DECEMBER 17, 2012
THANKS TO THE ASCENDANCE of Mitt Romney to the top of the Republican presidential ticket and to the vociferous Occupy Wall Street movement, private equity firms have entered the public consciousness. Conversation about complex economic issues, such as wealth redistribution, tax policy, and morality in the marketplace inevitably circles back to the murky private equity industry. Considering the vast wealth controlled by these firms, it’s no wonder public scrutiny is at its zenith. Blackstone Group alone has more than $200 billion in assets, more than any other private equity (PE) firm and twice as much as it controlled when the company went public five years ago. Steve Schwarzman, Blackstone’s cofounder, is estimated to be worth $5.2 billion. Bain Capital, Romney’s firm, has (a mere) $66 billion in assets under management, while Romney’s wealth is estimated at (a mere) $250 million.
So just how much money are we talking about? One study estimates that as much as 10 percent of U.S. GDP ($1.5 trillion) is tied up in private equity.
What exactly does a private equity company do? Generally speaking, a PE firm raises pools of capital (often called fundraising) from, say, a pension fund like CalPERS, in order to invest in or acquire another company, often through a leveraged buyout. A typical investment fund may have a life of three, five, or ten years, during which time the PE firm is expected to make a healthy return for its investors. The PE firm makes its money on management fees (charged to investors) and upon exit of the company they purchased, either by selling the company or its assets, or by taking the company public. The outcomes of a private equity investment can result in a fabulous turnaround (e.g., Continental Airlines) or putting a company out to pasture (e.g., KB Toys). Whether the target companies live or die, PE firms tend to do pretty well.
The ubiquity of PE in our everyday lives is startling. As I read Jason Kelly’s The New Tycoons, I kept a list of famous companies that have been affected by private equity: Toys R Us, Dollar General, Nabisco, Motel 6, Del Monte, J.Crew (twice), Domino’s Pizza, Burger King, Staples, Caesars, Clear Channel, Hertz, Lexmark, and on and on. Private equity touches each one of us and deeply impacts our economy. We would do well to learn more about this discreetly powerful sector.
I sat down with Mr. Kelly in early October to discuss his book, The New Tycoons, the mechanics of private equity operations, the moral obligations of firm managers toward their investors and society as a whole, and the would-be legacies of the billionaire private equity tycoons.
Shaun Randol: How does a private equity firm make an acquisition?
Jason Kelly: It depends. When acquiring a public company, a lot of different things have to happen formally to make an offer. For the most part, private equity firms and the ones I discuss in The New Tycoons do not do hostile deals. The approach usually happens over time. At some point the offer has to be disclosed, if it’s a public company, because the shareholders have to vote. Often the courtship is measured in months or even years, during which a lot of analysis is done on the private equity side, and then the typical negotiations happen.
SR: When a private equity firm acquires a publically owned firm, do they make it private?
JK: The most common way the private equity (PE) model works is for the firm to take the target company private. PE managers want to control the whole company, so they can do a lot of things they want to do with it outside the scrutiny of quarterly earnings and answering to public shareholders. Most of the examples I talk about in the book are those situations.
There are situations where private equity firms can buy a small slug of publically traded stock and get a board seat or two. This method tends to deprive the PE managers of elements of control that they really like to have in terms of making big, sweeping changes to a company.
SR: What is the difference between a private equity firm and a conglomerate?
JK: There are certainly similarities. The logistics of private equity determine the mechanics of needing to buy and sell on a relatively frequent basis, because [an investment] fund only has a 10-year lifespan. Investors are expecting to get paid back, which means that there’s more churn in the portfolio than there would be in a conglomerate.
Generally speaking, if a PE firm is doing its job and a discreet fund is doing its job, the firm only owns something for three to five years, maybe a little bit more, but not much more than that.
There’s no real, meaningful interaction among the companies that are owned by a PE firm. It’s very rare that [PE company] KKR would say, “Okay, you’re doing a great job at Dollar General, now we’re going to put you over at TXU Energy.” Each company is essentially a separate partnership, and that’s a big distinction between a private equity firm and a conglomerate.
