The End of Private Equity Is Coming

A change by Labor Secretary Eugene Scalia lets ordinary investors put their money into PE. Should they?


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Happy almost fourth of July. In 1787, the revolutionary era politician Noah Webster expressed the commonly held sentiment that economic equality and republic government go together. He said, “a general and tolerably equal distribution of landed property is the whole basis of national freedom.” That was the American experiment. Hopefully we can get back to it.

Today I have two pieces about key changes in the conversation around private equity. This issue is somewhat more jargon-y than the usual BIG issue, so apologies for that. If you do make your way through it, you’ll know a lot more about the politics of the money barons that control corporate America.

The first piece is about a paper by an Oxford professor addressing the important question of whether investing in private equity. generates good returns for the pension funds who put money into them. The second is an interview with Eileen Appelbaum, a private equity expert who is perhaps the central figure behind the political movement to restructure the industry. I talked to her about Trump and Biden and their relationship with private equity barons, as well as a little noticed decision by the Trump administration to let ordinary people buy private equity through their retirement accounts.

First, some housekeeping. I was on the Big Tech podcast to talk about, what else, breaking up Amazon, Google, and Facebook. I was also on Rising with Saagar Enjeti and Ryan Grim to talk about the Federal Reserve.

And now…

Private Jets vs. Pension Funds

It’s rare that a finance professor causes a public stir, but when it happens, it’s worth paying attention to, because it means that trillions of dollars may eventually start to change direction. A few weeks ago, Oxford professor Ludovic Phalippou published a paper striking at the heart of the modern private equity industry, and in particular, large buyout shops that borrow money to buy companies to flip them a few years later. His paper got coverage in the Financial Times, Bloomberg, Forbes, and Institutional Investor, and will in the long-term make it harder for pension funds to put money into private equity.

Most people interested in criticizing private equity discuss how leveraged buyouts (“LBOs”) are bad for society. For instance, one manufacturer I talked to a few years ago for a piece on how finance ruined our defense industrial base told me angrily about how the “LBO boys” destroyed our ability to make things. Phalippou, however, asked a different, and much more simple question than that of whether LBOs are good for America. He asked, are investors getting a good return? And his answer is, since 2006, no.

Phalippou’s paper is titled “An Inconvenient Fact: Private Equity Returns & The Billionaire Factory.” To paraphrase his argument, he basically described the private equity industry business model by saying 40 years ago there were a lot of people with pensions and very with few private jets, whereas today there are very few people with pensions and a lot more billionaires with private jets. In other words, buyout shops don’t offer good investment returns, but siphon off cash from pension funds and turn that into luxury goods and political power for a narrow group of billionaires.

Now to clarify, what Phalippou, and most of us, mean when we say “private equity” are buyout funds that use debt to buy companies like Toys R Us with borrowed money, and then find various ways of looting them. These are funds like KKR, Carlyle, Blackstone, etc. So when I write private equity, I mean those kinds of funds, the billionaire factories, not smaller funds with expertise in a specific style of growth investing. (Indeed, what I’m finding as I hear from many of you is that there is actually a great deal of frustration within the finance industry towards the private equity barons, because their giant financial engineering strategies are an unfair extractive game based on who has political connections.)

What intrigued me about Phalippou’s paper was not the observation that mega-cap private equity funds aren’t good investments, but that there was a shift in investment returns around 2006. Prior to that year, LBOs did generate returns for investors better than you could find on the public markets, but afterwards, those excess returns disappeared. Why?

The Children of Milken

To answer this question, I turn to a 2006 antitrust suit by private litigants against a group of LBO shops. These private equity firms were colluding to hold down the price of corporations they were bidding on, using something called “club deals.” This antitrust suit was an indication that there was just too much borrowed money available to make even the most extreme versions of financial engineering profitable for the end pension fund investor.

