The financialization of the U.S. economy was characterized by an enormous increase in indebtedness among corporations and consumers. Among the leading contributors to the rise in debt in the years leading to the financial crisis was the leveraged buyout boom, which represented an attempt to monetize all aspects of the business corporation. At the peak of the debt bubble that led to the 2008 crisis, private equity was the motivating force behind the leveraging of Corporate America. From 2003 through 2007, annual leveraged buyout debt issuance skyrocketed from $71 billion to $669 billion.¹ In 1980, $5 billion of capital was committed to private equity funds; by 2004, this figure had increased to $300 billion.² And by 2008, this number was approaching $1 trillion.³ As with all things on Wall Street, investors and promoters took a decent idea and replicated it into oblivion.

Promoters of private equity make two primary arguments. First, they argue that private ownership obviates the so-called “agency problem,” which refers to the issues that arise when the management of a public company has only a small ownership stake in the business. Harvard Business School Professor Michael C. Jensen sounded this cry in his 1989 apologia for leveraged buyouts, “Eclipse of the Public Corporation.” In that article, Professor Jensen wrote: “By resolving the central weakness of the public corporation—the conflict between owners and managers over the control and use of corporate resources—these new organizations [private equity-owned businesses] are making remarkable gains in operating efficiency, employee productivity, and shareholder value.”⁴ In the early years of the private industry, these claims were supportable. Unfortunately, as the industry grew and became commoditized, such claims lost their validity.

Second, private equity proponents argue that private owners of corporations are in a position to take a long-term view of these businesses and make decisions free of the short-term demands of the public markets. Like many aspects of the financial markets, these arguments work in theory but fail in practice. In particular, these arguments made sense when a few pioneers were engaging in these activities but became devalued when crowds rushed in to imitate them. To the extent that the agency problem is solvable (which is questionable), public companies solved it by granting their managers generous equity ownership stakes through stock options and other performance-based compensation schemes. These forms of executive compensation not only opened the door to a panoply of new abuses, but also undermined one of the justifications for private equity. Public company executives can be incentivized in very similar ways to private company managers. Moreover, private equity funds turned out to be as susceptible to conflicts of interest as public corporations and as short-term oriented as their public company brethren.⁵

The History of Private Equity Funds

In the 1970s, private equity funds did serve an important systemic purpose by pressuring public company management teams to improve productivity and better align their interests with those of their shareholders. Private equity played an important role in the 1980s in forcing large conglomerates to rationalize their holdings and maximize shareholder value. Unfortunately, the price of this activism was a growing love affair with debt as a means of enriching shareholders in the short run. Moreover, the evidence suggests that, over time, private equity’s original goal (in addition to generating profits for its partners) fell by the wayside as more entrants joined the industry. Instead of becoming an engine of innovation and change, private equity became little more than a fee vomitorium for Wall Street and a disposal site for businesses that had outlived their usefulness as public companies, components of large conglomerates, or productive contributors to the broader economy. By the mid-1990s, private equity was no longer focused on squeezing efficiencies out of stodgy businesses through superior management techniques; instead, it became focused on taking advantage of the low cost of capital to take dying businesses off the hands of owners who no longer wanted to provide them with decent burials. Private equity became the place where capital went to die.

In 1990, Hyman Minsky foretold the situation that came to pass with respect to the disproportionately influential (and negative) role played by private equity in the economy in the first decade of the twenty-first century:

A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market, to give value to shareholders. The giving of value to shareholders took the form of pledging a very high proportion of prospective cash flows to satisfy debt liabilities. This prior commitment of cash meant that there was little in the way of internal finance left for the capital development of the economy.... The question of whether a financial structure that commits a large part of cash flows to debt validation leads to a debacle such as took place between 1929 and 1933 is now an open question.⁶

In 2008, a little more than a decade after Minsky’s death, we learned the painful answer to that question. In the corporate sector, the 2008 financial crisis was the culmination of years of investment activity that consisted of little more than working to ensure that, in Minsky’s words, “the liabilities of the corporations were fully priced in the financial market, to give value to shareholders.” In other words, speculation trumped productive investment as debt was substituted for equity on corporate balance sheets in transactions whose primary purpose was not to add to the productive capacity of the economy but to generate fees for private equity firms and their Wall Street underwriters and advisers. Only secondarily were these transactions designed to generate profits that the firms could share with their limited partners after skimming their generous share off the top. And the primary use to which those returns were put was to raise more money from the same institutions to start the unproductive process all over again.

As Professor Jensen wrote in 1989, “the public corporation is not suitable in industries where long-term growth is slow, where internally generated funds outstrip the opportunities to invest them profitably, or where downsizing is the most productive long-term strategy.... In... cash-rich, low-growth or declining sectors, the pressure on management to waste cash flow through organizational slack or investments in unsound projects is often irresistible. It is in precisely these sectors that the publicly held corporation has declined most rapidly.”⁷ This was true in the 1980s, when large, profitable conglomerates like Chicago-based Beatrice Cos., which owned such well-known branded consumer product names as Avis, Tropicana, Playtex, Hunt-Wesson, and Samsonite, were disassembled through leveraged buyouts. Jensen’s observation continued to be true 20 years later, when faltering auto giant Chrysler Corp. and auto and consumer finance giant General Motors Acceptance Corp. (GMAC) were sold to the private equity firm Cerberus Capital Management LLC when there was nowhere else to bury these businesses other than bankruptcy court. The difference between these two types of companies, however, could not be starker.

Beatrice was an $11 billion conglomerate whose individual businesses were viable but undervalued by the public stock market. Chrysler was a dying business in a restructuring industry suffering from deep structural problems and needed to be liquidated.⁸ GMAC, on the other hand, was providing financing to an overburdened consumer purchasing products from two crippled industries: automobiles and housing. Cerberus Capital Management’s investment in Chrysler and GMAC was a vivid illustration of how businesses that were too infirm to be sold to strategic buyers could still be unloaded on so-called “sophisticated financial buyers” due to the availability of inexpensive debt capital and the ability of private equity firms to charge huge (and completely unjustified) fees for simply completing transactions regardless of their investment merit or prospects for profitability. Cerberus was no fool, however; rather than make the entire multibillion dollar investment itself, it managed to convince other buyout firms not only to participate alongside it in an investment syndicate but to pay it a portion of any future profits if the investment worked out. (While investors in Cerberus’s funds had a right to be unhappy with these two investments, investors in funds that couldn’t come up with enough investment ideas on their own for their capital and decided to let Cerberus promote them should have been apoplectic.) But when firms are motivated (and compensated) based on the quantity rather than the quality of their investments, as private equity firms came to be in the 1990s and 2000s, such seemingly irrational arrangements are tolerated in the money-driven logic of Wall Street.

From Boom to Bust

Due to the fact that the early entrants in private equity were able to enjoy little competition and therefore monopoly profits, the business gained the veneer of wealth, power, and legitimacy that allowed it to grow into a major financial force. But its growing size and scale quickly erased its so-called “advantages”—immunity from the agency problem, for example. A careful analysis of the private equity industry over the last 35 years—which basically spans its entire modern history—demonstrates that private equity funds and the executives who run them create limited value either for the economy at large or for their investors. A number of individual transactions indisputably created value, but on the whole the industry has been a bust from a macroeconomic and societal standpoint. What these investors did master is the art of enriching themselves at the expense of virtually everybody else with whom they come into contact. The primary economic act that a leveraged buyout or leveraged recapitalization (which is best understood as a partial leveraged buyout) accomplishes is to substitute debt for equity on a company’s balance sheet. It rarely creates new products. It rarely builds new plants. It rarely funds new research and development. And it rarely leads to the creation of new jobs or new industries. Every aspect of corporate existence is sublimated to the need to service the company’s debt. As economist Robert W. Parenteau has written: “With LBOs came a surge in corporate debt that was unrelated to the expansion of the capital stock. Firms were borrowing without building much in the way of new plants and equipment. Debt obligations were being piled onto an existing capital stock that was not much more productive than prior to the LBO boom.”⁹

