Heard off the Street: Private equity flaws in spotlight

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A new examination of private equity investors documents many of the criticisms confronting these knights of capitalism.

Economist Eileen Appelbaum and Cornell University professor Rosemary Batt believe that although investments by some private equity firms can save and create jobs at small companies, they more often than not are losing propositions for workers and the pension funds that invest in them. They are the authors of “Private Equity at Work: When Wall Street Manages Main Street,” published this week by the Russell Sage Foundation.

During a Thursday press conference, the authors outlined their main issues with private equity firms. Many of the same complaints surfaced during Republican private equity operator Mitt Romney’s unsuccessful 2012 run for the White House. The authors say the firms risk little of their own money; make all decisions with little investor oversight; rely on excessive debt; receive favorable tax treatment; and collect a disproportionate share of gains yet face few consequences if they fail.

“High levels of debt increase the risk of financial distress and the risk of bankruptcy,” said Ms. Appelbaum, who works for the Center for Economic and Policy Research. “These costs are not borne by the private equity firm. It can just walk away.”

Private equity firms invested more than $400 billion in about 2,000 U.S. companies last year according to the Private Equity Growth Capital Council, the industry’s lobbying group. The council said about 2,800 private equity firms and more than 17,700 private equity-backed companies are based in the United States.

Private equity investors purchased several Pittsburgh-based firms last year, most notably the $28 billion buyout of H.J. Heinz by 3G Capital and Warren Buffett’s Berkshire Hathaway.

Private equity firms organize funds, then solicit investors to stoke those funds so that the private equity firm can acquire companies. The firms typically have a two- to five-year plan for restructuring a company, then either sell it to another buyer or take it public by selling stock.

Ms. Appelbaum and Ms. Batt contend that although private equity firms promote the perception that they frequently target distressed companies in dire need of rehabilitation, that is not the case.

“That only accounts for about 2 percent of private equity investment,” Ms. Batt said. “Private equity tends to buy out better performing companies.”

Those large, well-run companies like Heinz have more assets that can be used as collateral to secure debt, according to the authors. In order to repay those loans, private equity firms close plants, lay off workers and resort to other financial engineering measures.

“A very large percentage of managers of companies taken over by private equity are replaced in the first 100 days and many more within the first year,” Ms. Appelbaum said. “They’re replaced by a cadre of managers that have been developed by the private equity firm … whose loyalty is to the private equity firm and not to the company they’re now managing.”

Ms. Batt adds that when private equity targets better performing companies, wage and job growth are stunted after they take charge.

“That is what the best econometric evidence shows,” she said.

The script is all too familiar to Heinz employees. They only needed to look at the financial engineering 3G Capital deployed after acquiring Anheuser-Busch and Burger King Worldwide to get an idea of what awaited them.

This month, Heinz’s new proprietors sent letters to 775 employees in the Pittsburgh area offering a minimum of six-months severance to surrender their jobs. New CEO Bernardo Hees, who worked 3G Capital’s magic at Burger King, had already cleared out much of Heinz’s pre-takeover management and installed his own team. He also had eliminated 600 office positions, including 350 in the Pittsburgh region.

Debt provided about half of the $28 billion 3G and Berkshire paid for Heinz. The buyers also assumed about $5 billion of the company’s existing debt. Those debt-holders have to be paid off as does Mr. Buffett, who is entitled to 9 percent dividends on the $8 billion he invested in the reconstituted Heinz’s preferred stock.

The authors say private equity does its best work at small companies that often have trouble securing financing from traditional sources. At those firms, private equity operators cannot use much debt because of the acquired company’s limited assets.

For the most part, the authors are at a loss to explain why pension funds and other investors insist on paying the high fees required to invest.

“Private equity did not succeed in beating the stock market in 2013 and, in fact, on average has not beat the stock market in any year since 2009,” Ms. Appelbaum said.

The Private Equity Council said the median private equity fund outperformed the S&P 500 by 1 percent over 5 years and by 6.6 percent over 10 years.

The authors take exception to the way the industry calculates those returns — which, according, to Ms. Appelbaum, “are not what they’re cracked up to be.”

Len Boselovic: 412-263-1941 or lboselovic@post-gazette.com

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