THE BLOG
02/18/2012 01:21 pm ET Updated Apr 18, 2012

Class Warfare and Private Equity

The world is a bad place and people do bad things in it. It's made worse when good people do bad things by just doing their jobs, trying to make it better.

And that's the sum of this story. Looking after the people in their care, the country's pension funds, and the government itself, are waging war on the middle class; cutting their wages and retirements and making rich people richer. Then said rich folk call questions about how much money they make -- you guessed it -- class warfare.

And you and I are supporting it every step of the way. Not by our say -- so. But because it's done in our name. With good intentions.

The troops waging that war work in the private equity industry and one of its main lines of business -- leveraged buyouts, or LBOs. The human cost of that well-established business -- the layoffs, the closed plants, the slashed retirements, and the towns left to shift for themselves without employers -- isn't necessarily their concern; they're in it to make money. To them, that human cost is just collateral damage.

But it's the business of a government of, by, and for the people, to look after them; and to the extent that certain things should or should not be, it should not be doing this. But it is.

How LBOs work is no secret, and the ideal its practitioners sell to the public almost sounds like a public good; find an undervalued company, straighten it out, and sell it for a profit.

That's nonsense of course. The way the game is really played, LBO operators use lashes of debt to buy good companies with strong brand names, like Eastman Kodak or Hostess Brands, which makes the cupcakes. Both are private equity-owned; both filed for bankruptcy in January 2012.

Once the PE guys own the company they use its assets to borrow more money--often to pay themselves big fees -- and begin cutting costs. The workforce shrinks, product quality often suffers, union salaries and benefits are renegotiated -- all so the company can pay its debts. If sales fall, or the economy slows, there's always bankruptcy court. But by then, the private equity firm's made plenty of money.

In fact, the struggling company story is pious baloney. Private equity firms operate by selling shares in a series of limited partnerships, and a leveraged buyout is just that -- leveraged, so that every dollar invested gets magnified returns.

And when some private equity guy sits down with an investor or banker and asks them for money, the first question he hears -- especially from banker -- is "How will you pay me back?"

The private equity guy never says, "I don't know." Or "This is a failing company but I think I can turn it around."

No. He says "This is a good company with established brands that will never lose you money -- and here's my plan to maximize profits. Even if that fails, here's how you'll make money in the bankruptcy. But don't worry; if that ever happens, you'll have made so much money that you'll still do better with this than anything else."

The employees' retirements aren't mentioned, because if the company does collapse under all the debt, the pension plan gets handed to the federal government's Pension Benefits Guaranty Corp., or PBGC, which keeps the plan alive, but cuts benefits. Substantially

The PBGC's top payout--for people like surgeons or airline pilots -- is between $4,188.07 and $4,653.41 a month, depending. That's great compared with the 70-odd percent of retired Americans relying on Social Security for no less than half their income. But if you're an orderly or a reservations clerk, not making big bucks and looking to your last three years' salary to decide your pension income, it's going to be a huge cut. No winter cruises for you.

The human costs of LBOs are in fact enormous. But until Mitt Romney began running for President--he used to be president of Bain Capital, a private equity firm--they were usually swept under the rug by reporters only too happy to write about financial Goliaths bestride the globe.

That tidy story ended, of course, when Newt Gingrich released a 27-minute campaign film called "When Mitt Romney Came to Town."

The pathos on display there, and the misdeeds that caused it, explode any notion of heroic capitalists. People lost their jobs, and then their homes. They were pregnant and couldn't pay their medical bills. The film was promptly attacked by Romney's friends on many issues -- usually that Romney was gone from Bain when the events on the film occurred; but none denied the human facts.

It should be said here that Bain Capital is not the only private equity company that does LBOs, or even the biggest, having raised $29.1 billion in funds between 2001 and 2011, compared with the leader, Kohlberg Kravis Roberts, which raised $46.7 billion in the same period.

Thanks to Mr. Romney, though, it's easily the most famous PE firm at the moment, and the stories told in Mr. Gingrich's film, and echoed in a New York Times article and film about Simmons Bedding in the hands of a string of PE firms (not including Bain), don't document any overwhelming concern within the private equity fraternity for what LBOs do to the people who work at what are called "target" companies.

What they do suggest is the posture usually reserved for primitive villagers incidentally killed by a Predator drone, in a country far, far away -- not for hard-working, home-owning Americans with stable, middle class careers and kids in school -- people who've done everything right, but lose because some guy in a $2,500 suit decides he wants the money.

It should be said here that private equity operations do little that doesn't happen in the general economy. Businesses streamline operations, borrow money, lay people off and file bankruptcy all the time. But that usually happens over time, and what happens in an LBO is concentrated; the average holding period for a private equity investment between 2000 and 2007 was 53.6 months, ranging from 89 months between 2000 and 2002, and 17 months between 2006 and 2007.

And those operations can be brutal.

Take, for instance, Archway Cookies, an Ashland, Ohio-based company that went through a series of owners before being bought in 2005 by Greenwich, Connecticut-based Catterton Partners.

According to an excellent New Yorker story by Ian Frazier, Archway's 278 workers showed up for work October 3rd, 2008 and found the gates locked. Next day they were all fired by certified mail.

The Worker Adjustment and Retraining Notification Act says they were supposed to have had 60 days' notice. The New Yorker piece says a lawsuit over the closing has been settled. Catterton, through a spokesman, had no comment about Archway, or anything else, aside from falsely denying it owned Archway when it entered bankruptcy.

