Just like $2.5 trillion worth of companies around the world, the company publishing the story you are now reading is owned by private equity firms. Most people have little idea what the private equity industry actually does. The truth is terrifying.
If you have seen the movie Goodfellas, you may recall the scene where the mob takes over a bar: they run up bills on the company’s credit, rob the place blind, and then, when they’ve gotten as much as they can, burn the place down and walk away. That is only a very slight exaggeration of the real business model of private equity. We turned to economist Eileen Appelbaum, co-director of the Center for Economic and Policy Research and the co-author of the book “Private Equity At Work,” for a straightforward explanation of the most vampiric of all industries.
The kindergarten version of the private equity business model description goes like this: PE firms buy a company, fix its flaws, make it more efficient, and then sell it at a profit. That description, though, barely scratches the surface of the incredible ways that the PE industry has found to take money out of formerly independent companies.
Appelbaum is quick to note that for smaller companies—say, those with a value under a few hundred million dollars—private equity can be a useful partner. PE firms can provide those smaller, regional companies with financing when local banks aren’t available, and smaller companies tend to actually have the sorts of inefficiencies that PE firms can fix to legitimately make the company run better. But smaller companies mean smaller profits. The bulk of the PE industry’s business is done by huge firms cutting multibillion-dollar deals for big companies. And that is where the industry’s true business model comes into focus.
Most big companies are already fairly sophisticated. They do not need an outside firm to improve their marketing, or put in a more efficient IT system. So how do PE firms make money buying these huge companies? “Financial engineering,” Appelbaum says. “Load these companies up with debt. Debt is the lifeblood of the private equity industry.”
Private equity has a great business model—if you’re a private equity manager. First, a PE firm raises a fund using money from large investors, including pension funds investing the retirement money of regular working people, many of them in unions. The firm puts in a small amount of money and borrows a large amount of money in order to purchase a big company. That debt is owed by the company itself. Now the PE firm owns a company, and the company has a huge amount of debt that it didn’t have before. (A nifty bonus was that until very recently, the interest on that debt was tax-deductible, meaning that taxpayers were, in essence, paying that bill.) The firm itself gets to make all of the operating decisions about what to buy and sell, and how to manage what they own. And typically, the firm itself has little of its own money on the line—it “typically puts one to two dollars for every hundred dollars of equity that the (investors) put in,” according to Appelbaum. The PE firm “takes 20% of the profits, even though they’ve only put up 2% of the equity. So they make money coming and going.”
On top of that cut of the profits, the firm charges investors a fee of around 2% of their money per year; and, on top of all of that, the firm charges the companies that they own hefty fees—millions of dollars a year—for their “advice” and “monitoring.” This is a steady revenue stream for the PE firms themselves, but only adds to the crushing financial burdens placed on the companies they own.
“What people often ask me is, ‘Why would any CEO agree to this?’” says Appelbaum. “And the answer is, the private equity firm gets to select the people on the board of directors. And the board of directors can fire the CEO.”
In this way, it is possible for PE firms—with very little investment of their own—to suck money out of a perfectly healthy company. If all goes well, they sell it; if not, they can still suck out enough to make a profit before the company collapses in on itself.
In most deals, private equity firms want to minimize the amount of their own money they put in, and maximize the amount of borrowed money they use. More debt means greater profits if the value of the company they buy rises. But debt also means greater risk. All of that debt that must be paid back means that companies are suddenly in a very perilous position should anything go wrong. Their financial cushion, their safety net, is now eaten away by payments on the debt that the PE firm used to buy them. Overnight, a financially healthy company becomes one that is living on the edge—not for any benefit for employees or customers, but solely for the financial benefit of the PE firm that bought them.
“What happens is, then everything has to fall into place,” Appelbaum says. “If anything goes awry, the risk of bankruptcy is just huge if you’ve loaded a company up with debt. And if not quite bankruptcy, certainly defaulting on their debt, financial distress, having to take radical actions to pay back the debt.” Those radical actions typically take the form of budget cuts, layoffs, and selling off parts of the company as necessary to raise cash. PE firms will slash every last part of a company before they will let themselves take a financial loss.
“It’s as if you buy your neighbor’s house. You put down the down payment. You own the house. But your neighbor has to pay off the mortgage. And if the neighbor can’t pay the mortgage, they go bankrupt, not you. That’s a sweet deal.”
In the financial media, discussion of the private equity industry usually centers on the profit and loss generated for PE firms and their investors. Less attention is paid to the effect of private equity on a much bigger group of people: those who work at all of the companies that PE firms buy, bleed, and sell. Gizmodo Media Group, for example—the parent company of Splinter—is owned by Univision, a major media conglomerate that was purchased by a group of big private equity firms in 2006 for $13.7 billion. “Univision has a very bright future,” said the CEO at the time.
Twelve years later, Univision is still owned by these PE firms. They have tried and failed multiple times to make plans to take the company public in order to recoup their investment. Although GMG on its own is not losing money, we find ourselves tied to a company with $8 billion in private equity debt, that is at this very moment seeking to make hundreds of millions of dollars in budget cuts. We are, in other words, caught in the classic trap of a private equity investment that is not panning out. Without the huge private equity debt, we would be fine. But with the debt in place, our future may be grim.
Appelbaum says that employees in our position are often squeezed for financial concessions by the company, so that debt payments can be made. Even employees of profitable divisions can be soaked in order to funnel money toward the PE firm and the lenders who helped them take the company private. They can always use the possibility of bankruptcy (induced, of course, by the financial burdens created by the PE firm itself) as leverage to get workers to give up things in a desperate bid to keep our own jobs. And help from above is not on the way; even though Univision received nearly $250 million as a result of the recent Republican tax cuts, that money is more likely to accrue to the financiers than to the thousands of employees who work here.
“We have to have employment laws that make sense in this era of private equity. One big one that we don’t have at all is severance pay. There should be a national employment law that gives workers in a company severance pay that is consistent with the amount of years they’ve worked at a company,” Appelbaum says.
Why a law? Because even if there are union contracts or other standing agreements protecting workers, private equity firms throw those out the window when they drive a company into bankruptcy. That’s why 30,000 workers at Toys R Us—a company healthy enough to stay in business, but bankrupted by private equity debt—will not be getting any severance pay, despite previous assurances that they would.
Appelbaum points out that PE firms operate just fine in Scandinavian countries, which have much stronger worker protections. The question is one of political will. Private equity managers will take every last dime that they are allowed. Legal reforms that would make PE firms “joint employers” would make them take responsibility when the companies that they buy go bankrupt.
The influence of private equity goes beyond the companies that the industry owns directly. To the extent that the cutthroat financial practices of PE firms draw investment money, major public companies will try to adopt those practices themselves. The result is a race to the bottom. In the long run, the entire PE model is the highest expression of the philosophy that working people are merely widgets whose cost must be minimized in order to serve the needs of capital.
“Once you get past the small private equity funds, the bulk of the money that private equity uses to buy up portfolio companies goes towards extracting rents from them—extracting everything they can from them,” Appelbaum says. “Nobody wants to be an employer any more. The goal of big companies is to get workers onto somebody else’s payroll... Think about it: workers build up a company. What made Univision attractive to private equity to begin with? It’s workers who built a company. And they take it over, and they don’t have to have any respect for that at all.”