Recommended Reading: The Buyout of America
posted by Frank Pasquale
As lawmakers squabble over the “carried interest” tax rate, it’s nice to find a big picture overview of some of the economic activity they’re discussing. I recently read Josh Kosman’s book The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis, and I highly recommend it to our readers. Kosman painstakingly describes the byzantine financial maneuvers behind marquee private equity firms which bought “more than three thousand American companies from 2000-2008.” He describes in detail how they resist transparency (164) and “hurt their businesses competitively, limit their growth, cut jobs without reinvesting the savings, and generate mediocre returns” (195). The recipe for high earnings is simple: the firms “get large fees up front and are largely divorced from their results if their transactions fail” (195).
Like Kwak and Johnson’s account in 13 Bankers, Kosman offers a political economy account of private equity’s favored treatment by government. As he notes,
[F]our of the past eight Treasury Secretaries joined the PE industry . . . . and they have significant influence in Washington. President Bill Clinton, and both President Bushes, have also advised PE firms or worked for their companies. . . . KKR retained former Democratic House majority leader Richard Gephardt as a lobbyist and hired former RNC chairman Kenneth Mehlman as head of global public affairs. (196)
Having analyzed a wide array of buyouts, Kosman concludes that “PE firms manage their businesses to satisfy short-term greed, not for long-term survival” (51). Robert Kuttner’s review of the book, like Kuttner’s own brilliant work in The Squandering of America, explains how starkly reality tends to diverge from the convenient economic theory advanced by PE’s defenders:
The fable told by the private-equity industry, Kosman explains, is that many companies are poorly managed and sources of cost-savings could be wrung out by new management brought in by new owners. Alternatively, the story holds that their share price undervalues the parts of an enterprise that could be more profitably deployed if reconfigured or broken up. But in reality, very few private-equity owners are willing to play the role of both disruptive innovators and patient capitalists. They are interested in quick windfalls. What makes the entire business model viable is that companies, or their parts, can be bought and sold several times with borrowed money, using the subsidy of a tax break on the interest each time.
Early in the last decade, private equity thrived on the same bubble that pumped up housing prices and created the sub-prime boom and the general illusion of prosperity. And the entire game was eerily reminiscent of sub-prime. Like much of the rest of the bubble, private equity’s windfall gains were based on borrowed money. Buyout volume, Kosman reports, peaked in 2007, at $486 billion. Between 2000 and 2008, there were a total of 3,188 such deals. Like sub-prime, private equity was one of the schemes that generated enormous fees for Wall Street firms that arranged the takeovers and the financing. The biggest financiers, not surprisingly, were JPMorgan Chase, Goldman Sachs, and Citigroup. Most of the debt, in precisely the fashion of the sub-prime disaster, was turned into securities and bought by pension funds, hedge funds, and ordinary investors. And like the rest of the economy, private equity is facing a day of reckoning — but one that has been slightly delayed because the collapse of the overburdened operating companies is not happening all at once. Kosman reports that private-equity firms own companies that employ some 7.5 million Americans, and he estimates that half of them will go bankrupt between 2012 and 2015, leaving a trillion dollars worth of debt in their wake and costing close to 2 million jobs.
It’s precisely this mentality that FDIC Chair Sheila Bair indicted in her testimony before the FCIC:
[W]hile the establishment of emergency backstops to contain financial crises can help to limit damage to the wider economy in the short-run, without needed reforms these policies will promote financial activity and risk-taking at the expense of other sectors of the economy. Corporate sector practices [have] had the effect of distorting of decision-making away from long-term profitability and stability and toward short-term gains with insufficient regard for risk. . . .Meaningful reform of these practices will be essential to promote better long-term decision-making in the U.S. corporate sector.
We can only hope that members of Congress keep both Bair’s and Kosman’s insights in mind as they debate the carried interest issue. Congratulations to Kosman for authoring a compelling and well-researched analysis of one of the most troubling engines of inequality in the US.
x-posted: Balkinization.
June 17, 2010 at 11:10 am
Posted in: Book Reviews, Corporate Finance, Current Events, Economic Analysis of Law, Law and Inequality, Politics, Securities, Uncategorized
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Responses (4)
Ken Rhodes - June 17, 2010 at 7:54 pm
There are few terms misused more, or worse, than “private equity.” In John O’Hara’s novels (Ten North Frederick, From the Terrace, etc.) investment bankers were just that. They took the funds of their clients and invested them, hopefully in companies that would make nice profits for a long time. And in the process they were generally providing investment capital for growth of productivity.
That, unfortunately, is ancient history. Private equity today is neither private nor equity. And the “equity capitalists” are not “investing,” but simply playing in a zero-sum game with the objective of withdrawing and distributing cash from the pot.
A.J. Sutter - June 17, 2010 at 11:56 pm
In seeing that this post bears the tag “Economic Analysis of the Law,” I wonder whether “analysis” is really the relevant word in this case. “Capture,” or “Subversion” maybe?
Frank Pasquale - June 18, 2010 at 12:05 am
AJ, I understand your point! I was disappointed recently to see that a Soros-funded project to rethink the foundations of economics invited a large number of . . . economists to complete the task:
http://business.timesonline.co.uk/tol/business/economics/article7087558.ece
If anything should be clear from this crisis, it is that we need a broader range of social thinkers contributing to policy decisions.
Steven - June 19, 2010 at 8:48 am
But so exactly which subset(s) of private equity does the book address? The industry is quite big, and I seems that e.g. venture capital firms are valuable intermediaries.
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