Thursday, November 30, 2006

Private Equity 

Private Equity

"Private equity" is a term that is comforting and, in a sense, politically correct. It conjures up pictures of private people with a few dollars saved up putting it into equities. Perfectly normal and harmless; in fact, it's just the way the economy should work, for the benefit of the widows and orphans as well as most everyone else.
However, private equity is a good deal more than that and it has been spreading, on a quite remarkable scale, all around the world. It has become bigger and bigger in the United States and the scale and value of the deals has been doubling and more in Europe. In "America's Suicidal Statecraft", I recorded that -

"....the economic and financial environment in which the IMF is required to operate has now changed, quite fundamentally, a second time. The first such change was in 1971, with the closing of the 'Gold Window'. Now, [Professor] Kolko writes, 'The whole nature of the global financial system has changed radically in ways that have nothing whatsoever to do with ‘virtuous’ national economic policies that follow IMF advice – [changed in] ways the IMF cannot control. The investment managers of private equity funds and major banks have displaced national banks and international bodies such as the IMF, moving well beyond the existing regulatory structures."

Further on, I said that former Chairman of the Fed Greenspan had shown -

"...a careless disregard for the dangers that a reckless quest for fast-buck profits posed for the American economy – and the society. In an article in Forbes, on 13 March 2006, entitled “Private Inequity”, Neil Weinberg and Nathan Vardi warned investors that, “driven by greed and fearlessness, private equity firms are the new power on Wall Street.” “A reckoning,” they said, “is nigh.” Amid other bubbles, the “buyout bubble” had gathered pace and scale in the course of 2005 and into 2006 and had changed ownership of major corporations in some six of the biggest buyouts ever recorded.
At $106 billion, investors more than doubled their stake in leveraged buyout funds in 2005 compared with 2004. A major operator, the Blackstone Group, after making gains said to be 70% on Blackstone Fund IV, launched a $13 billion Blackstone V in 2005. “Just half a dozen giant firms control half of all private-equity assets,” Weinberg and Varda wrote. “Three titans--Blackstone, Carlyle Group and Texas Pacific Group--lord over companies with 700,000 employees and $122 billion in sales. Buyout shops own such iconic brands as Hertz, Burger King, Metro-Goldwyn-Mayer, Entertainment, Linens ’N Things and more. Adept at reaping riches whether their investors win or lose, ten buyout chiefs grace the Forbes 400 list of wealthiest Americans. Among them is the billionaire cofounder of Blackstone: Stephen Schwarzman.”
They went on to say that 'There would be no reason to begrudge the financiers their take if they were building enterprises and creating jobs. But they do not make their fortunes by discovering new drugs, writing software or creating retail chains. They are making all this money by trading existing assets. Some buyout firms dabble in deeds that got Wall Street and Big Business in trouble in the post-Enron era--conflicts of interest, inadequate disclosure, questionable accounting, influence-peddling and more. Increasingly the big guys jump into bed with each other. Last year buyout firms sold more than $100 billion in assets back and forth to one another, 28% of all buyout fund deals are up fourfold in two years, says Dealogic. Moreover, some buyout shops ply rape-and-pillage tactics at their new properties. They exact multimillion-dollar fees advising businesses they just bought. They burden a target company with years of new debt, raised solely to pay out instant cash to the buyout partners. It is akin to letting the Sopranos come in and gut your business to cover your gambling debts.'
Neither the Fed under Greenspan nor other regulators showed any concern about these transactions and their possible effect on the American economy – that is, the macro economy, reaching far and wide into the health of enterprises and individuals. In any event, they took no steps to control or even effectively monitor “private equity” – or “inequity”. If the rewards of the operators were obscene compared with the rewards of the armies of workers whose jobs were potentially put at risk, the distortions and corruption of the American economy by financial sleight-of-hand of this kind – however legal – were obscene for the American economy as a whole and, ultimately, for America’s status as a world power. But the Fed, the Administration and the Congress and the regulators – whoever they might be - did nothing. They let the caravan – a caravan of ultimate destruction – roll on.The buyout mania spread to Europe and on to Australia. Some large Australian enterprises were bought by private-equity firms, including parts of the Packer media empire. Then, about a week ago, news emerged that a private-equity group was trying to buy Qantas, the famous Australian airline. I wrote to some friends and contacts in Australia along the following lines -

I have been disturbed by reports that Qantas is being targeted by a private-equity group headed by Macquarie Bank and Texas Pacific.
Amid a cluster of financial developments in recent years, involving credit and other derivatives, hedge funds and other, ever more intricately "sophisticated" devices, private-equity funds have grown to what we can now fairly call massive proportions. The risks they constitute to even the most powerful economies have grown robustly and continue to spread like a destructive wildfire, potentially consuming productive paddocks extending to the horizon and beyond, on an unprecedented scale and at unprecedented speed.
Private-equity funds are just one more feature - and an especially disturbing feature - of the self-destruction of the American economy. As with so many elements in the American model, the plague that these funds represent has been spreading its infection further and further - and with constantly greater risks and potential devastation - to other economies, in Europe, for example, and now, like a terrifying pandemic, to Australia....
I hope that you and others will do all that you can to bring the government, its economic and financial advisers and others to reflect on these issues and bring some sanity to Australian thinking and to the evolution of our financial and economic destinies, before it is too late.

