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Private Equity Robbed Taylor Swift & Dunkin’ — You’re Next.

In our latest from the Class Room, Adam Conover explains everything about private equity

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Over the last year, More Perfect Union has told the stories of workers, renters, homeowners, and consumers after private equity invades their lives. We covered how owners of mobile and manufactured homes in Colorado fought back as private equity quietly scooped up a third of the U.S.’s manufactured home sites; how Havenbrook Homes renters in Minnesota faced crumbling units, price hikes, and surprise eviction notices from their far-away private equity landlord Pretium Partners; how pet deaths at Petsmart doubled after private equity firm BC Partners slashed staffing and demanded unsustainable output; and how workers at the Cheesecake Factory found themselves trapped in low wages working 12-hour shifts throughout the pandemic after Roark Capital took over their restaurant chain.

But how does private equity actually work? What is private equity, and why are private equity firms so good at getting rich quick? And if it’s broadly harmful to most people – workers, consumers, and the overall health of the economy – why does the industry and its reach continue to grow essentially unchecked?

Private equity deals and leveraged buyouts

Private equity technically refers to an investment in a private asset, as opposed to public equity, like the stock market. The term can be used to refer to investments in venture capital, growth equity, or even real estate. But typically, the term is used to refer to the leveraged buyout industry.

About 60% of private equity deals use a strategy called leveraged buyouts. Taylor Sekhon, a former private equity insider and pension fund adviser who now works in sustainable investing, told MPU: “In 2021 alone, it’s estimated that there were 8,500 leveraged buyout transactions in the U.S. that were worth around $1.2 trillion. You’ve got hundreds, if not thousands of private equity funds that manage anything from… $100 million funds to $25 billion funds.”

Leverage, in a business context, means the borrowed money or debt used to buy an asset. Private equity firms essentially take out a lot of debt in order to buy up a controlling share in – or buy out – a given company. Over a period of about five to seven years, while the private equity firm owns the company, the firm takes action to try to pay down the debt and maximize the resale value of the business. The key thing to keep in mind about how this works is that the company being bought out, not the private equity firm, is responsible for paying off the debt incurred to buy the company. Private equity firms take on almost none of the risk in their transactions and reap all of the rewards.

During leveraged buyouts, companies often replace the existing management of the company, lay off workers, or sell off parts of the company. Private equity firms target and buy up many different types of companies, for a variety of reasons. They can purchase private companies, often those that have successful, revenue-generating models, or they can purchase public companies and take them private. Shareholders at public companies that are targeted by private equity often choose to sell because the fund will pay them more for their shares than they’re worth on the stock exchange, and they will benefit from the returns.

How private equity hurts the economy

A 2019 study by researchers at Harvard Business School and the University of Chicago found that private equity takeovers result in significant job losses. The report found average job losses of 4.4% in the two years after a company was bought by private equity, relative to control companies. When private equity firms buy out large publicly traded companies with numerous employees, job losses are far worse, about a 13% decrease in jobs in the first two years

In essence, private equity acquisitions put millions more jobs at risk. Eileen Applebaum, Co-Director of the Center for Economic and Policy Research said: “If you are a worker at a company that has been acquired by a private equity firm, these are the numbers that matter to you – the probability that you or some of your colleagues will lose their jobs.” And the share of people employed by private equity is increasing. Companies controlled by private equity interests employed 8.8 million workers in 2018; growing to 11.7 million in 2020, a 33 percent increase.

Even if workers aren’t directly laid off as a result of private equity acquisitions, their pay, benefits, and general working conditions are all at risk in private equity buyouts, because the company seeks to cut costs and trim any expenses that get in the way of extracting a maximum profit. Employees at private-equity owned companies pay more out of pocket for health insurance, get less employer retirement contribution, and get fewer raises.

Private equity control also harms consumers. Often, when private equity takes over management of a company, they are not experts in providing the products or services that originally made the company an attractive investment, and the firm’s incentive is simply to maximize the potential sale value of the company, not to provide consumers with high quality.

Sekhon told MPU: “I can tell you from firsthand experience when a company is so focused on repaying debt, they’re not actually focused on investing in the future, investing in R&D or equipment…that certainly makes it harder to provide good quality jobs and build new good quality jobs.”

This focus on prioritizing profits over people and over long-term business strategy can have life or death consequences. For example, private equity investments in nursing homes increased by $95 billion between 2000 and 2018. In 2021, one researcher estimated that as much as 10% of all nursing homes in the U.S. could be owned by private equity. Private-equity owned firms cut staffing and hours for nurses, so that residents receive less basic and emergency care. One study found that residents in private-equity owned nursing homes are 50% more likely to be on antipsychotic medicine than patients in non-private-equity owned nursing homes, and 10% more likely to die.

