, when a PE firm buys a company, it should be subject to merger review. The new antitrust regimes at the Federal Trade Commission (FTC) and the Department of Justice (DOJ) have raised concerns about firms’ ability to roll up smaller players and bolt them onto one company, giving them dominance in an industry while making the acquisitions small enough to avoid merger reviews.
Both Jonathan Kanter, head of the Antitrust Division of DOJ, and FTC chair Lina Khan have vowed to scrutinize private equity more closely when they buy assets available in a divestiture, raising challenges that previously flew under the radar. Both have also brought claims that certain private equity acquisitions are anti-competitive. This could hinder rollup deals that are among the most dangerous. You know they’re onto something because the industry and its allies have angrily objected.
Presumably, some deals would still get through. Right now, PE managers can siphon value from portfolio companies without caring whether they live or die. One of the most popular methods is through management fees or dividends, really just cash payments from companies to fund managers.
In addition to a strategy to prevent new acquisitions, we also need one to prevent corporate pillaging. Some politicians have proposed a moratorium on dividends for the first two years after a purchase, so PE firms can’t immediately strip a company for parts. More broadly, if you made private equity firms and their general partners jointly liable for any debt they place on a portfolio company, they’d have to think much more deeply about their activities. “That’s the stake through the heart,” said Eileen Appelbaum, one of America’s most careful observers of private equity.
Joint liability would get PE firms to actually fear the risk of bankruptcy in one of their portfolio companies. Ten of the fourteen largest retail bankruptcies between 2012 and 2019 came from private equity–owned companies. As the pandemic began, private equity was responsible for more than half of the corporate defaults in the U.S. economy.
An obscure case now in U.S. bankruptcy court gives a sense of the threat. Creditors at Toys ‘R’ Us, which was bought by multiple private equity firms in 2005 and then driven into liquidation, are suing former executives and directors over spending too much money after filing for bankruptcy, as well as for paying advisory fees to PE managers in the years before liquidation.
The judge in the case said the claims could proceed, which resemble a joint liability situation where the PE firms would have to pay out to creditors. If the industry faced that with every company, there’s no question it would be more responsible in limiting leverage. Plus, if workers at PE-owned firms were guaranteed severance, that would also force financiers to pay more attention to actually making companies work well rather than extracting value at workers’ expense.
MARK LENNIHAN/AP PHOTO
Blackstone, one of the world’s largest private equity firms, has been among the companies obtaining funding through life insurance annuities.
FEDERAL RESERVE TIGHTENING has cramped private equity in 2022. Fundraising targets have been lowered, and with interest rates up, leveraged buyouts are less likely. What’s more, the value of portfolio companies is much lower than what PE firms bought them for. Because PE firms have to return cash to their investors on prescribed timelines, these “bad vintage” companies are going to cause a “terrible hangover,” as the Financial Times put it.
PE firms have dealt with this by hiding the real value of their portfolios from investors, or selling companies to other PE firms that need to spend cash, in overinflated private deals. In a new and confounding wrinkle, they are now selling companies to themselves. These “continuation funds,” which are affiliates of the original firm, allow high valuations and more fees for PE managers, with investors kept in the dark. A top asset manager in Europe was spurred to call private equity a “Ponzi scheme” because of this maneuver. It’s reflective of the heads-I-win, tails-I-win mentality of the industry, which is able to find escape routes to avoid the pain of any negative consequence.
Joint liability could help fix this. So could a simple ban on continuation funds and other forms of self-dealing. In addition, the Securities and Exchange Commission’s new private fund rules would mandate quarterly statements to investors that detail fund performance, and require firms that make deals involving continuation funds to supply a “fairness opinion” detailing prior business relationships. The proposed rule has earned support from financial-reform groups.
Stringent monitoring would also tamp down another private equity innovation. The industry has recently taken to buying out life insurance companies for their annuities, turning the prodigious assets under their control. Blackstone took a stake in Allstate Life Insurance Co., for example, in exchange for the ability to manage their assets. While this could evade fundraising limitations, it brings private equity under the scrutiny of state insurance commissioners, which could put in guardrails, like prohibiting annuity assets from flowing into risky investments like private equity deals.
SOME OF THESE PROPOSALS are in the Stop Wall Street Looting Act, introduced by Sen. Elizabeth Warren (D-MA); some are not. Combined, they share the same goal of throwing kinks into private equity’s money hose. Putting PE back under the 100-investor rule would limit fundraising; enhancing merger review would make it harder to put the remaining money to use. The Warren bill mandates joint liability over debt and severance for laid-off workers, which would stick private equity with the consequences of their bad actions. It also limits financial extraction, like with a moratorium on early-stage dividends. Banning continuation funds and other forms of self-dealing would reduce the ways the industry seeks to engineer its own bailouts.
But the biggest single action to drive harmful private equity firms out of the economy would be to simply put all investment funds under the 1940 Act regulations with no exceptions, thereby limiting the leverage that is the mother’s milk of private equity. The societal value of allowing PE firms to load debt on companies is questionable and the harms can be great. The tools exist today to stop it, in a law written 82 years ago.
Crushing private equity would leave a lot of small and startup companies in need of funding. But that’s what the traditional banking system is for. When private equity controls the means by which companies can acquire needed funds, it’s no wonder that the terms are so tilted in their favor. But more reputable lenders whose interests are aligned with the companies doing the borrowing would eliminate the current need for private equity in the marketplace.
If we’re going to achieve broadly shared prosperity, we need to break the cycle of cheap money fueling runaway speculation. The goal should be to follow that money and keep it out of the hands of predators whose self-enrichment doesn’t correspond to society’s benefit.