The substitution of debt for equity was one of the leading contributors to the 2008 financial crisis due to the fact that it increased the volume of financial commitments that companies were facing as the financial markets ceased to function and the economy came to a grinding halt in the final quarter of 2008. This was a classic illustration of the “financial-instability hypothesis” outlined by Hyman Minsky, who, as we saw in Chapter 3, argued that years of economic stability would breed instability as economic actors grew increasingly complacent during calm periods and increased their risks by taking on more debt obligations. As Parenteau points out, “[e]ventually, the weight of an accelerating pace of financial commitments against little improvement in the means to increase corporate sector incomes would insure a state of rising financial fragility.”¹⁰ The private equity industry and the investors who provided it with equity and debt capital were a living example of Minsky’s hypothesis as they continued to build up Ponzi finance structures in the years leading up to the 2008 crisis through the use of financing strategies and instruments that allowed them to stretch balance sheets to the furthest possible limits. (These included covenant-lite bank loans, second lien bank loans, so-called “toggle notes” that could pay interest in cash or in additional notes, and similar structures.¹¹) This incessant buildup of debt, led by the private equity industry, rendered corporations increasingly reliant on functioning capital markets and their ability to access additional capital at low cost. This could only continue if lenders maintained confidence in their borrowers’ promises to repay them. In other words, the entire financial system was relying on lenders remaining as complacent about repayment in the future as they had been during the period when excesses were building. As we saw in Chapter 4, the death of the promise rendered this an extremely dubious proposition.

The private equity business began with a small number of firms and outsized returns. It is difficult to imagine today, in a world filled with multibillion dollar private equity funds, that the pioneers of the industry, Kohlberg Kravis & Roberts (KKR), started out raising money on an ad hoc basis in 1976 after Bear Stearns, the firm at which its principals were working, turned down a proposal to set up a separate unit to do leveraged buyouts. In 1978, KKR raised the first known private equity fund with a specific mandate to sponsor public-to-private transactions; the fund was all of $30 million in size. Initial investors included Allstate Insurance Co., Teachers Insurance, and Citicorp’s venture capital fund. KKR’s 1979 acquisition of Houdaille Industries for $355 million marked the first sizeable modern public-to-private buyout of a public company. It employed 13 percent equity and 87 percent debt. The pace of public-to-private takeovers picked up steadily after that. Between 1979 and 1982, the number of these transactions increased from 16 to 31, and the average value of deals rose from $64.9 million to $112.2 million. In the late 1970s and early 1980s, leveraged buyouts of public companies made sense because many public companies were trading below replacement value (i.e., it was less expensive to purchase the company’s stock than to try to rebuild the assets from the ground up).

Wall Street is a funny place. It touts originality but flourishes by copying the ideas of others. In the case of leveraged buyouts, it took one spectacular deal to open the floodgates for the private equity business. In 1982, a small buyout firm in New Jersey run by former Treasury Secretary William Simon and his partner Ray Chambers, Wesray Capital Corporation, purchased Gibson Greeting Cards from RCA Corporation for $80 million. The firm invested a mere $1 million of its own money in the deal and borrowed the other $79 million. A year later, Wesray sold 30 percent of the company in an initial public offering that valued Gibson Greetings at an extraordinary $330 million. This was better than the alchemists had done turning dross to gold in the Middle Ages. This transaction attracted hordes of copycats to the business. New private equity funds sprung up overnight around the United States. New commitments to these funds grew from a mere $0.5 billion in 1982 to $1.9 billion in 1983 and $14.7 billion in 1987. A new industry was born. Anybody who had studied business history would have known that the result would be an all-too-predictable crowding-out effect whereby too much capital would depress returns for all but a few firms.

By the time 2000 rolled around, the industry was grossly overpopulated with too many firms chasing too few targets, many of which had already been through one or more cycles of private ownership. Like many things on Wall Street, a good idea was taken to such extremes that it became a very, very bad idea. Private equity claimed that its raison d’être was the failure of public company management teams and boards of directors to maximize value for their shareholders. In the early days of the private equity industry, the targets of going private transactions were typically inefficiently run public corporations whose top executives were failing to maximize the value or efficiency of their companies’ assets. Many large conglomerates that were constructed in the 1960s and 1970s were disarticulated in the 1980s and 1990s by private equity firms that were able to wring efficiencies out of bloated overhead structures and inefficient managements. But soon the hunter came to resemble the prey. Early returns among the pioneers of private equity were high largely because there was little competition. The early industry leaders—KKR; Forstmann, Little & Co.; Wesray; Gibbons, Green, van Amerongen & Co.; and others—were able to generate returns of 30 percent or more partly due to the fact that they did not have many competitors when they were buying companies in the 1980s and early 1990s. By the mid-1990s, however, the market was populated by hundreds of private equity firms that were attracted to the high returns and fees earned by these early industry leaders. The entrance of multiple competitors turned a once extremely profitable industry into a much less profitable industry, if not for private equity firms than certainly for their limited partners. It also turned into an enormous source of profits for Wall Street, which cheered on the growth of the private industry with all of its financial and political might.

As the business became increasingly overcrowded, Wall Street adopted the auction process as the most efficient way in which to sell corporate properties. This was extremely positive for sellers and disastrous for buyers because it drove the prices of corporate assets through the roof. In an auction, the winner quickly became the loser as it immediately became the owner of a property for which it had likely overpaid by a considerable margin, particularly in periods when debt capital was cheap (which covered most of the 1990s and 2000s). Moreover, winning an auction required very little acumen on the part of private equity firms; it does not take any special skill to pay more than the next guy for a company. Accordingly, as the years progressed, acquisition multiples continued to climb to uneconomic levels. The race to the bottom was run by professionals whose skills were untested by adverse market conditions and whose qualifications as stewards of corporate assets were based primarily on their academic achievements and their ability to navigate benign fundraising markets (both with investors and lenders). Few boasted track records of managing businesses through difficult business cycles. The table was set for Armageddon.

Private Equity Fees: The New Agency Problem

Just as some pundits have described hedge funds as a compensation scheme rather than an asset class, the same could be said about private equity. Private equity firms mastered the art of charging fees with respect to virtually every activity in which they engage. In fact, prior to the financial crisis and the passage of Dodd-Frank, private equity firms charged their investors for practically everything they did short of going to their gold-plated bathrooms (high-priced attorneys reserved that right for themselves). Private equity firms charged fees on the money they raised, on each transaction they completed, on each portfolio company they monitored, on each financing or merger and acquisition transaction their portfolio companies completed, and on each portfolio company they sold. One would think that the management fees they charged on the money they managed would adequately compensate them for these activities, but apparently those fees (a more than generous 1.5 to 2 percent per year) were simply for the privilege of being allowed entrance to the club.

A simple example will suffice to demonstrate the egregiousness of these fees. When Dollar General Corp., the chain of discount stores taken private by KKR and Goldman Sachs, filed for a $750 million initial public offering of stock in 2009, it was required to disclose the fees the company was paying its two private equity sponsors. It turned out that Dollar General had paid KKR and Goldman Sachs a “success fee” of $75 million for buying it in 2007; $13 million in additional “monitoring fees” over the next two years; and would be paying them a final $64 million upon completion of the offering to terminate the monitoring relationship. In other words, KKR and Goldman Sachs soaked Dollar General for $152 million in fees in addition to the management fees (presumably 1.5 to 2 percent per annum) and performance fees (presumably 20 percent above a hurdle rate) they were earning from their funds. Some portion of these fees may have been shared with these firms’ limited partners, but that information was not disclosed. Nonetheless, this $152 million didn’t come out of nowhere; whatever portion (if any) that was not rebated to limited partners came out of the pockets of the same investors who were already paying management and performance fees. Moreover, Dollar General happened to be one of the very few large, private equity transactions of the 2005–2007 vintage that flourished sufficiently to be able to issue public stock in 2009. Most other large deals struggled yet still paid similarly large success fees, monitoring fees, and whatever other fees could be cooked up to their private equity sponsors. In every case, these large fees contributed to the weakening of balance sheets and enriched private equity sponsors at the expense of creditors and limited partners. In view of the fact that private equity returns are far less attractive than advertised even before risk-adjusting them (see the next section), it would seem that limited partners should have closed down this feeding trough long ago.

