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.
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.
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
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:
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.
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