Should Leveraged Buyouts Be Regulated?

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Includes: APO, BX, CG, KKR
by: Elliott R. Morss
Summary

Toys "R" Us collapsed.

Leveraged buyouts are back.

The question: are more government regulations needed?

Introduction

Leveraged buyouts are back. Is pension pressure enough to limit what they do? Or are new regulations needed? Private equity funds (PEFs) are growing and flush with cash. Leveraged buyouts remain attractive, allowing them to use borrowed funds to increase their investments several times over. The latest deals are big, though not yet on the scale of the first buyout boom, which was capped by the legendary $31 billion takeover of RJR Nabisco by Kohlberg Kravis Roberts in the late 1980s.

Some leveraged buyouts (LB) involve the buyer loading up the company being bought with the debt it took to make the purchase. And after some time, the indebted company is sold via an IPO or some other mechanism. If markets are working properly, the selling price will be lower to reflect the added debt burden. However, recent events recall the 1960s when LBs were used and abused. But times have changed. Most notable today, workers who lose their jobs when LBs go under are speaking up.

More accurately, their pension funds are pressing their cases. And their targets are the PEFs that bought them. And there is reason for concern. In April 2017, an analysis by Newsday found that of the 43 large retail or supermarket companies that had filed for bankruptcy since the start of 2015, more than 40 percent were owned by PEFs. Since that analysis was done, a number of others have joined the list, including Nine West, Claire's, and Gymboree.

Toys "R" Us

Consider the recent collapse of Toys "R" Us. In 2005, the Toys "R" Us Board sold the company for $6.6 billion to the private equity firms Bain Capital and KKR and the real estate investment firm Vornado. The firms put up about 20 percent of the total and borrowed the rest. Toys "R" Us had a debt load of $1.86 billion before it was bought out. Immediately after the deal, it shouldered more than $5 billion in debt. By 2007, according to Bloomberg, interest expense consumed 97% of the company's operating profit.

Toys "R" Us was still paying interest on loans it got from KKR and Bain up until 2016, as well as millions a year in "advisory fees" for unspecified services rendered. According to one estimate, the money KKR and Bain partners earned from those fees more than covered the firms' losses in the deal.

In other countries where PEFs have a meaningful presence, they operate with more restrictions. Germany and Denmark guarantee that most workers receive severance, making it far costlier for PEFs to use layoffs to increase profit margins.

PEFs vs. The Pensions

According to Preqin, about 35% of private equity's money comes from public pensions. PEFs have continued to produce high returns, but the industry faces resistance to its high fees and profit-sharing. Some large pension funds are starting to make more investments directly and cutting out PEFs entirely. Table 1 lists the largest PEFs and their total assets under management.

Table 1. - Largest Private Equity Firms

Source: Investopedia and Prequin

So called "Hedge Funds" often mimic what PEFs do and vice versa. They are projected to expand by 31% from $3.6 trillion in 2017 to $4.7 trillion this year.

While these sectors control significant assets, so do US pensions. Table 2 provides data on the largest pension funds. The total for the US pension funds is $25.4 trillion.

Table 2. - Largest US Pension Funds

Source: Willis Towers Watson

Growing Pension Pressure

Needless to say, the pensions have plenty of clout to influence investments made by PEFs if they choose to use it. And they are. A few examples of what they are doing follow:

  • Minnesota's pension plan ($3.4 billion) temporarily halted investments in one of Toys "R" Us's former private equity owners, Kohlberg Kravis Roberts, after hearing that 30,000 workers laid off amid the retailer's bankruptcy had been denied severance.
  • A top Oregon pension official ($102.6 billion) criticized the private equity firm TPG for what he said was its serious lack of diversity, specifically citing a disparaging remark that one of the firm's founders had made about women.
  • New Jersey's pension fund ($77 billion) moved recently to ensure that PEFs with mortgage investments in Puerto Rico were not foreclosing on residents of the island after the havoc caused by Hurricane Maria.
  • In Washington State ($130 billion), pension officials publicly questioned a top KKR executive, asking if anyone had lost his or her job at the firm over the Toys "R" Us bankruptcy or had gotten a cut in pay. The KKR executive pointed out that the firm had lost money in the bankruptcy and apologized to the pension Board. One pension board member suggested that the firm had a "moral obligation" to set up a fund to help the workers.
  • By late summer, growing pressure on the Toys "R" Us investors had begun to bear fruit: KKR and Bain agreed to contribute up to $20 million between them to a hardship fund for the workers.
  • The toy store workers are still pushing to recoup all of the $75 million they are owed in severance. Lately, they have been urging New Jersey pension fund ($77 billion) to put pressure on Solus Alternative Asset Management, which owns some of the failed retailer's debt. New Jersey has $300 million invested with Solus. In a statement, Solus said it was working to revive the Toys "R" Us brand "in a way that we hope will provide sustainable employment for workers in the future."

Conclusions

A lot has changed since the 1980s. Employees, with the support of unions, have been organized by the activist groups Rise Up Retail and the Private Equity Stakeholder Project. The Stakeholder Project, which is partly financed by labor unions, has focused on private equity's ownership of for-profit colleges, bail bond companies and the private prison industry. "There is a well-developed ecosystem of groups that focus on the practices of public companies," said Jim Baker, the Stakeholder Project's executive director.

A second and perhaps more important development in the last 40 years is the improved functioning of markets. In the past, PEFs could execute leveraged buyouts, load them up with debt, and do IPOs with IPO prices not reflecting the new debt. Today, markets are better and will register the additional debt in buyout prices.

As noted above, PEFs, hedge and venture funds have large amounts to invest. But pension funds are also large and are starting to use their power to influence investments. What happens bears watching. But in light of this growing countervailing power, additional regulations are not needed at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.