The private-equity buyout seems to have its origins in the junk-bond era of the 1980s when the "adventurers, marauders and buccaneers", as I called them then, managed to get hold of enough funds to make takover offers for often very large companies. There were stories of unknowns being able to bid for General Motors. In Australia, bidders emerged - some of them not so unknown, such as Holmes a'Court - for Australia's then largest corporation, BHP.
That phase passed but perhaps its essential nature can be seen reproduced in the mobilisation of funds of wealthy individuals by asset-management companies and the application of these funds to buy out, sometimes small, sometimes medium and sometimes large and often iconic corporations.
The dangers then arise from what happens to the companies that are "bought out". They are not acquired to make traditional fixed-captital investment in factories and machinery so as to improve productivity and production over the years. Rather are they acquired to make a fast buck through a transitory lift in the share price. Wages are cut, costs are reduced through "outsourcing" and some parts are sold off to make a quick cash "profit". The acquired company characteristically has a large burden of debt directly related to the buyout - a debt which will place severe limitations on its ability to maintain and enhance real fixed-capital investment in the enterprise in the future.
Those who gain most are almost certainly those smart financial operators who manage the private-equity funds and set up the buyout deals. Those who suffer most are those who get hit hardest as a result of the general deteriroation of the real economy. That means characteristically the workers and the middle-class professionals.
In that regard, I might just offer one final extract from "America's Suicidal Statecraft" -

What we have in the United States now is fragile and overstated economic growth precariously dependent on housing and refinancing bubbles that are already collapsing while shortfalls in consumer incomes persist. Only massive credit can sustain the consumer spending on which growth and some sort of febrile stability in the American economy are based. In addition, though seriously understated, inflation is increasing and the trade deficit – a product of disguised inflation - is reaching ever new records. Instead of strong fixed-capital investment which could and should, in a healthy economy, bolster sustainable consumption, corporations are pouring funds into stock buybacks, mergers and acquisitions. Supported by a moody, flighty and highly-leveraged carry trade, the highly vulnerable bond market faces a nervous future. Equities are overpriced – largely because of the merger/buyback fever and the competitive quest of mutual and other funds for “shareholder value” - and have been moving in a narrow range for long enough to suggest that, with a little nudging, they could be ready to tumble over a precipice. Despite it all, consensus economists remain steeped in denial: “The entrepreneurial spirit in the United States is alive and well,” is a common view. “We have a 4.2% unemployment rate. And it’s going down. Join us. Be competitive.” 4
Although these problems are particularly characteristic of the United States, the American model has crossed the Atlantic and been adopted to some extent – though far from completely - in Europe. For example, “merger mania” has taken hold in Europe to such an extent that the total value of all announced bids in the first quarter of the past five years has moved from $257.9 billion in 2002 and $229.8 billion in 2003, to $514.8 billion in 2004, $567.5 billion in 2005 and $859 billion in 2006. Cash takeovers especially put proceeds into the hands of individuals or – mostly – a variety of mutual, pension and other funds which then seek profitable reinvestment in markets in which private equity buyouts and cross-border mergers and acquisitions have caused the amount of available stock to shrink. Funds seeking to buy that stock continue to increase, with more and more publicly-traded companies making bids for rivals using borrowed cash. Prices rise, booms and bubbles appear and inflate and, just as in the United States, capital spending is diverted from much more highly desirable fixed-capital investment to risky and, to the general economy, much less beneficial investment through transfer of the ownership of assets.
When a moment of acute crisis does finally arrive – as it inevitably will - and decisive action becomes imperative, there may be little room left for any new monetary and fiscal stimulus, especially in the United States. American tax rates, especially for the rich, have already been cut in a way that has contributed substantially to the already massive budget deficit. Interest rates and credit policies are already, as the Fed sees it, “accommodative” even after the rate hikes in 2005 and 2006; and the economy is in even deeper trouble with debts, deficits and bubbles than it was around the time of the short recession in 2000 to 2001. So far as the instruments they commonly use are concerned, the administration and the Fed may be able to do little, in the event of a crisis, to haul the economy back from the brink of catastrophic collapse.
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