Yet not until the passage of Dodd-Frank and the requirement that private equity firms register as investment advisers did these practices come to an end. Since the financial crisis, these regulatory reforms and more aggressive negotiating by private equity limited partners have effectively eliminated these egregious fees. But the question that should have been asked much earlier is what were these private equity managers doing to earn these fees in addition to their hefty management fees? The answer is that they were doing nothing other than what they were being paid to do in the first place: managing their limited partners’ investments.

The inappropriateness of these fees is demonstrated by a simple comparison with another group of managers that is hardly reluctant to charge high fees: hedge fund managers. A hedge fund charges a management fee (normally between 1 and 2 percent) plus a performance fee (normally 15 or 20 percent of the profits). If, in addition, the hedge fund were to charge an additional fee on every stock or bond transaction into which it entered, that would be considered egregiously unfair to investors. Yet that is closely analogous to the additional fees that private equity firms charged with respect to monitoring their portfolio companies, or arranging financing or merger transactions for their portfolio companies. For some reason, private equity limited partners were convinced they should pay these additional fees, but it strains credulity to come up with a reasonable basis to justify this practice when they were already being charged hefty management and performance fees.

In 2015, a study done by Oxford University and the Frankfurt School of Finance & Management found that private equity firms charged an aggregate of $20 billion of these fees to 600 companies over the last two decades, including companies that failed such as Texas-based Energy Futures Holdings Corp., which paid $666 million of fees to KKR & Co., TPG, and Goldman Sachs.¹²

This is why it is not surprising that one study found that the actual fees paid to private equity firms amount to as much as 6 percent per year.¹³ Also in 2015, the California Public Employees’ Retirement System (CalPERS) reported that the difference between its returns were 19 percent before subtracting fees and 12 percent after subtracting fees on its private equity investments over the last 20 years.¹⁴ Such large percentage fees are prima facie evidence that private equity firms consistently abuse the special position of trust they hold as fiduciaries to their limited partners. These fees amount in aggregate to billions of dollars that reduce the value of portfolio companies and represent a direct shift of wealth out of the pockets of their investors and into the pockets of the private equity firms’ principals. Another study concluded that two-thirds of expected income for private equity firms comes from fixed revenue components that are not sensitive to investment performance.¹⁵ In other words, private equity firms have structured their businesses to reward themselves handsomely regardless of the outcome of their investments, which directly contradicts the private equity mantra that the interests of shareholders and management should be aligned. So much for solving the agency problem!

One further word should also be said about the industry’s high management fees. A 1.5 to 2 percent fee on the tens of billions of dollars that the private industry raised has a deeply corrupting influence on general partners because it amounts to so much money that it renders performance-based fees far less important. Private equity firms managing multibillion dollar funds are assured of gargantuan compensation regardless of whether or not their deals are successful, creating a clear conflict of interest between themselves and their limited partners. The payment of additional fees for monitoring portfolio companies or arranging financings or add-on acquisitions for them further exacerbate this conflict. A much more equitable arrangement would involve much lower fixed management fees, no additional fees for carrying out the necessary tasks of managing the portfolio companies, and a 20 percent performance fee with high water marks and claw backs. Such a fee structure would not only appropriately incentivize private equity firms to perform but also properly reflect their limited contribution to economic growth.

Accordingly, instead of solving the agency problems inherent in public companies, the typical private equity fee structure introduced a slew of new problems. It didn’t have to be that way. But human nature being what it is—and Wall Street being the kind of place it is—it was perhaps inevitable that the abuses that private equity was designed to cure would sneak back in through the back door. The combination of high management fees on invested and committed capital, additional fees for managing portfolio companies, and a significant share of the profits from selling portfolio companies established a strong incentive for private equity firms to raise as much money as possible, put it to work as quickly as possible, and then pay themselves a dividend or sell these companies at a profit as quickly as possible. Most significantly, even if the third part of this triad was not accomplished, the private equity firm profited handsomely merely from raising a fund and investing the money quickly regardless of the quality of those investments.

The behavior of the largest private equity firms in the period leading up to the 2008 crisis conformed to this pattern as they raised the largest possible funds and put their capital to work as quickly as possible in some of the largest and most questionable private equity deals on record. Examples include the $29.9 billion buyout of casino giant Harrah’s Entertainment, Inc., by a private equity group led by Apollo Management L.P. and Texas Pacific Group (which ended up in bankruptcy); the $17.6 billion purchase of Freescale Semiconductor, Inc. by a group of private equity firms that included The Blackstone Group, The Carlyle Group, Pereira Funds, and Texas Pacific Group; and KKR’s and Clayton Dubilier’s purchase of U.S. Foodservice at an actual multiple of EBITDA of more than 18 times (despite intellectually insulting attempts to convince investors that the multiple was much lower). While private equity firms used to take years to invest their funds, some of the largest funds raised by Bain & Company and The Blackstone Group in that period spent as much as half of their funds (which amounted to billions of dollars) within the first year of raising them.

In late 2009, a large group of institutional investors began organizing to fight back against the egregious fees being charged by private equity firms. A group of 220 investors with about $1 trillion invested in the asset class joined together to demand that private equity firms adopt a framework of best practices and align their interests more squarely with their investors. The new group was called the Institutional Limited Partners Association and focused on the panoply of fees that they were being charged in addition to the basic management and performance fees. This was the first step in ending the practice of private equity firms charging multiple sets of fees for effectively doing the same thing: managing their funds. The irony of such a demand should not go unremarked. Private equity transactions—leveraged buyouts—are based on the rationale that public corporations inadequately align the interests of managers and shareholders. Leveraged buyouts are intended to better align those interests as well as improve operational efficiencies in the business.

One would think that the private equity firms pursuing such strategies (or giving them lip service since few leveraged buyouts in recent years were done to improve productivity) would apply the same principles to their own businesses. Instead, they did the opposite. They disenfranchised their limited partners by providing them with limited transparency and liquidity while extracting huge fees that are unjustified by the risk-adjusted returns they offer (as well as basic standards of fairness and decency). Of course, nobody was putting a gun to the heads of the largest pension funds and endowments in the world to invest in these funds, but these institutions were placed under enormous peer pressure by the propaganda machine that was built up by the private equity industry and their consultants. A better educated investor community was finally becoming less tolerant of the abusive treatment that private equity firms had been doling out to their investors for decades.

The Myth of Private Equity Returns

In November 2015, the California Public Employees’ Retirement System reported that its private equity investments had produced an annualized return of 11.1 percent since 1990 compared with an annualized total return of 9.4 percent for the S&P 500.¹⁶ It trumpeted this return as the highest among all of its asset classes but it left out one important fact—it was reporting nominal and not risk-adjusted returns. On a risk-adjusted basis, these returns were arguably inferior to those produced by the S&P 500 and many other investments it could have made. Furthermore, a modestly leveraged investment in the S&P 500 over that period would have produced far superior risk-adjusted returns.

The quality of private equity returns is a topic that deserves more public attention than it has received. Like all investment returns (and statistics generally), private equity returns are subject to manipulation and interpretation. They are significantly affected by the timing of when investments are made and when they are sold, which is not always entirely within the control of the private equity general partner and therefore not necessarily a fair measure of performance. Moreover, public market conditions play an enormous role in determining the success or failure of private equity investments since the outcome of these investments is usually dependent on conditions in the public markets. Accordingly, measuring private equity performance must take into account timing and coincident market conditions as well as factors such as liquidity, leverage, and fees to come to a meaningful conclusion. Unfortunately, there is little evidence that any of these considerations are taken into account when investors evaluate these returns and render their decisions about whether to invest in this asset class.

If private equity returns were subject to the type of scrutiny that all investment returns should be subject, it is highly questionable whether any but a small portion of them would prove to be particularly attractive. Most important, all investment returns must be risk-adjusted in order to be properly evaluated. In the case of private equity returns, risk adjustment means reflecting the fact that these investment funds are highly concentrated, highly leveraged, extremely illiquid, and subject to inordinately high fees. In order to properly compare them to other types of returns in a fair manner, one has to make sure that these characteristics of private equity are fully accounted-for in the return calculation. In the case of private equity returns, there is little evidence that this is done. Instead, investors tend to look at nominal numbers and leave with the impression that private equity outperforms many other asset classes. This simply isn’t the case.