SR: How much U.S. GDP is tied up in private equity?
JK: One estimate for the U.S. is about 10% of GDP, and that is a stat I pulled from the Environmental Defense Fund (EDF). The EDF was making the case that, because private equity is so entrenched in the economy, the firms need to deal with issues around sustainability, as well as workers’ and environmental sustainable governance (ESG) issues. This is a huge thing I think we’ll see coming down the line.
A lot of the founders and other senior people in private equity firms said to me: When you’re ultimately responsible for this many employees in so many locations in so many communities, it changes the way in which you have to operate. You can’t be hidden. You have to be out there, not just for your own good telling your story, but actually thinking about issues beyond just financial returns, which I think represents a crucial moment for the industry right now.
SR: For a while private equity managers were behind the curtain. What propelled them to the front?
JK: It’s a great question. There are a couple of things that propelled them to the front.
One: When they started buying companies that you and I know, that pushed them further into the spotlight. When they spend tens of billions of dollars to buy a company that has so many employees and touches so many people and consumers, that necessitates a different approach. When KKR and [private equity firm] TPG bough TXU Energy in 2007, the acquisition required a whole lot of regulatory approvals and dealing with public service commissions, politicians, and local governments in Texas to get that deal approved. The guys at KKR told me that was a real eye-opener for them.
Two: Investors, as in pension plans, university endowments, sovereign wealth funds, and others, became more emboldened to ask more questions and to really press these guys, not only on the economics but on these ideas of “what are you actually doing?” What are you doing with these companies? Is it good? Is it helpful? I need to know that you’re not raping and pillaging, that the money I’ve given you is being used for some good.
Three: A lot of these big firms went public. Blackstone, KKR, Carlyle, and Apollo are now publicly traded, which changes the amount they have to disclose. They now have to answer to public shareholders. Going public fundamentally changes the way private equity firms have to operate in the world.
SR: There’s tension and some irony in the fact that private equity investments made on behalf of pension funds, many of which are tied to unions, could result in job losses, or in benefit cuts because of cost-cutting measures. If you are a pension fund manager, where is the line when making these investment decisions?
JK: There’s not an easy answer. There is an acknowledgment on the part of the private equity managers, the pensioners, and maybe most importantly the workers, that this tension does exist.
One of the things we’ve seen in the past couple of years is private equity firms make more of a concerted effort to work with unions on the front end and essentially to get their buy-in. I heard this from both the AFL-CIO and inside the PE firms.
There were two things I find interesting. The first was the AFL-CIO representative essentially said: Look, if they deal with us from the get-go, it’s going to turn out better. Everybody’s going to be happier if it’s clear up front what the plan is from their perspective, so that we can be prepared and we can offer our feedback. (“We” being the unions in this case.)
Secondly, as it relates to the unions, a hotel union leader I spoke to said: One theory behind this is private equity is so ubiquitous and so entrenched that unions have to deal with this huge entity. In their experience, these PE guys are not ideologues. In fact — and maybe this is spin to some extent — they’re very up front about what they’re going to do. PE managers are not anti-union as a practice; they don’t come in with a bias against unions. They come in looking at the numbers. They want the company to work. They want the company to be successful, in most cases. In some ways, the approach can accrue to the benefit of the workers because managers are not coming in and saying, “I don’t care what you say, I hate unions.”
Do the private equity guys love buying something that’s already organized? Probably not. It’s much harder to do more radical things to a company if the workers are organized. But if they know it going in, it factors into the model. They can, if they’re smart, get the workers on their side, get the unions on their side, and hopefully progress in a profitable way for everybody involved.
SR: Are pension fund investors more demanding of private equity firms than of typical, publically listed corporations?
JK: Yes. They definitely become more demanding. They’re asking a lot of questions.
About two years ago, in the wake of the financial crisis, there was the first real organized effort on the part of the limited partners — which is a catch-all phrase for the investors in private equity — to get together and talk about what they want in terms of communication, governance, best practices, performance benchmarks, and the justifications of management fees.
