The private equity industry represents the great, hidden-in-plain view predator of American capitalism. As the Prospect has detailed in numerous articles examining markets like newspapers, grocery stores, and retail, these firms are secret entities whose basic business strategy is to borrow money to buy healthy companies and then loot the assets.
They accomplish this feat first by putting the acquisition debt on the balance sheet of the target company. Next they pay themselves exorbitant dividends and management fees, further stressing the companies they purchase.
This forces target companies to slash costs by cutting wages, benefits, laying off workers, and selling off real estate. And when the company goes broke, they abuse the bankruptcy process. Whether the company fails or manages to survive, the private equity managers have often made back their money many times over. Sometimes, as in the case of the great abuser of iconic Sears Roebuck, Eddie Lampert, the private equity predator keeps control after the bankruptcy process is used to shed debts.
Much of the agony of American retail or newspaper chains comes not from Internet competition or bad management, but of manipulations by private equity owners. Workers have been abused by many facets of today’s American capitalism. But if you see a company with particularly brutal layoffs, pay cuts, and scams to loot pension funds, the owner is often a private equity firm.
Private equity went under the more accurate name of the leveraged buyout industry; when that moniker became too controversial after the junk-bond scandals of the 1980s, the industry didn’t reform but merely re-branded. It likes to mislead the public to believe that it is similar to the venture capital business, in which investors actually contribute new capital. But private equity exists to extract capital.
In short, there is no constructive reason for this industry to exist. Loopholes in the securities laws, as well as lax provisions of tax and bankruptcy law, make possible its perverse business model. It is astonishing that it is even legal. Yet in an era bracketed by the financial collapse of 2008 and the 2010 Dodd-Frank reforms, there has never even been legislation aimed at reining in the industry’s abuses.
Today, Senator Elizabeth Warren introduces the perfectly named Stop Wall Street Looting Act of 2019. Warren declared: “Let’s call this what it is: legalized looting -- looting that makes a handful of Wall Street managers very rich while costing thousands of people their jobs, putting valuable companies out of business, and hurting communities across the country.”
The lead cosponsors of the bill are Senators Sherrod Brown and Tammy Baldwin in the Senate, and Progressive Caucus co-chairs Mark Pocan and Pramila Jayapal in the House, with seven other legislators joining.
The Act methodically goes after every predatory aspect of the private equity model. Basically, Warren reverse-engineered the private equity industry, and blocked each of its techniques, one by one. The Act’s several provisions provide a useful guide to the industry’s serious abuses.
First, the proposed Act establishes legal responsibility for private equity, by defining a “control person” as someone who owns at least 20 percent of the parent firm. Existing law allows the true owners to evade accountability for their actions. Among other things, private equity “control persons” are made responsible for debts they incur, rather than leaving target companies holding the bag.
That provision alone should throw some constructive sand in the industry’s gears.
Control persons are also made personally responsible for violations of a range of federal laws, including labor laws and pension looting, as well as for frauds. Owners would also have fiduciary obligations to act in the best interest of investors, rather than dumping losses upon them.
Second, the Act would prohibit any capital distributions from target companies to private equity managers in the first 24 months of ownership. Exorbitant executive compensation and management fees and other gimmicks that transfer money upstream to the private equity investor would be barred in the first two years as well. That provision is intended to impede private equity’s “strip and flip” strategy of getting back all of its money and more on the front end.
Other provisions prevent abuses of the bankruptcy process. In cases of bankruptcy, the bill directs the bankruptcy court to approve the offer that provides the best job preservation, wages, and other terms of employment for workers.
Importantly, the bill requires owners to retain some risk when they securitize debt. This “risk retention” provision was part of the Dodd-Frank Act but muted in its implementation. In addition, the bill requires extensive disclosures of financial information from which private equity is now exempt under the basic loophole in the securities laws (particularly the 1940 Investment Company and Investment Advisers Acts) that allow this industry to exist at all.
The Act limits the tax deductibility of debt incurred to take over a company, beyond what is currently limited today. For good measure, the Act closes the carried interest loophole, so that general partners in private equity firms pay taxes at the ordinary rate and not at the reduced capital gains rate.
It is just staggering that nobody has stepped forward with this bill until now. There is a great deal wrong with American capitalism but private equity is a special form of malignancy, since it is parasitic on the aspects of capitalism that are relatively healthy: well-run, ordinary companies that attract customers, pay workers fairly, and turn a normal profit.
Private equity has increased seven fold since 2007, at a time when real capital investment has been relatively flat. The value of private equity deals soared to $1.4 trillion last year, according to Eileen Appelbaum, one of the few critical scholars of the field, a regular contributor to the Prospect on the subject, and coauthor of the landmark study, Private Equity at Work. At a time when other abuses of American capitalism have come in for scrutiny, there has been too little appetite for taking on private equity, in part because its owners include Democrats as well as Republicans.
Should such a bill pass, what would be left of the private equity industry? Not much. Lisa Donner, executive director of Americans for Financial Reform, which helped spearhead the research that led to the bill, says firms could still provide management expertise and capital, like ordinary venture capitalists.
Elizabeth Warren was the logical lead sponsor and prime architect of this bill, not only because of her fearlessness, but because of her deep knowledge of the intricacies of American capitalism. Much of the abuse is rooted in manipulations of the bankruptcy code, so who better than one of America’s leading legal scholars and critics of the double standards of bankruptcy.
“Elizabeth Warren has had private equity in her sights for decades. Her bankruptcy textbook goes into detail on abuses of leveraged buyouts,” says Adam Levitin of Georgetown Law School, one of the kitchen cabinet advisors who worked on this bill. “She uses it to teach the law of fraudulent transfers.”
What also propelled this bill was widespread indignation and a good deal of organizing, spearheaded by the group United for Respect, in the wake of the gross abuse of workers in the bankruptcies of Toys “R” Us and Sears.
“This is literally the first major bill on financial regulation since Dodd-Frank,” says Levitin. “It shows that Democrats are back on the offensive on financial reform.”