A similar argument was made in an important comprehensive study of corporate capital structures in the United States in the 1980s and 1990s that concluded the following: “The investors in LBO funds might be thought smart money, but this identification is not self-evident. Returns of 30 percent sound good until one recognizes that a bet on the S&P 500 consisting of one part equity and five or ten parts debt would have done better, given the trend of equity prices. Institutional investors who are prepared to sell their shareholdings in the market to LBO organizers who then reap substantial fees from the same institutions for underperforming a (leveraged) benchmark does not meet a minimal test of smart money.”¹⁷ In an age when consultants and investors place a special emphasis on “Sharpe ratios” (which measure the excess return generated per unit of risk taken) and other risk metrics, it would seem a fairly elementary proposition that returns from private equity should be risk-adjusted.

A typical leveraged buyout fund suffers from a number of risks that fiduciaries are taught to frown upon—concentration risk (funds are generally invested in a limited number of portfolio companies compared to a public equity fund); liquidity risk (portfolio companies must be sold in private corporate transactions or in initial public offerings of stock rather than in public markets); and leverage risk (portfolio companies are purchased using significant amounts of leverage, particularly in the years approaching the 2008 financial crisis, and again in 2014-15). Accordingly, when a private equity firm advertises that it has earned compounded annual return of 15 percent over its lifetime, that number needs to be understood (and adjusted downward) in the context of the concentration, liquidity, and leverage risks that were taken to obtain that return.¹⁸

A simple illustration drawn from a 2005 study of private equity returns by Steve Kaplan of the University of Chicago Graduate School of Business and Antoinette Schorr of MIT’s Sloan School of Management will suffice to demonstrate the complexity of the task.¹⁹ Between March 1997 and March 2000, an investment of $50 million in the S&P 500 would have grown to $103.5 million, a return of 26.8 percent. A private equity fund investing $50 million and realizing $100 million after fees during that same period would have generated an internal rate of return (IRR) of 26 percent. The three-year period immediately following paints a completely different picture. A private equity fund investing $50 million in March 2000 and realizing $50 million in March 2003 would have returned 0 percent, but would have grossly outperformed the S&P 500 during that period, in which a $50 million investment would have shrunk to $29.5 million. This lesson in absolute versus relative returns should be kept in mind when evaluating all money managers, including private equity firms. But the analysis is even more complex than that, because a truly accurate analysis of returns would have to dissect the specific investments that a private equity firm makes, the amount of leverage it employs in each investment, the manner in which it treats its limited partners with respect to transparency and fees, and other factors. Investing in the public markets is much simpler and more transparent, even in hedge funds that also suffer from agency problems due to their fee arrangements.

Even with these qualifications, it is highly questionable whether any but a very few private equity firms have earned their keep. Most of the studies of private equity returns have concluded that private equity returns are no better than the returns that an investor could obtain from investing in the public stock market using similar amounts of leverage. Investors in private equity funds pay a high price in terms of liquidity and fees for the right to become members of the private equity club. But a closer look at this club suggests that membership does not have its privileges. In fact, after 2008, investors in private equity did well to recall the old Groucho Marx joke that says that a person should be wary of joining any club that would invite him or her to become a member. Private equity clubs share some of the attributes of roach motels (once you enter, it takes years to exit) and high-end luxury vacation home clubs (the exit fees may be painful, they require a lot of upkeep, you are partners with a lot of difficult people, and there may be little money left at the end).

The most damning broad-based study of private equity returns was performed in 2008 by two European professors, Ludovic Phalippou of the University of Amsterdam Business School and Oliver Gottschalg of HEC Paris.²⁰ Professors Phalippou and Gottschalg evaluated 1,328 mature private equity funds and found that performance estimates identified in previous research and used as industry benchmarks are overstated. They summarize their conclusions as follows: “We find an average net-of-fees performance of 3 percent per year below that of the S&P 500. Adjusting for risk brings the underperformance to 6 percent per year. We estimate fees to be 6 percent per year.” With respect to benchmarks, the authors found that “it is basically impossible for investors to benchmark the past performance of funds with information reported in prospectuses. These documents contain only multiples and IRRs.... We show... that average IRRs give upward biased performance estimates. In addition, IRRs cannot be directly compared to the performance of, say, the S&P 500 over the same period.” They also pointed out that while many investors told them they were satisfied with private equity returns because they had “doubled their money,” the average fund duration was 75 months (6.25 years); in comparison, the average public stock market portfolio returned on average 1 percent per month between 1980 and 2003, which would have produced a better return than a doubling of an investor’s money over that period. The authors also offered possible reasons for private equity underperformance (and investors’ acceptance of it), including the possibility that investors “might attribute too much weight to the performance of a few successful investments”; and the possibility that “investors have a biased view of performance because performance is generally reported gross of fees and... fees [are] larger than for other asset classes.” Finally, the authors pointed out that some investors such as pension funds and government-related entities may have noneconomic motives for investing in private equity such as stimulating local economies. Unfortunately, in view of ugly pay-for-play scandals that occurred in California, New York, and other states, it appears that the non-economic motives for investing in certain private equity funds were hardly benign.

About the only independent study (that is, a study not financed by the private equity industry itself) that argues in favor of private equity outperformance was one conducted by Professor Gottschalg and Professor Alexander P. Groh of the Montpelier Business School in France in 2006.²¹ This study, however, was narrowly based and focused on only 133 U.S. buyouts between 1984 and 2004 and compared this limited universe to a simulated portfolio of equally leveraged investments in the S&P index. This study claimed that the 133 buyouts outperformed the public market by 12.6 percent per annum gross of all fees. Based on the fact that this study only looked at a very small number of the buyouts done during the 20-year period in question and compared them to a simulated selection of S&P 500 companies, it is difficult to conclude very much from it. Moreover, this study says very little about the returns of private equity funds since it focused on individual private equity transactions. It was a theoretical exercise that has little application to the real world where investments are made and money is earned and lost.

The 2008 financial crisis demonstrated several of the inherent flaws of the private equity industry. This is unfortunate because an industry that is designed to be sheltered from the vagaries of the public markets should have been better positioned to survive such a market downturn. The fact that the private equity industry fared so poorly during the crisis revealed that its original character as an asset class that was designed to be a superior form of long-term ownership of capital assets failed. The losses generated by firms in 2008 wiped out years of positive returns and strongly suggested that previous years’ returns, to the extent they were based on unrealized gains and subjective valuations of portfolio companies, were illusory. The industry wants to have it both ways; it wants to be judged on long-term performance but be compensated on short-term performance. Those goals are at odds with each other. After the financial crisis, most firms (even the elite performers) were far under water in terms of earning their performance fees and some faced large cash claw back liabilities resulting from losses that ate up profits from performance fees earned on companies that were bought and sold at a profit in earlier years. The results from 2008 damaged the long-term track records of virtually every private equity firm in existence, making it harder for them to conceal the true mediocrity of the industry’s returns and more difficult to justify its very existence. This contributed to many of them shifting their business models away from private equity toward more stable asset management businesses in the years that followed. Over time, their track records improved as their portfolio companies recovered and some firms took advantage of market conditions to make timely investments in beaten down companies. But their failure to anticipate the crisis and the losses suffered as a result tarnished their reputations as the smartest guys in the room.

Men Behaving Badly

The behavior of private equity firms is usually a reliable indicator of the stage a credit cycle has reached. The less productive their behavior, the more likely the cycle is reaching its late stages. Two types of transactions in which private equity firms repeatedly engage during the late stages of credit cycles tend to indicate that credit is mispriced, the credit cycle is far advanced, and debt investors should be running in the other direction from bond and loan offerings involving private equity-owned borrowers.