In the 1980s, financial engineering was relatively rare, and so American corporations had large amounts of cash to invest in future prospects, big research divisions, and highly paid workforces. These are exactly the forward thinking corporate practices LBOs like to destroy, and unleashed by financial deregulation and the end of anti-merger enforcement, they did. Michael Milken helped finance a host of takeover artists, some of whom built real companies like CNN and MCI, but many of whom just bought up corporations like American Can, Beatrice Foods, or department stores, pillaging them with layoffs and debt. But in terms of investment returns, LBOs delivered.

The LBO industry collapsed after Michael Milken went to jail in 1989 and Drexel Burnham collapsed, leaving a massive void in the financial capacity of buyout shops. The industry was also burned because of the massively expensive contest to buy RJR Nabisco for $25 billion in 1988. This auction was won by the most powerful buyout shop, KKR, but it proved to be an investment that was both unprofitable and embarrassing, splashed across the country’s bookstores in the best-seller Barbarians at the Gate.

The industry continued at a low-level in the 1990s, but the hot investment trends of that decade were venture capital in dot com ventures and hedge funds to take advantage of globalizing financial markets. In 1996, Bill Clinton signed the National Securities Markets Improvement Act, which made it much easier for unregulated pools of capital to get investment and set the stage for what came next. Starting in 2001, leveraged buyouts came back, with the value of deals increasing from $30 billion in 2001 to $450 billion in 2007. The Fed kept interest rates low, capital flooded into the U.S. from all over the world, and the same deregulated financial system and “reach for yield” by pension funds that pushed capital into mortgage-backed securities moved too much capital into large LBO shops.

In 2006 and 2007, eight out of the ten largest buy-outs in private equity history occurred. Major companies were part of this bonanza, like Hilton Hotels, the Hospital Corporation of America, First Data, Daimler Chrysler, TXU, Equity Office Property Trust, GE’s plastics business, Bell Canada, and a host of others, with total private equity acquisitions valued at $660 billion in 2006 alone. The Department of Justice Antitrust Division began asking questions about the bidding process for these deals, basically trying to figure out if large leveraged buy-out shops were colluding to hold down prices.

The DOJ never brought a suit, but private litigants did. Investors sued 13 different firms for forming “clubs deals” from 2003-2007 in which they would come together and agree to hold down prices for corporations being bought in auctions. The defendants were a small circle of firms who had emerged from a group who had learned how to do takeovers largely with Milken-organized junk bond syndicates, including KKR, Carlyle, Bain, Blackstone, Thomas Lee Partners, TPG, Apollo, Clayton, Dubilier & Rice, Goldman Sachs, Merrill Lynch, as well as Silver Lake Partners, Warburg Pincus, and Providence Equity Partners. Not everyone came out of Milken’s circle, but it was a small club wielding large amounts of capital.

Eric Lichtblau and Peter Lattman at the New York Times wrote up the case in 2012, noting that “competitors agreed privately to ‘stand down’” on companies at auction as a way of divvying up acquisition targets. Some of the corporations included in the suit were Neiman Marcus, Toys R Us, Michaels Stores, Univision, Loews, the AMC movie chains, Freescale Semiconductor, and Alltel. The suit was settled in 2014, with eight buyout firms paying $590 million to shareholders.

What makes this case interesting is that the practices came just as the leveraged buy-out game was becoming commodified, with too many firms chasing too few corporate assets. The club deals, and the huge size of the buyouts, essentially eight different Barbarians at the Gate-size purchases in 2006, were indications that there just wasn’t any more debt you could load onto corporate America. Either buy-outs would stop reflecting economic reality, or returns for investors would turn down, or both.

Certainly corporate America fell into disrepair as private equity funds cut much more than fat, carving deeply into bone and muscle. Here’s a chart of zombie companies as a percentage of corporations in the U.S., which is to say, companies that pay more in debt servicing costs higher than profits.


