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The ugly side of private equity

Assif Shameen
Assif Shameen • 10 min read
The ugly side of private equity
Of all US emergency rooms, 30% are managed and run by doctors employed by just two PE firms, Blackstone and KKR. / Photo: Bloomberg
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Just days after the US Federal Reserve raised the Fed Funds rate to 5.5% from nearly zero 16 months ago, a friend mentioned that the wealth management firm that handles his retirement account was nudging him towards buying into a private equity or PE fund. As interest rates are likely to stay higher for longer, PE firms are scrambling for new sources of funds. Pension funds and retail investors are key targets.

PE already has more money than you can imagine. Bain & Co, a consulting firm, estimates that PE firms are currently sitting on US$1.1 trillion ($1.48 trillion) of dry powder and US$2.8 trillion in un-exited assets, more than four times the money they had at the height of the Global Financial Crisis 15 years ago. There are more than 18,000 PE funds in the US alone, a 60% increase over the past five years. PE now employs nearly 11 million people or over 9% of America’s working population.

PE is a rebranding of the 1980s-era leveraged buyout, or LBO, industry. PE pools money to invest in undervalued or underperforming private firms, or listed firms, only to take them private. PE firms take a controlling stake in an operating business with the hope of increasing their value over time by whipping them into shape, and a few years later selling them for a lot more than what they were originally purchased for. A key part of their operating method is to cut costs, fire a lot of workers, strip the pensions and healthcare benefits of remaining staffers, and prepare to sell the acquired firm in five to seven years.

The sprawling PE industry is dominated by four giants — Apollo Global Management, Blackstone Group, Carlyle Group and, of course, KKR & Co, formerly Kohlberg Kravis & Roberts — the company behind the 1998 US$25 billion takeover of RJR Nabisco chronicled in the book Barbarians at the Gate. In recent months, I have read two new books on the PE industry. Former New York Times’ Pulitzer Prize-winning columnist Gretchen Morgenson’s These are the Plunderers: How Private Equity Runs — and Wrecks — America was published in May. Some weeks earlier, another book Plunder: Private Equity’s Plan to Pillage America by Brendan Ballou, a federal prosecutor who served as Special Counsel for Private Equity in the US Department of Justice’s Antitrust Division, hit the shelves.

During the zero interest rates era, institutional investors like insurance firms chased alternative assets like PE because they believed traditional assets such as equities, bonds or real estate could no longer give them the kind of returns they needed to match their long-term liabilities. Over the years, PE has lured university endowments, pension funds, sovereign wealth funds, family offices and individual investors to long-gestation and higher-risk investments with the promise of outsized returns.

New breed of customers
To be sure, the ground beneath PE firms is shifting. PE players who grew at warp speed when interest rates were near zero now have to contend with higher rates and a much-tighter credit environment which make leveraged deals more expensive. With US treasuries paying up to 5.5% interest, institutional investors these days have a smorgasbord full of opportunities, so PE is being forced to woo retail investors as the next growth engine. Since you cannot fool all of the people all of the time, you need to keep acquiring a new breed of customers to keep on growing. Individual investors hold roughly 50% of the estimated US$300 trillion of global assets under management, or AUM. Yet those same investors represent less than 16% of AUM held by alternative investment funds. That makes them a prime target for PE
firms.

See also: Southeast Asian stock exchanges need to play a larger role to move the region’s PE market forward: Bain & Co

Oh, there is one other thing. Wealth management firms and stockbrokers used to make money on trading commissions. Now that trading of stocks, bonds and ETFs is mostly commission-free, they are looking to sell you anything that can generate fees. And believe me, there are few financial products out there that generate more fees than PE funds.

Before we go any further, let me say this: there is a legitimate need for PE. There are 4,500 domestic US companies listed on the New York Stock Exchange or Nasdaq, including 900 or so spacs, or special purpose acquisition companies, that were listed during the pandemic. That is down from 8,500 listed firms in 1996. With fewer listings, many middle market firms in America need capital to grow and prosper. Less than 15% of US firms with revenues over US$100 million are listed. The rest are unlisted or under PE’s umbrella. PE firms have traditionally been a source of capital for them. Critics argue that the main US benchmark, the S&P 500 index, is dominated by a handful of large tech firms. As such, it is not surprising that institutional investors who want exposure to a broader swath of companies continue to be lured by an uncorrelated asset class that until recently promised, and indeed delivered, superior long-term returns.

Yet, PE no longer generates outsized returns for its long-term investors. Indeed, in recent years, PE’s total returns, net of all fees and taxes, have consistently been lower than the average returns on S&P 500 Index. Over the long term, you would have made more money by just buying S&P 500 Index ETF.