The first type of transaction that investors should avoid is the infamous “dividend deal,” in which a private equity-owned firm borrows money to pay a dividend distribution to its owners. The debt raised in these transactions is not used to enhance the business of the borrower in any way, for example, by building additional facilities, funding research and development, creating new products, or hiring new workers. The money instead is paid out to the private equity sponsor in order to reduce the capital it originally invested in the business. This practice is contrary to the raison d’être of private equity, which is supposed to be based on overcoming an important aspect of the agency problem, specifically, the potential conflicts of interest raised when the owners and management of the company have only a small ownership stake in the enterprise. While the private equity firm generally maintains a significant ownership position after a dividend transaction, the amount of money it has at risk in the business is significantly reduced if not eliminated.

Dividend transactions are particularly noxious to the health of lenders, who are left lending money to a company whose owners are in possession of a free “call option” on any appreciation in the value of the business but are also in a position to walk away without losing money if the business begins to falter under the weight of its new debt. The only potential limitation on these dividend deals is the law governing fraudulent transfers, but these are relatively easily avoided.²² Many companies that have paid dividends to their private equity sponsors over the years have subsequently gone bankrupt, leaving their lenders with large losses and their private equity sponsors feeling no pain.²³

The second practice that indicates that the credit cycle is entering its terminal stages is the phenomenon of private equity-owned companies being sold by one buyout firm to another. Some firms, like Simmons Company (the mattress manufacturer) or General Nutrition Companies, have been sold numerous times between buyout firms. Simmons Company, in fact, is a company that fell into bankruptcy after paying a large dividend to one of its private equity owners during the course of being bought and sold seven different times by buyout firms over a period of two decades.²⁴ One of the purposes of a leveraged buyout is supposed to be to wring efficiencies out of a business that was previously publicly held. Accordingly, there is little rationale for a private equity firm purchasing a company that has already been retooled by another private equity firm (or several) since there should theoretically be few efficiencies left to capture. The real reason such deals are done, of course, is to generate fees for private equity firms. The selling firm is able to generate a “realization event” that triggers a “transaction” fee and allows it to return capital to investors, while the buying firm is able to pay itself a transaction fee on the purchase. The wonder is that lenders continue to finance such transactions, which are done at higher and higher multiples of cash flow and contribute little to economic growth. The question investors and lenders should be asking when they see such deals is why no strategic buyer is interested in buying these companies at a higher price than another private equity firm. The answer to that question is the reason why investors should avoid lending to these companies and be asking private equity firms why they can’t find something better to buy than somebody else’s used merchandise.

Private Equity and Cheap Debt: Birds of a Feather Flop Together

The private equity industry could not have flourished without access to investors willing to pay its egregious fees. But there is another group of investors who have been more than willing over the years to lend their capital to this industry at rates that offer nothing close to an appropriate return for the risk: junk bond and leveraged loan investors. Without investors willing to grossly underprice risk, the private equity business never would have reached its enormous size and scope.

The story of Michael Milken and Drexel Burnham Lambert, Inc., has been told many times (mostly inaccurately), and this is not the place to repeat it. Suffice it to say that Mr. Milken never intended the market he founded to be used to finance the types of change-of-control transactions in which private equity specializes. In the early days of the junk bond market, Drexel Burnham financed new businesses and new technologies such as Turner Broadcasting System, Inc. (CNN), McCaw Cellular Communications (cellular telephones), Circus Circus Enterprises and other gaming companies that now comprise modern Las Vegas, and many other productive projects that contributed to the growth of the economy. By the time Mr. Milken was forced to leave Drexel Burnham to fight highly politicized government charges against him (that alleged conduct that pales in comparison to the wrongdoing that has occurred in the succeeding two decades), private equity was beginning to become an unproductive force in the financial markets and Mr. Milken was advising companies to issue equity, not debt. But the many copycats on Wall Street that saw the profits that Drexel Burnham generated from the junk bond business had no interest in heeding Mr. Milken’s warning. The leveraging of the United States had started apace.

KKR became the dominant private equity firm of the 1980s on the back of Drexel Burnham’s junk bond financing engine. The relationship culminated in the ill-advised buyout of RJR Nabisco (completed without Mr. Milken’s involvement), which boasted a novel security called “increasing rate notes” that ultimately threatened to blow up the tobacco maker. KKR and its investors were able to escape (barely) from this transaction with their capital intact, and KKR was able to console itself with the enormous fees it paid itself while taking a reputational beating in the press from which it never fully recovered. The RJR Nabisco deal showed Wall Street at its egotistical, greedy worst, and the years that followed did little to dispel the view that private equity dealmakers and their Wall Street amanuenses were interested in little but lining their own pockets at the expense of everyone else.

Drexel Burnham was not so fortunate and ultimately succumbed in February 1990 to the pressures of a government investigation that began in 1986 (extremely poor management of the firm didn’t help either). But the rest of Wall Street took up the mantle of junk bonds and continued to feed the private equity monster. In the wake of Drexel’s bankruptcy, LBO transactions plunged from $75.8 billion in 1989 to $17.9 billion in 1990 and $8 billion in 1992 as the savings and loan crisis and a deep recession slowed deal activity to a halt. But soon merger activity reignited, with M&A activity increasing from $100 billion in 1992 to almost $600 billion in 1996. During that period, the number of completed deals increased from 3,500 to 6,100. This increase in transactional volume was part of the deconstruction of American conglomerates, a process that many view as having contributed to productivity improvements and operating efficiencies in U.S. business.

There is another view, however. A great deal of evidence shows that most mergers do not lead to efficiencies and enhanced productivity but instead lead to job cuts and constitute admissions that companies can’t generate internal growth. Moreover, there is very little strategic impetus or justification for most private equity transactions. As noted above, private equity became a dumping ground for businesses that no longer fit inside conglomerates and could find no strategic purchaser or partner. The high cost of capital involved in leveraged buyouts suggests they are an extremely inefficient way for an economy to recycle its garbage, although outright liquidation or downsizing may be no more efficient. Accordingly—and this is borne out by the declining condition of American industry today—it might be more appropriate to view the statistics describing the merger boom of the 1990s as an augur of negative economic things to come.

In the early twenty-first century, a new kind of cheap financing became the main facilitator of leveraged buyouts—leveraged loans purchased by collateralized loan obligations (CLOs). While leveraged loans had been around since the 1980s, they only developed into a tradable security in the 1990s with the introduction of prime rate mutual funds, hedge funds that were willing to invest in them, and the creation of CLOs. Figure 6.1 shows the growth of this market through the late 2000s.

The market exploded with the advent of CLOs, a type of collateralized debt obligation that holds leveraged loans as its primary form of collateral. Banks began to shape loans to these borrowers to conform to CLOs’ specific structural needs, and a marriage made in heaven was born. Figure 6.2 shows the explosion in the CLO market and how it almost perfectly tracked the growth in the leveraged loan market.

By the mid-2000s, private equity firms dominated the market for leveraged loans and were able to dictate the terms on which such loans were offered. Pricing on these loans was based on the London Interbank Offered Rate (Libor), which is the rate at which banks loan money to each other in the London banking market. The price of a loan was based on the spread (number of basis points or hundredths of a percentage point) above Libor that a borrower is required to pay on a loan. As the market became increasingly overheated in the mid-2000s, spreads tightened and private equity firms were able to borrow at very low rates (Libor plus 125 to 250 basis points) and also negotiate extremely favorable covenants that gave them a great deal of latitude not previously accorded borrowers. These covenants, which were described in Chapter 4, allowed these borrowers to incur additional debt, pay dividends, and engage in many other activities that were contrary to the interests of lenders. The low cost of this financing, which generally came to less than 5 percent, enabled many transactions to be completed that could not have been done had money been more expensive. Alternatively, low-cost financing allowed private equity firms to pay higher prices for companies than strategic buyers who were no longer able to finance at lower rates than private companies (in part due to the costs associated with the Sarbanes-Oxley Act of 2002).²⁵

While the CLO market fell dormant for a couple of years after the financial crisis, it returned with a vengeance in 2011–2012 courtesy of the cheap money policies of the Federal Reserve and the ingenuity of Wall Street’s leveraged finance bankers. In 2014, more than $100 billion of CLOs were issued and the leveraged loan market was again breaking records for new issuance while covenant-lite loans were the rule rather than the exception. In fact, new variations of covenant-lite loans were so extreme as to render bank debt almost unrecognizable in terms of the weak protections it provided lenders. But one thing that had not returned to its previous peak was leveraged buyout activity. For the moment, at least, the era of the mega-buyout was dead.

