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Home Publications Blogs Beat the Press NPR Does Fluff Piece for Private Equity

NPR Does Fluff Piece for Private Equity

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Friday, 13 January 2012 05:19

A Morning Edition segment today told listeners (sorry, no link yet) that "there's no doubt that private equity firms create value," which it then justified by referring to the high returns earned by those who invest in private equity (PE) companies. This is WRONG!!!!!!!!!!!!

First, it is not at all clear that those who invest in PE funds (not the PE partners themselves) do beat the stock market when a full accounting is done. Recent research shows that net of fees, private equity investors (pension funds and university endowments) would have been better off buying the S&P 500.

Furthermore, even if the PE investors did come out ahead, this does not mean it created value. Investors in Bernie Madoff's fund, who got out, made money too, but Bernie Madoff did not create value.

Much of what private equity does is financial engineering. For example, it is standard to load up the companies they purchase with debt. The resulting interest payments are tax deductible. This increases profitability but creates no value for the economy. It simply transfers money from taxpayers to the private equity company. 

To take a simple example, suppose a public company (let's call it Gingrich Inc.), has $1 billion a year in profits. If Gingrich Inc. paid taxes at the full 35 percent rate (fat chance), it would have $650 million [thanks Robert] a year to either keep as retained earnings or to pay out as dividends to its shareholders.

Now suppose that a PE company (we'll call it Romney Capital) steps in. The current price to earnings ratio in the stock market is around 14, so Gingrich Inc. would have a pre-takeover market value of approximately $9.2 billion (14*$650 million). Romney Capital then arranges for Gingrich Inc. to borrow $6 billion which it pays out as a dividend to itself. This means that the Romney Capital has just gotten back almost two-thirds of its investment.

Suppose that Gingrich Inc. pays 5 percent interest on its debt (closer to the 5.20 Baa rate than the 3.80 Aaa rate). This means that before tax profit falls by $300 million. This leaves Gingrich Inc. with $700 million in before tax profit. Deducting the 35 percent tax, Gingrich Inc. now has $455 million a year to distribute to Romney Capital, 70 percent as much as before ($455 million/$700 million) even though Romney Capital has already recovered two-thirds of what it paid for Gingrich Inc.. In this case, the benefit to the Romney Capital came at the expense of taxpayers, not through the creation of value.

Now suppose that the Romney Capital arranges to sell off some of Gingrich Inc.'s assets, such as real estate or a highly profitable subsidiary, and then uses the proceeds to make a payment to the Romney Capital rather than leaving the money under the control of Gingrich Inc. Such sales may allow Romney Capital to recoup the rest of its investment and possibly more. Gingrich Inc. is then left as a highly indebted company with few assets.

In this story, Romney Capital may have earned a substantial profit on a limited investment (it recouped most of its money almost immediately when it loaded Gingrich Inc. with debt), without doing anything to improve the operation of Gingrich Inc. If Gingrich Inc. manages to stay in business and generate profits, then this will increase the return. Romney Capital may be able to resell the company and treat the whole sale price as profit.

On the other hand, if Gingrich Inc. goes bankrupt, this will primarily be a problem for creditors, since Romney Capital has already gotten its investment back. In effect, Romney Capital might have secured large gains entirely by financial engineering, while creating no value whatsoever.

The sort of asset stripping described here, which harms creditors by taking away potential collateral for their loans, violates the law. However it is extremely difficult to prevent, especially with private equity companies that have to make few public disclosures. If Gingrich Inc. were to fall into bankruptcy, this is the sort of thing that would likely be contested in the bankruptcy proceedings. Of course the resources used in fighting out this sort of legal battle are a pure waste from an economic perspective.

Anyhow, these are the sorts of issues that are raised with private equity. It is flat out untrue to say, as NPR does:

"Here's what private equity firms like Bain Capital do: First, they go out and find a few large investors — usually pension funds, university endowments and possibly wealthy individuals. Then, says Ohio State professor Steven Davidoff, they take that money, borrow a lot more, and buy companies — usually companies that are in trouble or undervalued.

'They buy them in hopes that they can increase the value of the companies and sell them at a fantastic profit,' Davidoff says."

Private equity companies absolutely do not have to increase the value of a company to make a profit. They can end up making a profit on their investment even if they take the company into bankruptcy and leave it much worse off than it was before the takeover.

Comments (15)Add Comment
Factotum
written by Robert W. Mann, January 13, 2012 7:18
Oooops. Millions not billions in paragraph 5. Might make someone think you were a Republican.
Fire and Hire is How the One Percent Got Theirs - You Can Get Yours Too, Low-rated comment [Show]
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written by MB, January 13, 2012 9:19
This is a helpful explanation. I'm wondering if it would also be useful for the media to address the issue of how hard it is to make real money---in reality performing real services and making real goods requires real effort. The major theme of financial engineering seems to be all about shifting numbers around and playing rules to tilt the numbers in a desired direction. But that activity is disconnected from the real value of producing real goods and services. PE firms would not be able to loot functional though imperfect companies of their value if they were actually relying on the value of those products to earn profits. And since it is very hard and can be very expensive to make real things, it makes sense that financial engineering would become all the rage since it can be easier to make money by sitting comfortably in a climate-controlled room (or on a balcony overlooking an ocean) and shifting numbers rather than doing heavy lifting. In the case of financial engineering the value is coming from the automation of computing capacities rather than production of a company's product. So just wanted to mention that, the concept of making real money has been blurred---it's interesting to become more aware of the distinctions among real work, real effort, real products, real earnings.
...
written by skeptonomist, January 13, 2012 10:00
The name "private" equity seems to be misleading, since these outfits make money by buying into corporations and seizing control. To the extent that this is harmful, it is another loophole in the hodgepodge of custom and court decisions that is corporate law. There is no reason that the operation of corporations should be governed by things such as the Santa Clara v. Southern Pacific Railroad decision which established corporate "personhood" (and which was really aimed a very narrow issue) not to mention Citizens United.