See also: Southeast Asia private equity capital deal value up 31% y-o-y to US$586 mil in 1Q2024: EY

Did I mention these PE funds are illiquid? Indeed, they lock you in for seven or 10 years. You can get out but at a huge discount. They are also extremely opaque. As an investor or limited partner, you do get a quarterly performance statement, but it is unclear exactly what your original investment is worth at the end of the quarter.

PE firms have great leeway on how they value the assets of the firms they invest in. An asset inside a PE fund might be valued at US$1 billion even though the market might be valuing a similar listed asset less than half, or even a third of that. S&P 500 index fell 18% last year and the Dow fell 8.8%, but PE firms’ marked-to-market value of their own portfolio of highly geared smaller companies was down just 7% in 2022. Over the last two years, there has been a big increase in portfolio companies from one PE fund being sold to another run by the same firm. PE firms seem to have difficulty finding buyers outside their own four walls.

New business model
PE’s business model has been transformed over the past three decades. It is no longer about funding middle-market firms but PE giants who take over companies, break them apart, lay them with a ton of debts and systematically milk them off for exorbitant fees. For example, PE firms put their own representatives on the boards of the companies they acquire. They then charge the company they just bought, huge monitoring fees as well as fees for its oversight and its management expertise. They also force it to pay its representatives huge directors’ fees. But the monitoring fees are often structured as long-term 10-year contracts. So, a PE firm might acquire a company and then sell it five years later but still keep charging it monitoring fees for the next five years. And, it is perfectly legal.

Big money is in debt though. PE firms pile on a lot of debt on the companies they acquire. That means the firm’s expenses increase dramatically to pay off those liabilities. There is also a lot of money to be made in what is called dividend recapitalisation. They take a portion of the debt they have raised for the company they have just acquired and pay it to themselves as fees and other charges. In 2007, PE firms extracted US$20 billion from companies in the form of dividend recapitalisation. By 2021, dividend recapitalisation by PE firms had burgeoned to over US$70 billion. While PE firms filled their coffers, the acquired companies still have US$70 billion in liabilities to pay back to banks. PE firms can afford to let those companies go bankrupt, because they have already collected a ton of money. Oh, that is aside from all the other fees and charges they collected before the firms go bankrupt.

PE is now in everything from retail to hospitals, nursing homes to manufacturing, media to insurance firms, as well as software to services. PE investments in healthcare have increased more than 20-fold over the last 20 years with US$1 trillion worth of PE deals in the sector. That is not surprising because healthcare now makes up over 17% of US gross domestic product, or GDP. PE’s healthcare investments span from nursing homes to hospitals to ambulatory services. PE owns two of the three medical air transport firms that together control two-thirds of that market. Over 40% of all emergency departments in the US are overseen or managed by PE-backed firms cleverly disguised through contracts with staffing firms. Of all US emergency rooms, 30% are managed and run by doctors employed by just two PE firms, Blackstone and KKR.

Putting profits ahead of patients is scandalous because for-profit companies are not supposed to run emergency rooms in hospitals. Massachusetts Senator Elizabeth Warren noted recently that PE has invested at least US$1.1 trillion in the energy sector over the last decade, with over 80% of that in fossil fuels. She also noted that three PE firms control more than 90% of the US prison telecom market. They are also big players in prison healthcare, commissaries and prison food service.

Why does PE get such bad publicity? For one thing, it has traditionally “extracted” wealth, rather than creating wealth. Most of the wealth “created” through PE has been with a huge dose of help from political power brokers and Washington lobbyists who are paid handsomely to keep the much-hated tax treatment of “carried interest”. PE investors pay just 23% carried interest tax compared to the 37% that retail investors might pay. Lobbyists for PE firms won over Arizona Senator Kyrsten Sinema to narrowly defeat a proposal scrapping carried interest tax loophole last year.

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So, why don’t people get the real truth about the dodgy business model of PE? PE firms do not just employ some of the most highly paid public relations people on earth. They actually go one step further. They have a chokehold on the media. About half of all the US daily newspapers are now owned either by a PE firm or a hedge fund. Little wonder, then, that PE-controlled newspapers generally steer away from writing stories about how bad their owners are.

Bain & Co believes PE firms might be better off focusing on investments in AI and automation, as well as supply chain and management of balance sheet risk, by locking in interest rates. PE firms have long relied on floating-rate debt. That helped juice profits in the zero-interest rate era. In comparison, 85% of the S&P 500 firms have fixed rates locked in at 3.5% or below. It will be hard for PE firms to compete if the companies they acquire are forced to pay 7.5% in interest. If they can just deliver on their original promise of whipping companies into shape, PE firms will not need to chase retail investors or pension funds.

Assif Shameen is a tech and business writer who is based in North America

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