This was due to several factors. First, the disappointing returns and large losses generated by the huge buyouts of the mid-2000s (including in particular the bankruptcies of KKR’s buyout of Energy Future Holdings and Apollo’s and TPG’s buyout of gaming giant Caesars Entertainment)²⁶ did serious damage to some private equity firms’ reputations and convinced them to focus on smaller targets. In addition, the Federal Reserve and other banking regulators began pressuring banks to reduce their loans to highly leveraged companies, discouraging them from extending loans above a certain leverage threshold (generally 6.0x EBITDA/Interest coverage). This significantly reduced the appetite for highly leveraged transactions although a few were still financed by firms that are not federally insured institutions like Jefferies & Co.²⁷

But there was another reason why buyout activity has waned. As the stock market continued to rally to high valuation levels, strategic buyers were better able to compete for target companies against private equity firms and use their own high stock prices as currencies to outbid them. Unlike the 2000s, private equity firms were no longer able to overpay since they could not borrow unlimited amounts of money. Instead, corporate buyers became the new buyout artists and unleashed a massive acquisition wave that was financed with huge amounts of low cost debt and bloated stock prices courtesy of the Federal Reserve.

These changes led the largest private equity firms to dramatically alter their business models in the years following the financial crisis. Following the model of The Blackstone Group L.P., which established a formidable and well-balanced business that includes private equity, investment banking, real estate and asset management, the other large firms followed suit. Today, private equity represents a much smaller part of the businesses of these companies. Furthermore, they reformed their compensation structures to better align the interests of their general partners with those of their public shareholders. For the most part, their general partners now take only de minimus salaries (by Wall Street standards) and earn virtually all of their income through dividends, although in some cases they are paid slightly larger dividends than public shareholders due to dual class share structures. This is a major improvement, however, over the original compensation structures that existed at the time these firms went public. The general partners have succeeded in creating enormous fortunes for themselves, but at least they are now eating their own cooking.

Private Equity Goes Public: A Study in the Oxymoronic

The very idea of a private equity firm going public is deeply ironic. While investing in the stock of private equity firms was a poor investment for the first few years after they went public, it proved to be a great investment since stock markets recovered from their post-crisis lows of March 2009. And while these novel ownership structures opened multiple cans of worms in terms of creating conflicts of interest for the owners of these firms, these conflicts appear to have been resolved to the satisfaction of shareholders. The real lesson that the public ownership of private equity firms has taught is one that I learned when I was involved in managing the Drexel Burnham Employee Partnerships during the 1990s: Investing at the bottom of a credit cycle can be enormously profitable.

The Drexel Burnham Employee Partnerships held private equity securities in many of the leveraged buyouts that were underwritten by Drexel Burnham Lambert, Inc. during the 1980s. My firm began managing this portfolio at the nadir of the 1991–1992 credit crisis triggered by the collapse of the savings and loan industry and the bankruptcy of Drexel Burnham. The high yield bond market was in disarray and high yield bond prices and private equity values were severely depressed. But as the economy recovered, I watched the value of these securities recover as we worked to maximize the value of the portfolio. This taught me an invaluable lesson: When markets recover from a credit crisis, the value of leveraged securities skyrocket. I watched that happen again 20 years later to the depressed assets held by publicly traded private equity firms as well as to their own stock prices. In addition to huge capital gains that investors garnered from investing in all but one of these firms (Fortress Investment Group, LLC’s stock has yet to recover), they were paid handsome dividends along the way. This is a lesson that investors should keep in mind when the next credit crisis hits as it inevitably will.

KKR completed the first major public offering of a private equity investment fund in Europe in May 2006, listing KKR Private Equity Investors L.P. (KPE) on the Euronext exchange in Amsterdam. The manner in which this offering was handled illustrates why these offerings ran into early trouble. KPE increased the size of its offering from $1.5 billion to $5.0 billion due to strong demand, but the shares themselves received a lukewarm reception, traded down on the opening, and have never traded above the $25 per share offering price. Naturally, the firm rewarded itself with €70 million of advisory fees immediately upon being listed, not only shifting a significant chunk of money from the pockets of the public shareholders to insiders but also signaling to investors that going public would not change the general partners’ practice of charging exorbitant fees every chance they could. (What other type of public company would have the gall to reward its executives for going public with such an egregious fee?) Within two months the stock had dropped to less than $22 per share, hurting the chances of any other private equity firm pulling off a similar offering. (See Figure 6.3.)

KKR’s goal of listing its stock in the United States took three more years to realize. On June 24, 2009, KKR announced plans to have KPE, which was then trading at about $5.00 per share, purchase 30 percent of KKR’s parent company. This was KKR’s second attempt to bring the parent public through some type of backdoor offering, the first attempt having failed during the financial crisis in 2008. KKR finally accomplished its goal of becoming a public company on October 1, 2009, with the completion of a merger between KKR and KPE. The new company was renamed KKR & Co. In the merger, KPE received interests representing 30 percent of the outstanding equity in KKR, and KKR’s owners and employees retained the remaining 70 percent. In the period between the June 2009 announcement of the merger between KPE and KKR and the final merger, the price of the KPE units rose 65 percent to over $9.00 per share (the overall stock market was enjoying a strong rally at the time). By June 1, 2015, KKR stock had recovered with the rest of the market to $22.71 and was paying an 8 percent annual dividend, but by December 31, 2015, it had fallen to $15.59.

KKR earlier brought public another investment entity, KKR Financial Holdings LLC (KFN), in June 2005 at $24.00 per share. KFN was a real estate investment trust (REIT) that was turned into an entity primarily invested in collateralized loan obligations (CLOs). Through KFN’s CLOs, KKR was able to purchase large chunks of the bank loans that were used to finance KKR-sponsored leveraged buyouts (as well as loans of other private equity deals) during the height of the LBO boom in the mid-2000s and thereafter. KFN turned out to be KKR’s biggest public embarrassment since the RJR Nabisco buyout until the bankruptcies of Energy Future Holdings in 2014 and Samson Resources in 2015. Between the time of its IPO on June 23, 2005, through December 9, 2009, KFN stock declined by approximately 80 percent due to a combination of poor loan selection, difficult market conditions, and the difficulties facing the private equity business. (See Figure 6.4.)

KFN never recovered its IPO value of $24.00 per share. It was ultimately acquired by KKR in 2014 at a price of roughly $12.00 per share. Some investors, including readers of The Credit Strategist who were advised to purchase the stock when it was trading below $2.00 per share, made out like bandits, however. KFN now serves as the foundation of KKR’s growing asset management business.

The Blackstone Group L.P. was the first of the large private equity giants to announce a public offering in the United States. Blackstone filed its public offering plan with the Securities and Exchange Commission in March 2007. The prospectus it filed was lengthy, highly convoluted, and disclosed little real information about the company’s operations, a sure sign to wise investors that it should be avoided. This offering came just a few weeks after Fortress Investment Group LLC completed its initial public offering in February of that year. Fortress’s IPO was a huge (albeit short-lived) success, with its shares rising 68 percent on the first day of trading. Fortress was both a private equity and hedge fund manager, with about 60 percent of its assets devoted to leveraged buyouts. The offering made instant billionaires of its principals and, according to The Wall Street Journal, “had other hedge funds and private-equity managers scrambling to their calculators, gazing over their own potential worth if they were to follow the lead of Fortress and become public.”²⁸ The bloom quickly came off the rose, however, and Fortress’s stock has been the worst performing private equity stock since it was issued at $18.50 per share in February 2007. As of December 31, 2015, it was trading at only $5.09 per share and had lost more than 70 percent of its IPO value (not to mention nearly 85 percent of its peak trading value of over $33 per share reached in April 2007), and even traded at under $1.00 per share on several days during the last week of 2008 before closing at $1.00 per share on December 31 of that year. (See Figure 6.5.)