The effort that was led by some of the very big pensions: Teachers Retirement System of Texas (TRS), CalPERS, a number of the Canadian pension plans. They formed the Institutional Limited Partners Association (ILPA), which was the first time that private equity’s main backers got together and said: Here’s what we want. Here’s what you want. We think this can be a beneficial relationship. We need you, you need us, but we need a common set of rules, and we really need to come together and decide how both of us can end up benefiting from this whole arrangement.
SR: Are pension managers the tails wagging private equity dogs?
JK: I don’t think they are, and I’ll tell you why. They certainly helped fuel the rise of the industry, no question, both in the early 1980s when George Roberts was going to meet Oregon pensioners to convince them to invest with KKR, then Washington very soon after that, and then eventually CalPERS and CalSTRS got into the act. In the late 1990s and at the turn of the century, the pensions definitely fueled this huge run up in the amount that was managed by private equity firms.
The reason that I don’t think they have as much power as they’d like is that they so desperately need private equity, especially right now. A typical pension needs 7.5-8% annual return to meet its obligations to its pensioners. You know as well as I do what the stock market has done over the past decade. We’re in a zero interest rate environment. Those returns are not readily available. So then here you have private equity, which historically the best managers have delivered above 10 or 20 percent a year. Because of that, the pensions are increasingly looking to these guys for those returns.
So I don’t think it’s the tail wagging the dog. I think they have a stronger voice, but they don’t have the — pun intended — leverage they would because they need these returns so badly.
SR: But also the firms need these funds.
JK: Absolutely. It’s a very symbiotic relationship. There is some inherent tension as we’ve discussed, and the pension managers have certainly become more discerning about whom they give their money to and how much they give.
SR: If I were a partner at a private equity firm, would I rather deal with one of these large pension funds or a sovereign wealth fund?
JK: You would want to deal with sovereign wealth for a couple of reasons. They typically have a lot more money, especially if you’re dealing with some of the Middle Eastern institutions where they are in a big move to diversify beyond natural resources. They have a lot less political constraint around them. You’re dealing with a smaller set of decision makers.
Now, the decision makers may be tougher to win over, but they’re more concentrated. They are sensitive to economics, but maybe not as sensitive to the perceptions that a public pension has to deal with in terms of answering to the public.
Sovereign wealth will at some point cross over — maybe in the next 10 years, maybe sooner — to become the biggest source of capital for private equity funds.
SR: What are the downsides to private equity acquisitions? Who loses?
JK: If a private equity firm is coming in and doing its job, some element of turmoil is introduced. These firms are very unlikely to buy something and do nothing. Private equity benefits very little from status quo. They make their money by upending the status quo.
The data seem to indicate that the job question is ultimately a wash, meaning the acquisitions are not great job creators, nor are they great job destroyers. But there is almost always some sort of turbulence in the job numbers. So there may be initial job cuts, and then down the line job growth. There is likely to be some sort of reorganization or some sort of rationalization over which unit is doing well and which isn’t, and some decisions made around that. The firms are likely to change management.
In times of great change there are consequences intended and otherwise. Certainly this has come to the fore in the presidential campaign. Both the Republican primary challengers to Mitt Romney as well as President Obama’s campaign trotted out a number of examples, whether it’s [Bain Capital’s acquisitions] of KB Toys or Dade International, or others, where real people were hurt or were affected, either through job loss or losing health insurance or something like that. There are real people behind the numbers.
In short: it’s messy. This is not a clean business in a lot of ways.
SR: Do private equity firms benefit from certain tax policies or loopholes?
JK: The individual managers have certainly benefited from the carried interest tax treatment given that their profits are taxed as capital gains rather than ordinary income. There’s no question about that.
One of the interesting regulatory twists is that, with Dodd-Frank and the Volcker Rule really limiting what the big Wall Street banks could do, especially in terms of principal investing and a lot of their other business activities, private equity firms Blackstone, KKR, and Carlyle have really benefited in terms of new businesses they can get into. That was an unintended consequence of a lot of that regulation. The government seemed to look at private equity and ascertain that it was not a systemically risky business, at least for the time being.