The Archway story actually has a mostly happy ending, because another bakery, Lance-Snyder Inc., bought Archway out of bankruptcy that December and re-opened the factory.

Then it bought Bronx-based Stella D'Oro Biscuit Co. -- owned by 2009 by a private equity firm called Brynwood Partners -- and brought its operations to Ashland. Now, says the story, more than 200 people work at the plant. Alas; Stella D'Oro's 134 employees are not among them; they were left in the Bronx after a long and bitter strike, resolved by Brynwood when it shut the Bronx factory and sold the company to Lance-Snyder.

What does Ashland's mayor, Glen P. Stewart, think of how private equity companies do business?

"Generally speaking it's morally wrong to everyone involved," he says. "I wouldn't do business that way, and I wouldn't want to do business with someone like that."

Whether or not Mr. Romney et al want you to believe it, the experience of Simmons, Archway and their ilk is typical. Luckily for them, the real impacts are hidden.

Details about layoffs and plant closings tied directly to PE-connected firms are lacking; the federal Bureau of Labor Statistics (BLS), for instance, doesn't break out data by whether or not the firm was owned by a PE firm.

And a PBGC spokesman, Marc Hopkins, treated a request for how many pension plans and beneficiaries the PBGC assumed from PE-owned firms that filed bankruptcy like a matter of national security; he insisted on a Freedom of Information request, written on paper with an ink signature, and wouldn't speculate about how long it would take to comply--or even if the PBGC would comply.

But none of that would have laid out the human cost of PE activity anyway. The "target" companies we're talking about are often passed from one PE firm to another like the only girl at a frat party; in 2011, 151 such companies were sold to other PE firms, out of 420 "exits"--companies shed by PE firms in some way.

Also, many had been sold to large corporations before passing into the PE realm. Simmons Bedding, for instance, was first sold in 1979, to Gulf + Western Corp., and then, in 1986, bought by William Simon's Wesray Capital.

Every step along the way, these companies are moved from town to town, or restructured, or endure mass layoffs. There are no easy-to-get statistics of how many towns like Ashland, Ohio lost their main employers, or how much cumulative pay or benefits cuts the affected workers lost.

So what's government been doing while all this has been going on? As we said at the top, it's been investing in it, and subsidizing it.

David Marchick, a managing partner of the Carlyle Group, told a Senate Committee last year that "...without the long-term, patient capital provided by private and public pension funds, private equity investment would not be possible."

Indeed, pension funds are private equity's biggest investors: A study by Prequin, a London-based company that tracks alternative investments, says pension funds accounted for 42 percent of private equity investments in 2011 -- 29 percent of the overall came from public pension funds.

A pension fund's responsibility, of course, is to their beneficiaries; they only exist to pay their pensions. You could imagine that a corporate pension fund invests in private equity like a man feeding a lion, hoping it wouldn't eat him: But you'd likewise imagine that, as government entities, state, municipal and local pension funds have some responsibility to their citizens.

We asked the executive director of a large state pension fund with significant private equity investments if he had any such purview. His answer?

"No, we don't," he said. "We have a responsibility to our plan participants. Money stops being public when it comes in the door, and the notion that we have some sort of societal obligation is untrue."

This is news to Mayor Stewart, who says Ashland "... took a whale of a blow when (Archway) hit the rocks. And as it turned out, (Catterton Partners) knew they were close to the rocks. It makes me wonder, having a retirement fund financing business practices like that."

Still, the pension fund at least invested in private equity to make a lot of money for its beneficiaries, right?

No. "We moved into alternative investments in the late 1990s to diversify our portfolio, not hit a home run," says the pension director.

That's actually just as well. According to the Financial Times, private equity investments charge a lot in fees--usually about 4 percent of assets--and net of them, returned about 4.5 percent between 2001 and 2010.

That's not bad comparatively: The Standard & Poor's 500 closed at 1,283.27 on January 2, 2001, and at 1,257.60 on December 30, 2011. On the other hand, whether the returns justified the human costs -- never mind the issues raised--are at best a matter of opinion.

That government subsidy we mentioned? The only way to put it is that the federal government -- that's you and me -- is being played for a chump

First of all, the debt private equity loads on companies is all short-term, interest-only debt. So all the money it uses to buy the "target," and all the money it borrows with the "target's" assets to pay itself fees, is tax deductible.

Then, there's the matter of carried interest. Private equity managers pay normal income tax rates on his or her salary, but only carried interest rates -- usually between 15 and 20 percent -- on the money that amounts to why they're in the business. That's what Mitt Romney was talking about when he said he pays about 15 percent in taxes.

Those incomes are large, but in the greater scheme of things, there aren't many of them -- something you can't say about typical, middle-class salaries. And in fact, the federal government makes its living taxing salaries: In 2011, almost half the government's revenues came from salary taxes -- $1.091 trillion out of $2.3 trillion.

The thing is, most every time an employee of a "target" company is laid off and eventually finds another job -- after at least a year's unemployment, these days -- it's a job that pays less, has fewer if any benefits, and pays less in taxes. This, in a world of trillion dollar deficits.

When you add it all up -- lower revenues, unemployment, dislocations, no responsibility to your citizens, the lot of it -- you've got to ask: Is watching this happen wise public policy?

Please visit me at my website, Reinbach's Observer.