Despite mild protests from some of Blackstone’s limited partners, who were perhaps coming to realize that a public offering might sacrifice their interests to those of the firm’s principals, the firm made an unseemly rush to complete its offering in June 2007 just as members of Congress and the media were catching on and began calling for regulators to scrutinize the deal more closely. And stock market investors, thinking they were being let in on some kind of inside deal by being allowed to invest in Blackstone, piled into the IPO. The stock, which was issued at $18 per share, closed at slightly over $35 per share at the close of trading on the first day, June 22, 2007. Blackstone Chairman Stephen Schwarzman was worth $10 billion on paper and his archrival Henry Kravis was surely tearing out what was left of his hair at having been beaten to the public market trough in the United States. At the time—June 2007—I observed in The Credit Strategist that the Blackstone offering would undoubtedly signal the top of the market and that Blackstone stock would prove to be a terrible investment.²⁹ Barron’s also presciently called the Blackstone IPO the top of the private equity market. But the firm’s competitors were not to be easily deterred when they saw that Blackstone’s principals were able to monetize billions of dollars of their ownership interests in their firm. (See Figure 6.6.)

Since the financial crisis, Blackstone has become the dominant private equity firm in the world and a powerhouse in all of its businesses including the predominant global real estate investment firm. As of June 1, 2015, its stock was trading at $42.42 per share and paying an 8.5 percent annual dividend, though it fell back to $30 by the end of 2015.

Next up at the plate was Leon Black. His firm, Apollo Management L.P., completed a convoluted backdoor merger into a public shell corporation in Europe called AP Alternative Investments L.P. in November 2007. For a long time, this deal was a money-loser for public shareholders, with the stock declining by more than 60 percent between its offering in November 2007 and December 9, 2009. This stock also had the dubious honor of spending much of late 2008 and early 2009 trading at under $2.00 per share. Smart investors would have bet on Mr. Black, however.

Meanwhile, Apollo Global Management (APO) finally went public in the U.S. in 2011. As of December 31, 2015, Apollo stock was trading at $15.18 per share, down from a high of $35.72 per share on January 6, 2014. (See Figure 6.7.) Apollo, which reportedly was in desperate straits at the depths of the financial crisis, was founded by three former Drexel Burnham executives, so it is not surprising that it was able to realize the value of its deeply distressed assets. One reason for the sharp decline in Apollo’s stock price since 2014 may be the firm’s abusive treatment of creditors in several deals, including its ill-fated leveraged buyout of Caesars Entertainment. Apollo, along with Texas Pacific Group, significantly overpaid for the gaming giant. Moreover, shortly after the deal was consummated, the financial crisis sent the gaming industry into a sharp decline. When it became obvious that Caesars would be unable to pay its debts by 2011, Apollo and TPG should have initiated a series of debt-for-equity exchanges to reduce the company’s debt load. Instead, they engineered a series of highly questionable transactions designed to salvage their equity at the expense of creditors, triggering billions of dollars of losses for lenders, unleashing lawsuits against the firms and their principals, and severely damaging both firms’ reputations. As a result, many lenders were left questioning Apollo’s willingness to honor its obligations and stopped financing Apollo’s private equity transactions, increasing the firm’s cost of capital in other leveraged buyouts. The bankruptcy court overseeing the Caesars’ bankruptcy appointed a bankruptcy examiner to investigate the transactions arranged by Apollo. The $6 billion that Apollo and Texas Pacific invested in the deal appears to be a total loss.

After the Apollo offering, the window for these deals closed for several years until The Carlyle Group L.P. went public in late 2012 and Ares Management LLC went public in 2014.

Taxing Labor as Capital

One of the truly unfortunate ways in which public policy encourages private equity activity is the favorable tax treatment of the “carried interests” of private equity firms. The “carried interest” tax creates an enormous incentive to engage in leveraged buyouts and increase the debt burden of American corporations; one would think this would be precisely the types of activity that policymakers would want to discourage. Yet like so many policies that are dictated by special interests and flawed economic thinking, the private equity industry was granted a tax break that has little intellectual, economic, or social policy justification.

Carried interests represent the share of the profits (generally 20 percent) that a private equity general partner is paid when it sells a portfolio company and realizes a gain. Due to manipulation on the part of clever tax lawyers and accountants, as well as lobbying by the Private Equity Council, the industry’s mouthpiece, the private equity industry garnered capital gains treatment of its carried interest profits for many years. After the Bush administration lowered the tax rate on capital gains to 15 percent, private equity firms’ principals were able to pay a much lower tax rate on the fruits of their daily labor than any other worker in the United States was required to pay on his or hers. This unjustifiably favorable tax treatment was not only poor public policy that contributed to the widening gap between rich and poor in our society, but it generated disrespect for the tax system through its obvious unfairness. It was another example of the corruption of our moral sentiments

A similar tax regime was introduced in the United Kingdom as well. In 1998, then Chancellor of Exchequer Gordon Brown introduced tax relief to encourage new business investment. Known as “taper relief,” it lowered the capital gains tax on business assets, which were defined to include private equity carried interests. This regime was even more egregious than in the U.S. The capital gains tax rate was lowered from 40 percent (which was clearly too high) to an almost irrelevant 10 percent, provided that the assets were held for 10 years (this period was subsequently lowered first to four years in 2000 and then to an almost laughable two years in 2002).³⁰

There is a significant distinction between a carried interest, for which a private equity partner makes no investment of capital, and an investment by a private equity general partner in his fund or directly in a portfolio company. To the extent that any individual, including a private equity partner or executive, makes an investment of capital in a company and later makes a profit upon the sale of the company, he is entitled to capital gains treatment. But carried interests do not represent an investment of the private equity principal’s capital—they represent an investment of his labor. And labor is taxed—and has always been taxed—at higher ordinary income rates.³¹ There is no intellectual justification for taxing one type of labor—a private equity partner’s carried interest—as a capital asset when all other forms of labor are not taxed as capital assets. The fact that the private equity industry was able to convince the tax authorities, who ultimately answer to the U.S. Treasury and Congress, to allow this treatment is deplorable.

When Congress was threatening to begin taxing carried interests at ordinary income rates, a number of private equity chieftains hiked up to Capitol Hill to lobby against this change in an unseemly show of greed. Among the arguments they trotted out was one that struck an especially insincere chord: They argued that taxing them at the same rate as every other American would make them stop taking risks. Considering that 60 percent or more of the income of private equity firms is generated by fees that are unrelated to the outcome of their investments, and that the individuals making these arguments already possessed personal wealth beyond the dreams of most Americans, this argument ranked among the most appallingly cynical and intellectually vacuous to ever disgrace the halls of Congress. Sadly, our intellectually bankrupt and morally corrupt Congress bought these arguments and the private equity industry was successful in buying off repeated attempts to repeal this egregious gift to the least deserving 1 percent.

The carried interest tax break is less important in reducing the taxes of private equity executives of publicly held private equity firms. For the most part, these firms compensate their senior executives through dividend payments on their stock that are taxed at the lower long-term capital gains tax rate. Nonetheless, this egregious tax break is long past its sell-by date and should be eliminated once and for all.

Calling Dr. Kevorkian?

The true toll that private equity has exacted from the U.S. economy will not be known for decades. A mind is a terrible thing to waste, and too many minds have been squandered on the types of financial engineering to which private equity is devoted. While many of the brightest and most promising students attending U.S. universities are attracted to the exorbitant compensation offered by private equity firms and the investment banks that cater to them, American society and the entire world would be far better served if these promising young men and women became scientists and teachers. Instead, as the U.S. economy struggles to recover from the 2008 financial crisis, the corporate landscape remains littered with the carcasses of overleveraged companies that were seduced by the siren song of private equity profiteers.

