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Private equity is being squeezed from all sides

The private equity boom came to an abrupt halt last year when the U.S. Federal Reserve started hiking interest rates. Still, Bain & Company’s latest Global Private Equity Report remains upbeat about the industry’s prospects. The consulting firm says past market downturns have thrown up juicy buyout bargains. This time may be different, however. Throughout its four-decade history private equity has sailed forth on the tailwinds of easy money and lax regulation. Neither of these conditions are likely to pertain in future. (LONDON, May 12 Reuters Breakingviews)

Private equity is being squeezed from all sides
The modern private equity industry got started in 1981, when former Treasury Secretary Bill Simon acquired the card company Gibson Greetings for $80 million, selling out sixteen months later at a fabulous profit. In the same year, the great U.S. bond bull market commenced. Since then, private equity has bounced back from several market downturns, buoyed by ever cheaper financing. After the Fed lowered interest rates to zero in the wake of the collapse of Lehman Brothers, buyout financing became more attractive than ever. Income-starved investors snapped up leveraged loans shorn of their traditional protective covenants and acquired junk bonds at the lowest yields in history. Ultralow interest rates also inflated stock market valuations, further boosting returns for investors in leveraged buyouts.

Private equity was never more popular: in the decade after 2012, the industry’s assets under management increased by nearly $10 trillion, according to Bain. During the pandemic market frenzy, the value of global private equity deals topped $1 trillion for the first time. Companies controlled by buyout firms borrowed billions of dollars at low cost to finance dividend payments to investors. At the same time, private equity funds raised more money than ever, leaving the industry with some $3.7 trillion of so-called dry powder.

The music stopped in mid-2022 after the Fed started to hike and banks became more reluctant to lend. The value of U.S. buyout deals in the last quarter of last year fell to half the level of a year earlier and has remained depressed since. The current market downturn will likely produce bargains. But this time around there’s a lot more private equity money chasing a limited number of opportunities. Furthermore, it’s unlikely that financing conditions will ever be as easy as in recent years. Bond bear markets usually last for decades. So private equity funds could face the prospect of a prolonged period of higher borrowing costs, lower valuations, and depressed investment returns.

The buyout industry also faces another potentially more serious threat. Regulatory cycles, like bond market cycles, can last decades. The birth of private equity coincided with the Reagan administration’s policy of relaxing regulations and tax cuts. The U.S. Labor Department had allowed pension funds to make riskier investments in the 1970s. Congress reduced taxes on capital gains. Antitrust enforcement also became more lenient. As a result, private equity has been able to acquire multiple businesses operating in the same sector. So-called industry rollups have consolidated a variety of U.S. sectors ranging from dental practices to prison telephone services. More than two-thirds of North American buyout deals last year consisted of so-called “add-ons,” Bain reckons.

The rationale for this permissive enforcement of competition law is that efficiency improvements from mergers benefit consumers by lowering prices. Brendan Ballou, a federal prosecutor and Special Counsel at the U.S. Department of Justice, begs to differ. He’s the author of “Plunder: Private Equity’s Plan to Pillage America”. In his blistering polemic, Ballou holds private equity responsible for a variety of ills, including the rise in inequality, unnecessary company failures, the mistreatment of workers and a declining quality of services. (Another recent book, “These are the Plunderers: How Private Equity Runs – and Wrecks – America”, by Gretchen Morgenson and Joshua Rosner, explores similar themes.)

Ballou claims that private equity favours businesses with captive audiences and robust cash flows, which can support large amounts of leverage. But when companies take on too much debt, they go bust. Recent high profile corporate bankruptcies owned by private equity include car-rental firm Hertz and retailer Toys R Us. Buyout firms often arrange for their portfolio companies to sell and lease back their real estate assets. Such acts of financial engineering generate a quick profit but can leave firms struggling to pay the rent when the economy turns down. According to Ballou, more than two-thirds of U.S. retailers that failed in 2019 were private equity owned. He even suggests that the industry has on occasion allowed firms to fail to slough off pension obligations.

Private equity, according to Ballou, is an extractive institution, which exists to suck incomes and wealth from one subset of society to benefit a different subset. Such institutions don’t create economic growth but destroy it. They also acquire privileges through their political connections. Ballou complains that private equity firms have evaded responsibility for their actions: when taken to court, they claim they are not owners but advisers to the funds that own the companies. The industry, he says, has its tentacles deep into federal and local government. Several prominent Washington insiders, including former Treasury Secretary Timothy Geithner, now work in private equity.

Many of Ballou’s claims are dubious. He maintains that private equity has a short-term focus, whereas the industry’s advocates argue that it is public markets which are myopic. Given the sector’s growth, it’s not hard to cherry-pick a few bad apples and adverse outcomes. Corporate failures, such as Toys R Us, could have occurred under a different ownership structure.

Ballou’s model is former Supreme Court Justice Louis Brandeis, whose best-selling 1914 book “Other People’s Money: And How the Bankers Use It” attacked the money trusts, arranged by the likes of JPMorgan (JPM.N) for the tycoons of the Gilded Age. By the time it was published the federal government was already employing antitrust laws to break up large monopolies.

Ballou wants to use existing laws against private equity. He is part of a growing lobby that aims to shame, litigate, regulate, and legislate against the industry’s abuses. The Department of Justice and Federal Trade Commission are already taking a tougher approach to anti-competitive mergers. The private equity industry could soon find itself caught in a pincer, between tighter financing on the one hand and tighter regulation on the other.
REUTERS By Edward Chancellor

Vendredi 12 Mai 2023