Why would American corporations systematically borrow more than they can service? The answer is that those who control corporations are increasingly using them not as businesses that produce things, but as limited liability vessels useful mostly for transferring money from lenders to private equity firms. Note the timing of the upturn in this chart, which is right around when club deals became popular and the new LBO boom started. Leveraged buyout shops, once they ran out of corporate targets who had some unexploited pricing power or extra cash tucked away somewhere, turned to mobster tactics, the corporate version of burning down a restaurant to collect the insurance money, writ large across the economy. Lots of angry workers have noted that running an economy through financial gangsterism is a very anti-social practice, and political leaders have proposed laws to end many of the practices that enable such predatory behavior.

But Phalippou’s paper is the flip side of this argument. He shows not that the LBOs are bad for the country, but that they are bad for the pension investors who supply the money. This fact is not apparent, because industry could blame the financial crisis for any problems in its funds raised in 2006. Since 2009, the Federal Reserve has supplied the industry with cheap debt for a decade to expand valuations, and the industry uses metrics that can be gamed (like the Internal Rate of Return). In a rising market, such as the one we’ve had since 2009, the industry looks like it is doing fine, but that’s only because borrowing money to buy assets always looks good when times are good. Phalippou essentially controlled for these factors, which is why his paper is so powerful. Returns turned down. In other words, pension fund managers should stop putting money into leveraged buy-out shops.

And that’s why his paper matters.

Eileen Appelbaum: The Quiet Economist Reforming Private Equity

A few weeks ago, I did an interview with Eileen Appelbaum, who co-authored the book Private Equity at Work: When Wall Street Manages Main Street. She’s a quiet yet fierce woman, and her work has been critical to the reform movement around leveraged buy-out funds. In early June, Trump’s Labor Secretary Eugene Scalia opened the door to ordinary investors being able to buy into private equity funds through their retirement accounts. I wanted to know what this means for the industry, so I asked her.

Thanks for your work and for agreeing to this interview. Last month, the Department of Labor allowed private equity firms to access retirement account money. Can you explain what happened?

Private equity has wanted to get its hands on the retirement savings of ordinary workers for years. There’s about $6.2 trillion in workers’ 401ks right now, and they would be happy to get their hands on five percent of it.

They don’t need the money right now. They have so much money they can’t even figure out where to put it at the moment, but they decided that this was an opportune time to move on something they’ve always wanted, which was the opportunity to be included in these products sold to individual investors in their defined contribution retirement plans.

Under cover of everything that’s going on in the country, they made their move. The Department of Labor regulates the IRAs and the 401ks, and the Secretary of Labor Eugene Scalia just issued a letter allowing private equity to sell retirement products to everyday investors.

Couldn’t you see this as useful for private investors? Hasn’t private equity delivered good returns?

Private equity tells investors they get these really high returns, but it turns out not to be true. It was true at one time, but they are living off of past reputations. It has not been true since 2006. Since 2006, the median private equity fund has matched stock market returns. The difference is, you’re taking on a lot more risk with private equity than with the stock market, so you should expect a lot higher returns than with the stock market. But that hasn’t happened.

And remember, half the funds are doing worse! The top funds are still doing very well, but they are oversubscribed as is, some sovereign wealth funds and pension funds can’t get into them. It’s not likely that ordinary investors will be able to get into those funds.

Private equity firms have disguised this underperformance by changing benchmarks or using inappropriate metrics like Internal Rate of Return. Some public pensions have also disguised disappointing performance by changing benchmarks. They will often defend their investments in private equity by saying private equity is their best performing asset. But that’s only because their stock picking has been so bad. If they had invested in index funds for stocks and bonds that they use for their benchmarks, they would have matched or outperformed their private equity investments.

Apollo has been lobbying aggressively for this regulatory shift. Why do big LBO shops like Apollo want 401k money?

This is a really good question. The bigger question is how are they going to be able to handle it? And this is the piece that I’m looking into at the moment. I don’t know the answer. A private equity firm like Apollo can’t take a contribution of less than $10 million. It’s not set up to take $250 here, $250 there. It takes this in $10 million increments. Some of the smaller funds open at $5 million increments, but nobody is taking it in tiny little increments. In 2013, the SEC made a little change that allows private equity to market its product to the general public.