According to the research firm Preqin, one-year returns for the private equity industry fell by 27.6 percent in 2008, the nadir of the financial crisis. But that hardly tells the full story of the damage these investors wrought, since private equity firms were not required to mark their assets to market in any meaningful way for decades. Only in July 2011 did the SEC require private equity firms to register as investment advisers under the Investment Advisers Act of 1940, which subjected them to new rules regarding how they value their assets and how they charge fees to their limited partners. During the financial crisis, even as they were losing hundreds of billions of dollars, private equity groups required investors to invest an additional $148 billion of cash under previous commitments in 2008 with virtually no prospects of investing it profitably while distributing back only $63 billion.³² The outlook for 2009 was even bleaker; hundreds of billions of dollars were locked in partnerships that required further capital contributions from damaged limited partners even while the opportunities for making leveraged investments were slim or none. Rather than a source of funds for investors and a source of liquidity for financial markets, the private equity business spent itself into exhaustion and inflicted significant systemic damage while doing so. It would take several years, and the Herculean efforts of the Federal Reserve, to bail out private equity investors.

The damage wrought by the crisis was enormous and despite recovery in asset values since the market’s low in 2009, many public pension funds remained seriously underfunded after the financial crisis. The California Public Employees’ Retirement System (CalPERS), the nation’s largest pension fund, announced a 23.4 percent loss for the fiscal year ended June 2008, a drop in value of $56 billion to $180.9 billion. It also reported that its returns from private equity were in the bottom 1 percent of its peer group with a 5.8 percent return for the past 10 years (compared to a median peer return of 9.6 percent for the period).³³ The California State Teachers’ Retirement System (CalSTRS), the nation’s second largest pension fund, lost 25 percent for the fiscal year ended June 2008 as well, losing $43 billion in assets to fall to $118.8 billion in size.³⁴ Among the largest contributors to these losses were private equity investments, although virtually every asset class (including public equities) plunged in value over the last half of 2008. Major universities like Harvard and Yale that championed the so-called “endowment model” of investing and endorsed the private equity ideal (long-term investment inured from the short-term focus of public markets) were also severely damaged by private equity losses in their endowments in 2008.

Unlike public equities and fixed-income portfolios, however, private equity portfolios left these and other institutional investors stuck with illiquid holdings and commitments to fund similar investments in a climate in which private equity investments were virtually impossible to make due to the lack of leveraged buyout financing. Some private equity firms allowed their investors to back out of these financing commitments, while others begged their investors to honor their obligations. In the meantime, most of 2009 passed without new investments being made. Instead, these firms spent most of their time propping up their existing portfolio companies, negotiating with creditors, and trying to figure out how to justify their existence now that their business model had been definitively revealed to be a “heads-we-win, tails-we-still-win-but-our-investors lose” proposition. Since the end of the financial crisis, there have been a limited number of multibillion dollar leveraged buyouts. The biggest profits were earned by firms “doubling down” on their own or their competitors’ bad investments and investing new capital into bankrupt or troubled companies such as Lyondell Chemicals. Once again, the lesson is that those who can read credit cycles and ride them out or invest at precisely the moment when everyone else is panicking can earn enormous profits.

As signs of market stress began to materialize, some of largest firms began to shift their business models from leveraged buyouts to asset management just before the full force of the financial crisis hit. Apollo Management L.P., Texas Pacific Group, The Blackstone Group (through its acquisition of then-troubled asset management firm GSO Capital Partners L.P.), Bain Capital, LLC’s credit affiliate Sankaty Advisors, LLC (which was already an experienced debt investor) and KKR (through KKR Financial Holdings, LLC) all loaded up on leveraged loans in early 2008 using large amounts of borrowed money and significant amounts of their limited partners’ capital. Apollo even managed to convince CalPERS to give it $1 billion to invest in leveraged loans in a separate account. These firms generally followed the same formula, borrowing approximately 75 percent of the purchase price of the loans in which they invested. They thought they were getting a steal buying these loans at 25 percent discounts to par, licking their chops at the desperation of the banks that were unloading these albatrosses. Apparently they did not suspect that the banks’ willingness to finance their investments in these loans was not a sign of their strong relationships with these institutions but rather an indication of the banks’ desperation to shrink their balance sheets as credit markets were collapsing around them. For once, the banks took the clever private equity firms for a ride. In the second half of 2008 the loan market came apart, with the average price of a leveraged loan dropping by approximately 35 to 40 percent, wiping out the private equity stake’s holdings in these loans. By then, many of these firms’ limited partners had reached the limits of their tolerance for the so-called “privilege” of belonging to the private equity clubs that would have them as members. It would take years for these investments to recover in value as private equity firms morphed into large asset management firms and reduced their reliance on leveraged buyouts.³⁵

Private Equity: The Damage Done

While leveraged buyouts started with the legitimate purpose of increasing corporate efficiency, by the mid-1990s they were little more than a speculative activity that generated fees for Wall Street and private equity sponsors. Instead of feeding innovation and creativity, which even the ultimately overblown venture capital-funded Internet bubble accomplished to some extent (bringing us companies such as eBay, Amazon.com, and others), the private equity machine simply provided a market for changes in corporate control that substituted debt for equity on corporate balance sheets. Capital that could have been used for research and development, new buildings, jobs, or funding innovative new products was instead consumed by interest payments. The opportunity cost in terms of financial, physical, and intellectual capital is incalculable. Private equity is where capital went to die, and it managed to bury too many bodies with the full complicity of virtually every constituent of the financial system.

But the indictment of private equity doesn’t stop there. The influence of these firms in terms of the fees they pay to financial institutions and the political influence they exercise on Capitol Hill altered the incentives that drive the financial world and deeply corrupted the moral sentiments of our entire society. Private equity was instrumental in forging a financial ethos that favors the interests of the individual over those of the group, debt over equity, and speculation over production. It managed to perpetuate tax laws that led to the overleveraging of the U.S. economy as well as unjustifiably favorable tax treatment of its own profits that helped create an American oligarchy and contributed to the growing gap between rich and poor that threatens long-term social stability. As such, history should rightly look back on private equity as a deeply pernicious influence that contributed to the decline of U.S. financial and moral hegemony in the world.

The growing corporate sector indebtedness that was a defining feature of financialization was driven by the going private boom that began in the late 1970s and gained momentum in the 1980s. This phenomenon was rationalized by arguments that promoted return on equity (increasing shareholder value) at the expense of all other measures of value in a capitalist economy. The blind pursuit of shareholder value argued that the sole purpose of management is to maximize the short-term return to shareholders. Other considerations—the fair and equitable treatment of labor; sound environmental policies; enhancing the long-term health of the enterprise and surrounding community—were sacrificed at the altar of shareholders’ demands for immediate gratification. This view dovetailed perfectly with the free market ideology that grew dominant during the 1980s when President Ronald Reagan and Prime Minister Margaret Thatcher reigned over the Western world and helped drive the Iron Curtain into submission (although the Communists inflicted much of the damage on themselves).

Into the breach stepped the private equity industry. Over the past 40 years, private equity gathered an inordinate amount of capital and power. The result was a leveraging up of the U.S. economy and soon thereafter of Western European economies. Now Asia is on the radar screen of these financiers. What has followed? The private equity industry’s lobbyists will tell us, flying in the face of common sense and substantial evidence to the contrary, that industry has become more efficient and productive. But there is little question that crucial activities such as research and development have suffered tremendously at the hands of these owners. Rather than building businesses, the lion’s share of private equity firms have made servicing debt the new Holy Grail of corporate management. They strip their portfolio companies of excess employees and assets in the name of efficiency instead of developing new products or adding new jobs or facilities or anything else of significance to the productive capacity of the economies in which their portfolio companies operate. They transferred an enormous amount of wealth from the pockets of public shareholders and their own limited partners into their own pockets. Due to the egregious fee schemes they foisted on their investors, this has not even had the desired effect of transferring wealth back into the pockets of institutional investors who saw it disappear from their public equity portfolios. Instead, private equity managers got rich at the expense of every other party with whom they interacted in the economic system. The private equity industry has inflicted so much damage on the economy in terms of draining resources and wealth away from productive uses that it is doubtful that the United States will ever recover what it has lost. Rather than proving to be the innovators that reawakened U.S. enterprise, private equity turned out to be the undertakers that buried a good part of it.

Reform of Private Equity Firms

Private equity would never have inflicted so much damage on the economy had it been subject to a modicum of sensible regulation. Fortunately, some of the reforms that I recommended in the first edition of this book were adopted to subject this industry to greater oversight.