Elizabeth Warren, one of the leading candidates for the Democratic presidential nomination, is bearing down hard on private equity.
It’s not the first time the private equity giants – often referred to as LBO firms, as in ‘leveraged buy-outs’, and increasingly known by the sanitised term ‘sponsors’ – have taken heat. It was one of the attack lines in 2012 that helped Barack Obama sink Mitt Romney, who made his fortune at Bain Capital. This is different. Warren’s proposal is smart politics because it’s utterly radical and yet “to a non-financial audience, it just sounds so reasonable.”
Most notably, Warren proposes to make PE responsible for the debts of its portfolio companies.
To understand the force of this change, consider a typical buy-out deal. ABC Partners buys XYZ Plc for £1 billion. ABC forms a new company, Alphabet LLP, to buy XYZ. But Alphabet won’t just use ABC’s money for the acquisition: in fact most of the £1 billion will be borrowed from banks and institutional investors such as pension funds. If XYZ underperforms in future years, Alphabet LLP won’t repay its creditors and in theory ABC won’t get its money back either*. But crucially, ABC isn’t on the hook for Alphabet’s debts. If it were, ABC would have to hold back millions of its assets from being put to work on other deals – just in case the debts of XYZ need to be made whole. In practice this would kill many PE companies and force those remaining to become conglomerates, taking on leverage at a corporate level and funding its loss-making subsidiaries until they can be improved, sold or closed.
It’s possible none of the will happen even if Warren is elected President and Democrats take full control of Congress. Ending limited liability, if that’s what the final proposal really does, is a big deal and Wall Street can afford lots of lawyers and lobbyists to say so.
For me this debate flared up at an opportune moment. I’ve just finished Bryan Burrough and John Helyar’s Barbarians At The Gate, their 1989 fly-on-the-wall account of the bloody battle between Ross Johnson and Henry Kravis’s KKR to take over the enormous biscuit and tobacco company RJR Nabisco. It’s one of the foundational texts of business journalism and was a source of increasing embarrassment that I hadn’t read it. The “Barbarians” line is attributed to Ted Forstmann, a rival financier who loudly denounced KKR’s use of junk bonds to finance its mega-deals.
What lifts the book to the status of a “Classic Business Thriller” advertised on the dust jacket is the contemporaneous level of detail illustrating the interplay between rival suitors for RJR and their pumped-up Wall Street advisors, moved by ego as much as financial self-interest.
Barbarians is journalism, it doesn’t dwell on doctrine, but it’s striking how little the generic debate about private equity has moved on in three decades. Burrough and Helyar wrote then, “Everyone knew LBOs meant deep cuts in research and every other imaginable budget, all sacrificed to pay off debt. Proponents insisted that companies forced to meet steep debt payments grew lean and mean…Critics of this procedure called it stealing the company from its owners and fretted that the growing mountain of corporate debt was hindering America’s ability to compete abroad.”
* I feel obliged to note the conceptually separate controversy that arises when ABC Partners, whose executives also control the decisions of Alphabet LLP, pay themselves handsomely in management fees or dividends before Alphabet concedes it can’t repay creditors after all.