From that point on private equity has worked really, really hard to be able to get into your IRA. In early 2015, we had a couple of the major companies at that time —Blackstone, Carlisle, Carlyle, KKR, which developed a particular product that could take money at lower than five or $10 million. But largely they haven’t been able to get it down to a small enough size. There are just a handful of private equity funds that have worked out a method, or worked with brokers to figure out a method, which I’m not sure exactly what it is yet, of combining all of the 401k money that they’re going to get into one payment to them.

Vanguard and Fidelity are not equipped to sell this product right now. This will be a slow roll out. But the dam has been breached and they are all going to be working really, really hard to figure out what kind of products they can offer and how they can make this work for them.

Why is it so hard to get the money from 401k investors? Is it that private equity funds require a long-term commitment of money?

Liquidity is an issue. In order to be able to take 401k money, it has to appear that people will be able to get their money out if they want to get their money out. Transparency is another issue. There’s very little transparency about fees with private equity — even large pension funds have a hard time getting the information about fees. So I don’t know what’s going to happen on the transparency front.

I’m not sure how the liquidity is going to work. As we know, there have been times when mutual funds just refused to give investors back their money, because they didn’t want to have to sell things at a fire sales level in order to pay off the redemptions. I don’t know what would happen if you suddenly had private equity funds that were in big trouble, and people wanting their money out. I don’t know how that would work, but there would have to be a plan for that. At least they have to appear to be liquid. And those are the hurdles. That’s what the private equity funds have been working on.

Why do they want this money? I mean, why isn’t the money that they’re getting from pension funds enough?

At the moment, the money from pension funds is enough, but the more sophisticated pension funds are saying, “hey, we can do this kind of investing without private equity. We don’t need a middleman; we can just do it ourselves.” The biggest pension funds are trying to move away from private equity. The second thing is that there has been an attack on public pension funds. For instance, you have the leader of the Senate, Mitch McConnell, saying “hey, those blue states they are in trouble because they have public pension funds. We’re not going to bail them out.” The attack on public pension funds has been relentless, and ironically, some of it has been funded by private equity firms.

At one point back in 2013, 2014, and 2015, it looked like it was a defensive move. If public pensions are shrinking in size, you’d like to have another source of money that you can count on. It made a lot of sense then. Today it’s just an opportunistic move. This is a time when they can do it, but they definitely do not need the money.

How has private equity and the pandemic intersected?

Well until the Federal Reserve relaxed its rules for who it was going to bail out, private equity was just sitting on the sidelines, hoping to get through this. Some private equity businesses have been very badly hurt, like doctor’s practices. Hundreds and hundreds of doctor’s practices are owned either by KKR or by Blackstone and those doctor’s practices are really in big trouble. Some private equity firms own retail, which has also been in big trouble.

They’re sitting on the sidelines mostly waiting to see how it all shakes out. Where they are planning to invest is more of what they already know how to do. They’re not looking for big deals right now because nobody knows post-pandemic what the economy is going to look like, but in the areas where they have experience, they’re looking for add-ons. (An add-on is when a private equity firm already owns a business, and it has that business buy a competitor or set of competitors, in effect an attempt to monopolize an industry.)

When the pandemic ends, or as we start to end it, you’re going to see a wave of mergers and acquisitions as private equity buys up companies at fire sale prices that have been beaten down by the pandemic and add them onto the companies they already own.

There will also be a lot of what’s called private investment in public equities. They’ll buy stocks that are beaten down rather than try to take over a whole company. Why not invest in shares of the stock of publicly traded companies so that as the market recovers, you make money on it?

After the pandemic, they plan to take over lots and lots of parts of the economy, where companies are beaten down and they can buy them up. In the European Union, many of the competently managed countries have put a pause on merger and acquisition activity until after the pandemic is over. They don’t want beaten down companies that are going to recover to be bought up by private equity at fire sale prices. But that’s what we’re going to see in this country.