Who gets rich and who loses out

Oxford researcher Ludovic Phalippou called the private equity industry a “billionaire factory.” Phalippou’s research estimates that about $270 billion in carry (the cut of profits owed to the investment managers) has been transferred from investors into the pockets of private equity fund managers. And the executives in the private equity world are getting very rich indeed: the 22 individuals on the 2021 Forbes 400 list who made their fortunes in private equity are now worth a combined $153.7 billion.

But other than the ultra-wealthy people controlling the funds, who is sharing in the gains? Who provides the money that private equity uses to get rich?

Private equity gets most of its investment capital from institutional investors, or large pooled amounts of capital, like state employee pension funds or university endowments. Most of these institutional investors choose investment in private equity because of the promise of secure, stable returns that will outperform the public market. However, over the last five to ten years, a growing body of research and analysis challenges many of the claims private equity funds make about the stellar performance of their investments.

Jeffrey Hooke spent two decades working in investment banking and the private investment sector. He’s now a professor at Johns Hopkins University’s Carey School of Business and has written books and analyses on finance and private equity. In his recent book The Myth of Private Equity, Hooke explored the performance of private equity funds compared to the S&P 500 – or, in other words, comparing the private equity market to the performance of the public market.

“The marketing pitch is that these private equity investors are geniuses and are hitting the cover off the ball, and they’re beating the public markets by leaps and bounds,” Hooke told us. “When you dig a little deeper, when you lift up the rocks, you find out that these kinds of claims are untrue. In fact, the private equity business, particularly the LBOs…do not beat the public markets.”

Hooke explains that there are several ways that private equity funds take advantage of the lack of transparency and disclosure requirements about fees and costs to investors, and how the commonly used metrics to evaluate fund performance can be easily gamed. For example, most of the “rate of return” data reported by private equity funds includes unrealized gains. In other words, the investment has not yet actually been sold. The private equity funds themselves estimate the value of the potential future sale and report the rate of return. “So, in effect, on a year-to-year basis the private equity fund is grading its own homework,” Hooke said. “They are telling the outsiders what the portfolio is worth.”

Private equity firms also charge hefty fees to their investors. The firms commonly use a structure called “2 and 20,” meaning the firms receive 2% of all the money invested with them, and also collect 20% of all profits generated above a certain amount.

In 2021, Americans for Financial Reform and the American Federation of Teachers partnered on a study to evaluate the promises of the private equity industry that they would deliver massive returns to institutional investors, like teachers’ pension funds. The study found that from 2006 to 2019, private

equity fund performance, when taking the incredibly high fees paid to the firms into account, either just matched or underperformed the performance of the S&P 500.

Ultimately, the downsides of investing pensions in private equity outweigh the benefits to pension holders, including exorbitantly high management fees, discrimination against smaller investors, illiquidity, and more.

Sekhon told MPU: “One of the things that always surprised me working for a pension fund and investing in private equity was how returns were shared, and the fact that so much of the performance was going to private equity fund managers and that was being paid for frankly, by firefighters and people in the public service and teachers and others that you know, or whose pension funds these are.”

The private equity industry also has powerful, well-financed lobbying entities and an extensive revolving door between the industry and government. Randi Weingarten, president of the American Federation of Teachers, told MPU: “I find really offensive that these folks who make money off of teachers, who make money off of other workers, then go and fund entities like the Manhattan Institute or these other anti-public schools, or anti-worker, or anti-pension entities, and then try to actually undermine the very same institutions that they’re making money off of.”

How to rein in private equity

Critics of private equity’s practices have long called for additional scrutiny from federal watchdogs, in particular the Securities and Exchange Commission,  or SEC, the federal agency charged with stopping bad actors from manipulating the markets. Recently, the SEC, chaired by Biden appointee Gary Gensler, proposed regulatory changes requiring private equity firms to provide additional information about the performance of their investments, and requiring more disclosure and transparency about the fees that they charge to investors. The American Investment Council, one of the biggest lobbying groups representing the private equity industry, signaled early opposition to even these modest standards: “We are concerned that these new regulations are unnecessary and will not strengthen pension returns or help companies innovate and compete in a global marketplace.”

Progressive members of Congress have also proposed legislative fixes that would significantly reform how the private equity industry operates. The Stop Wall Street Looting Act (SWSLA) would require private equity firms to shoulder more of the risk involved in their investments, reducing the current incentive structure through which private equity firms siphon out as much value as quickly as they can from the companies they control.

In addition, workers at companies controlled by private equity are taking action to organize and stand up for their rights and labor conditions. And labor unions like AFT, whose pensions are often invested in private equity portfolios, are working to educate their members and trustees to be more active and vigilant in where their money is going and how it’s used. As Weingarten said: “[Our members] understand that retirement income is, is basically deferred wages that in exchange for basically making a moderate wage for one’s life, that you get a pension so that you can live in dignity in retirement, and they don’t want their pensions undermined by a so-called investor who has over-promised and under-delivered. They don’t want there to be pension cuts because of Wall Street vultures.”

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