Dear Editor,

Private Equity (PE) is one of the most obscure corners of the capital markets. Its enormous scale gives it massive influence, yet most people have no clear idea what PE is, how it operates, or why it matters. According to a study by McKinsey & Co. private equity assets under management hit $7.4 trillion in 2021. PE firms own over 8,000 US companies, roughly double the number of public companies, and those firms produce more than 5% of GDP. According to the American Investment Council close to 9 million people work for PE-owned companies in the US. In Colorado, 834 PE acquisitions were completed between 2013-2018 for a total of $98 Billion, and those companies had over 169 thousand employees.

PE behavior frequently changes US employment and business practices. Private Equity led the charge to ship manufacturing jobs overseas, consolidate mid-sized companies into behemoths, reduce employee benefits, and turn salaried positions into part-time ‘gig’ jobs. If you believe that the (economic) system is ‘rigged’, the folks doing the rigging are often fund managers at PE firms.

The ‘Private Equity’ label is relatively new but the investment strategies employed by the industry - growth capital, venture capital, leveraged buyouts - are as old as capitalism itself. The essence of the PE model is to raise a pool of other people’s money to buy companies, restructure those ‘portfolio’ companies, and then sell them at a profit. The holding period is short (generally 2-4 years). Just like R/E ‘flippers’, the faster a PE fund resells, the lower their carrying costs.

PE firms use three primary strategies to increase the value of a portfolio company: cost cutting, tax optimization, and roll-ups. The first two are self-explanatory; the roll-up strategy consists of buying multiple companies in the same industry and merging them to eliminate overhead. All three strategies can have adverse societal effects. 

Cost cutting is predicated on shedding jobs, reducing employee benefits, selling idle assets and converting owned assets to leases. A typical result is fewer living wage jobs, the employment model shifts to the cheapest possible workforce. Stripped of assets and loaded with debt, the operating entity also becomes more fragile. Even before Covid-19, bankruptcy courts were littered with failed PE deals like TXU, Wamu, and Payless Shoesource.

Tax optimization may not sound like a big deal until you consider that the lost government revenue must be replaced. PE firms use sophisticated tax software and consultants to identify every deduction and tax avoidance scheme available. It is common for PE managers to deploy offshore shell companies and convoluted financing structures solely for the tax benefits they generate. Property tax abatement (a legal form of extortion where a business threatens to move unless a tax break is provided) is also common. 

A fourth strategy, leverage, is such a standard practice that it defines the PE business model. When a PE fund buys a company (say for 8-12x annual cash flow) a majority of the purchase price (typically 4-7x cash flow) will be funded by debt that must be paid off by the acquired company. This ‘highly leveraged’ deal structure inspired the LBO (leveraged buyout) moniker the industry was known by in the 80’s. 

PE firms operate by doing difficult things that inflict pain (like replacing legacy management or downsizing employees) and by elevating financial efficiency above other stakeholder interests (employees, local communities and the environment). This orientation is not a bug in the PE operating system; it is a feature. The opaque ownership structure of PE is designed to provide plausible deniability to the Limited Partners (LPs) who supply the industry with capital, so that they are not associated with the pain caused by restructuring activities.

This brings us to the final leg of the PE story - where does all the money come from?

Most PE firms raise a series of funds structured as partnerships. The General Partners who manage the fund invest a small portion of capital and Limited Partners provide the rest. The LP universe is a vast collection of ‘institutional’ investors: insurance companies, union pension funds, university endowments, banks, sovereign and state entities. In some respects, PE funding comes, invisibly, from almost every segment of society.

Given the sometimes toxic effects PE restructuring can have on labor, one might be surprised to find unions, universities and government funds as LPs. Why invest in something that can damage employment? For investors with a fiduciary responsibility the draw is actually simple: Over the 25 years ended in March, PE funds returned more than 13% annualized, compared with about 9% for an equivalent investment in the S&P 500.

The industry defends its pain-inflicting model by pointing to the increased productivity that results from more efficient allocation of capital and labor, and there are studies that show labor productivity - the revenue generated per employee - rises by 7.5 percent relative to peers in the two years after a PE acquisition. But labor productivity does not measure other societal effects PE ownership can have: wage pressure, erosion of benefits, reduced tax revenue, lower R&D spending and a dearth of civic engagement.

The ‘financialization’ of America unleashed by Private Equity has fundamentally altered society. On the one hand it made our economy more productive and nimble. Unlike China, Japan and Europe, few ‘zombie companies’ exist here. On the other hand, it destroyed the historically paternal employer / employee relationship, and severed many of the links that connected businesses to the civic and cultural ‘commons’. If you are looking for the proximate causes of our ruthless economy, Private Equity surely played an enabling role.

Derek Ridgley
Nederland