It is long past time for Congress to directly address the issue of corporate structure and the role they should play in society. This could be a winning issue for Democrats, if not in this election cycle maybe in the next one after the effect of Citizens United money shows up in this one.
thanks Dean for great explanation of PE harm and thanks Izzatzo for great display of ignorance!
written by trish, January 13, 2012 10:41
"Thanks to Whose Your Nanny Baker for clarifying how we - the One Percent Job Producers - achieved our economic position in life without dependence on the nanny state."

Uh, infrastructure (including financial)...defense...etc. etc. etc.
Vocabulary
written by Jeffrey Stewart, January 13, 2012 11:31
Could you please give your definition of "value?" Is it synonymous with profit?
Plus Private Equity's Dividends are Taxed as Capital Gains, not Income...
written by Will, January 13, 2012 11:39
The author left out one thing that benefits Private Equity enormously...when they pay out a dividend to themselves it is taxed as capital gains, not ordinary income. So they get a nice break on their taxes. All around this is the clever exploitation of tax loopholes. This how to argue against it - not just from a 1% - 99% standpoint, but from the clever exploitation of tax loopholes that allowes multimillionaires - maybe billionaires - to keep their taxes low while working class Americans have no such access to loopholes. Classic case of the golden rule (cynical version) - those who have the gold make the rules.
Let me add one more way
written by John Q, January 13, 2012 5:09
that PE firms make money while destroying manufacturing companies: by cheapening the quality of the product, so increasing short term profits as the costs are lowered, and then selling off the manufacturer at a premium based on the increased profits. But as the manufacturer loses its market because its products are now inferior, the company ends up in bankruptcy - after the PE has walked away from the wreck it made.
New Class Struggle: Pension Returns vs. Jobs
written by TVeblen, January 13, 2012 6:22
NPR/Bain also implicitly promote the canard that pension funds can only earn adequate returns by investing in companies that undermine job security of workers in order to fund retiree benefits. As has been pointed out, private equity does nothing more than skim off cash in management fees (deja vu all over again with LBOs in the late 1980s). Like insurance companies pensions need steady returns over long time horizins because they have to match long-dated assets with their liabilities. Thus, their bond/stock mix is usually around 70/30. Declining bond yields have pushed up the present value of the assets and libilities, however, for a properly funded pension that is in actuarial banlance, this shouldn't be a big problem. However, as the embedded yields fall, they will need to up contributions from current workers. Now with wages stagnating, workers will opt to take cash today and not fund their pensions in the future. Solution: repatriate the $1.5 in overseas cash earnings and use it to fund pensions who will invest in long-lived infrastructure projects.
Table, please!
written by McDruid, January 13, 2012 11:17
Please put these calculations in a table to make them easier to follow.
...
written by Mark Jamison, January 15, 2012 6:26
Now you know why Mr. Romney won't release his tax returns. Some of those interest losses and other tax tricks may have been used to reduce his tax liability to virtually zero.
It's not even that he pays an obscenely low percentage on lots of income, the Republican echo chamber could finesse that by pointing to the actual number as being high. No, he probably pays virtually nothing.
reforming corporate boards instructions
written by fairleft, January 17, 2012 1:58
Very well done imho. And, a note for when, after the revolution, the social democracy legislates that all corporate boards of directors be 'public good oriented', your explanation illustrates succinctly why creditors are an important stakeholder in corporations.
Manufacturing
written by scott moore, January 17, 2012 12:02
Excellent account of the process. I actually was employed, like I am sure many others, in a company taken over by a VC. It is not possible to describe in words the destruction of wealth this process brings to a company, community and a nation.
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written by Al Schmeder, January 22, 2012 1:36
If the $6 billion loan taken out by Gingrich Company is paid to Romney Capital as a dividend, wouldn't Romney Capital have to pay taxes on that? So in the short run, at least, Uncle Sam would actually get additional tax revenue. In fact, the dividend would get taxed at a rate higher than the capital gains rate. Therefore, even in the long run, total tax revunue would be greater, unless the repayment takes so long that the total interest exceeds the principal.
Of course, this does not contradict your main point about this kind of financial engineering being non-productive, but we should always be fair and factual.
..
written by br, January 23, 2012 10:48
"his leaves Gingrich Inc. with $700 million in before tax profit. Deducting the 35 percent tax, Gingrich Inc. now has $455 million a year to distribute to Romney Capital, 70 percent as much as before ($455 million/$700 million) even though Romney Capital has already recovered two-thirds of what it paid for Gingrich Inc.."

that should say 455 million/650 million, shouldn't it?

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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