SR: Do you think private equity needs a regulatory regime, one that is distinct for its operations?
JK: I don’t know whether it needs one that is distinct for its operations. This is a new class of financial institution. Washington needs to figure out exactly who these guys are and what levers they are able to do within the broader financial system.
SR: The people who seem to be gaining the most are the partners at the top of the private equity firms. Their salaries are through the roof, so much so they can donate hundreds of millions of dollars to public institutions without denting their fortunes. Is there a disconnect between private equity partners and the rest of us?
JK: There is something of a disconnect, for sure. I believe that disconnect is in part what has helped the pensions really feel their oats a little bit to come back and say: You guys are making a lot of money. We’re okay with you making a lot of money, but you need to make a lot of money on our terms: you’re not going to get rich on the management fee; you’re not going to get rich just for convincing us to give you money. You’re only going to get rich if you do really well. We are going to pay you for performance.
Having said all of that, there is still an astronomical amount of money being made here. There is no denying it. As I was writing The New Tycoons, I kept being surprised at how much money we’re talking about. You have to have a lot of money to give away $100 million in a single stroke, which both [Blackstone co-founder] Steve Schwarzman did for the New York Public Library and [KKR co-founder] Henry Kravis did for Columbia Business School.
That’s not the only thing they’re doing. You look at [Carlyle co-founder] David Rubenstein, whose philanthropy has been very broad based, whether it’s fixing the Washington Monument or donating to Lincoln Center or Kennedy Center.
SR: How much does greed play into the motivation of the men at the top?
JK: I think greed certainly plays a role. I am taken by what I would describe as hubris more than greed, in part because I think greed certainly motivates Wall Street, broadly defined.
Hubris, to me, plays into it because one of the things that is consistent across all of these firms and founders is that they decided they could do something different and better than anyone else. There’s this entrepreneurial streak in private equity that you don’t normally associate with more classical Wall Street.
Hubris or confidence or whatever it is also plays into this idea that these firms are also formed in their founders’ images. Everything, down to the décor of the office, much less the type of deals, is very much informed by who these guys are and what they think about and what drives them.
When you reach a certain level of wealth, greed may still be a factor, but there’s something else going on there that continues to drive you well into your 60s and in some cases 70s to keep doing this.
SR: What legacy do private equity managers intend to leave?
It’s a very good question and it’s one that’s on the minds of these guys, no doubt about it.
In terms of the firm legacy, there’s no question they definitely decided to have these firms outlive them; that’s in part why they took them public. They’ve grown these once-small partnerships into firms that have 1000-plus employees, in most cases. They have succession planning. They have leadership training. It’s hard to imagine, barring something catastrophic, that 20, 30, 50 years from now these firms don’t exist in some form or fashion.
On the personal legacy front, the private equity managers are still very much wrestling with what legacy looks like, how to give their money away, when, and to whom. David Rubenstein [of Carlyle] has definitely been the most aggressive in his philanthropy; he’s signed The Giving Pledge, which Warren Buffett and Bill Gates created. Pete Peterson, Blackstone co-founder, also signed The Giving Pledge. There have been only a relative handful of private equity guys that have signed that pledge.
There is hope in the philanthropic community that these guys will emerge more strongly as public faces, that they will spend more time giving away their money. Schwarzman has indicated that he’s got another major gift in the works. The New York Public Library was his first, major, public gift, and he’s still got a lot of money left.
I talked to [KKR co-founder] George Roberts about his legacy. His philanthropy has been mostly focused on the West Coast. He has an effort called REDF — Roberts Enterprise Development Fund — which is interestingly about getting people back to work.
To go back to the title of the book, one of the reasons that I did call it The New Tycoons was to evoke this previous generation. This is essentially hundred-year wealth. We have not seen this sort of concentration of wealth since the early 20th century, when we were talking about the Morgans, the Rockefellers, and the Astors. These guys have that sort of money and one of the looming questions is: What are they going to do with it?