Saturday, January 14, 2012

On leveraged debt bondage

The best articles about Romney, Bain and private equity as it's developed over the last thirty years make it clear that it's very difficult to draw a fair scorecard. Private equity firms can deploy strategic smarts and managerial skill to turn around troubled companies or turbo-charge successful ones; they can also load down their purchased companies with debt, denude them with fees and dividend payouts, and sell them off before chickens come home to roost. Whether PE-owned companies thrive or fail, we never know how they would have done under prior or different ownership. The story of private equity since about 1980 is very much of a piece with the story of American capitalism: impressive growth, but with gains going disproportionately to the very top in a game that seems ever more rigged.

When PE firms (including Bain) do drive a portfolio company into bankruptcy, it's often the result of saddling it with debt.  That highlights a basic fact about private equity that I could never quite wrap my head around: when an investment firm or fund uses mainly borrowed money to buy a company, why should the purchased company own that debt?

Steven Rattner, in a defense of Bain, relays the investor's rationale for high leverage:

First, it’s fair game to question the amounts of debt that are sometimes used in leveraged buyouts. While higher debt usually means higher returns — because debt is cheaper than equity, thanks in part to its tax deductibility — it also means higher risk of bankruptcy
Yes, higher debt means higher returns for the fund owners -- but not increased profitability for the purchased company.  When current owners of a company borrow money, the loan may boost profitability, because the money is used to fund operations.  But when outsiders use debt to fund their own purchase, the debt, it seems to me, is dead weight for the company. At best, if the new owners do add value, the company (which often includes retained existing management) might be thought of as "buying" them with debt.  The price is high. According to one study of European LBOs from 2000-2007, the mean debt to assets ratio for companies purchased by LBOs in that period was 70%, versus 29% for comparable public companies. The debt ratio is even higher for U.S. LBO companies. Debt financing is perceived to have a "disciplinary role"  for the purchased company -- which means extreme short-term pressure to cut costs, e.g., lay people off.  That could be understood as pressure either to be ruthlessly efficient or to privilege short-term thinking -- or both. 

I realize that the purchased company becomes a subsidiary of the PE firm that buys it, and that the owner is free to use the company's cash flow to pay off the debt taken on at purchase.  That's the way it is, now.  But the laws enabling this are not laws of nature; could not laws be passed to shield a company from liability for debt incurred in its purchase?  Insurance conglomerates, by way of analogy, cannot use the assets of an insurance subsidiary to pay or guarantee the debts of another subsidiary or of the parent company (as we learned in the AIG bailout, when NY Governor Paterson and Insurance Superintendent Dinallo briefly showed themselves willing to put those rules aside). It is considered in the public interest to provide special protections to insurance policyholders. Could we not do the same for workers? Could the law not stipulate that if a company has a minimum number of workers (5? 50?), its assets cannot be used to pay the debts incurred at its purchase? Could the balance sheets of a PE firm's portfolio companies not be in some way sequestered from that of the the acquisition subsidiary the PE firm uses to control them?

Given U.S. business norms and political culture, mine is a utopian solution.Would a law that shielded the target company from debt incurred in its purchase end leveraged buyouts?  Perhaps a PE firm could service debt out of the profits it earns from selling portfolio companies. Maybe not.  A  less radical response would be to equalize the tax treatment between debt and equity, as Jimmy Carter tried unsuccessfully to do in 1977. Some kind of cap on the amount of leverage used would be another option.

In any case, the brutal demagoguery of the GOP nomination fight is raising in the most unreflective way imaginable a question that might otherwise seem more at home on Daily Kos than in the midst of a radical right presidential slugfest: are leveraged buyouts something that ought to be encouraged (as current tax law currently does), countenanced, made more difficult, or effectively banned? Gingrich and Perry's opportunistic characterization of Bain, one of the nation's premiere PE firms, as purely predatory implies that a death sentence might be appropriate. Maybe I should contact the Gingrich campaign with my 'sequester.'

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