Now, if you were to make a recommendation for two policy changes, and I know you’ve written a lot about this in your book and elsewhere, what would they be?

Well, the most important policy change in my opinion is making private equity firms jointly liable with the portfolio companies for the debt that has been placed on the portfolio companies. That will not stop them from putting debt on these companies, but it will stop them from overloading these companies with debt. What you don’t want is the use of excessive amounts of debt, which is really what puts companies at high risk for bankruptcy.

My number two, I guess I’m torn between more transparency so that we know more about what these private equity funds are doing, and a guaranteed severance for workers. The reason a severance matters is because it changes the incentives. What often happens is private equity comes in and loads a portfolio company up with debt. Somehow the portfolio company now has to get the cashflow up so that it can now make the debt payments. And the easiest way to do that is to cut worker hours, employment, or benefits. They tend to cut jobs when they take over big companies, but I think if they had to pay severance, they would think twice about whether that was really the way to go.

If you look at the Toys R Us liquidation, I blame the private equity firms who are running up the debt, but it was actually the debt holders who forced the closing because they thought they’re never going to get their money back if they didn’t force a liquidation. But if there was a requirement that if you liquidate, every one of those thirty thousand workers is going to get a separate severance package, that’s a big chunk out of what the creditors think they’re going to get. They might’ve thought twice about how to proceed.

And then last question, who are the private equity guys around both Trump and the Democrats?

Goldman Sachs has a private equity arm, and Trump has had Goldman Sachs people around him. Peter Thiel has a fund, and Apollo has been around and is very close to Jared Kushner. I’m sure that all the major private equity firms have people who are close to Trump. Of course, you know, they are all shameless, so they have the partner who is close to Trump and they have the partner who wants a major position if there’s a Democratic administration. I mean, if you think about Blackstone, Stephen Schwartzman is the Trump person, but Tony James has been ingratiating himself with the Democrats for as long as he can.

And places like the Center for American Progress invite him to speak. I’m not going to name names because it’s embarrassing, but he spoke on Capitol Hill at a seminar that was sponsored by several progressive groups around town. I could not get over it. These groups said, well, we don’t have to agree with what he says, we sponsor lots of people that we don’t agree with. That’s true. But what this guy is looking for, he doesn’t care if you agree with him or not, he wants the imprimatur for being able to say, “Well, all of these various progressive groups in Washington have sponsored my speaking at this engagement or that engagement. I’m good to be in a Biden administration.”

Do you think that the Biden administration, assuming that he wins, should make it a point to radically shrink private equity as an industry?

I don’t know how you radically shrink it. I think if you are interested in the kinds of things that Warren had in the Stop Wall Street Looting Act, it will limit the bad behavior. So basically I’m not interested in shrinking it; I’m interested in getting rid of the bad behavior. The smaller private equity firms that invest in smaller companies actually do good. And there are lots of companies looking for money. One of the things we did is let the banking system consolidate and all of the local banks that used to be able to make loans to small and medium sized enterprises don’t exist anymore. There’s nobody willing to do due diligence on some smaller, medium size enterprises.

So many companies, as they get to a certain size, become desperate for further funding, and they turn to private equity and private equity is inundated with requests. In 2018, a study found that private equity funded just 15% of the companies that comes to them asking for private equity investment. If we had a banking system that actually worked, that could actually provide funding to small and medium sized enterprises. I think these companies would be happy not to go to private equity, because venture capital money or private equity money is the most expensive money you can get, because you have to give up a huge part of your ownership of your own company to get the money. But banks are just not generally available.

Thanks for the interview! So then it seems like we have to not only end the bad behavior at private equity funds, but also rebuild a functional banking system.

Yes, that’s right.

Thanks for reading. Send me tips, stories I’ve missed, or comment by clicking on the title of this newsletter. And if you liked this issue of BIG, you can sign up here for more issues of BIG, a newsletter on how to restore fair commerce, innovation and democracy. If you really liked it, read my book, Goliath: The 100-Year War Between Monopoly Power and Democracy.


Matt Stoller