Motley Fool Money - Private Equity’s Opaque World

Episode Date: April 30, 2023

If you want to maximize the value of your home for decades, you might update the kitchen. But if your time frame is one week, then you might burn down the house. Brendan Ballou is a federal prosecutor and special counsel at the Department of Justice, where he led the antitrust division’s work on private equity. He's also authored a new book, “Plunder, Private Equity’s Plan to Pillage America.” Ricky Mulvey caught up with him to talk about: - The techniques many private equity companies use to generate short-term returns - A key misunderstanding about the fall of in-person retailers - Private equity’s impact on medical billing, bakeries, and insurance Companies discussed: CG, KKR, BX Host: Ricky Mulvey Guest: Brendan Ballou Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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you know, when you're talking about private equity firms having their companies exit through an IPO, I can't talk about any specific company. But one of the challenges that you've got is they've been taken a very short-term perspective and, you know, potentially selling off the company's assets. So, you know, the company that emerges through private equity ownership, it's not always this case, this way, but sometimes the company that emerges from private equity ownership, you know, may just not be as strong or as valuable a company as it was when it entered. I'm Chris Hill, and that's Brendan Ballou, special counsel in the Antitrust Division at the Department of Justice and author of the new book, Plunder, Private Equity's Plan to Pillage

America. Ricky Mulvey caught up with Ballou to talk about the lesser known ways that private equity can impact your life, their methods for generating short-term returns, and how a profitable toys are us managed to go bankrupt. Brendan, this is the first time I've voluntarily spoken with a federal prosecutor. I appreciate you joining me for this journey. Thank you so much for the time. I also understand that you've got to say something before we dive into the questions.

Yeah, as I say in all of these interviews, you know, I'm speaking personally and what I say doesn't necessarily reflect the views of the Department of Justice. Let's dive in. So there are a lot of ways to raise capital. You've got public markets. You got bonds. Why pick on private equity? Why go after them?

Sure. Well, it's a great question. And maybe, you know, you've got a very educated audience and financially literate one. But it might be helpful to just set a baseline for what, private equity is. So private equity firms use a little bit of their own money, some borrowed money, and some investor money to buy up companies. They try to make operational and financial improvements, and then flip those companies for a profit a few years later. That's a really simple idea. But to get to your question, there are some basic problems with the private equity business model. One is

that private equity firms tend to invest just for a few years and want to flip companies for profit, you know, in three, five, or seven years' time. The second problem is that firms tend to load companies up with a lot of debt and extract a lot of fees from them. And the third, and this is the part that really interests me as a lawyer, private equity firms are really good at insulating themselves from liability for the consequences of their actions. And so what that means is when you've got short-term thinking, a lot of debt, and insulation from responsibility, it tends to create a lot of bad outcomes for the companies that private equity firms buy. Yeah, I want to get to incentives in a bit.

One of the things that is key about private equity is this short-term shot clock. All of them seem to operate on a five-year investment cycle. They want to get in and out within that five-year period. What's the reasoning behind that shot clock? And maybe what are some of the implications of that? Yeah. You know, I think it's probably a number of different reasons, partly just sort of the practice of the industry as a whole,

partly because they're getting money in part from limited partnership investors who are going to want to return on their investment in just a few years' time. And partly because, you know, the whole idea of private equity is that they can get superior returns faster than other kinds of investments means that they need to think short-term. The challenge that we've got is when you really think in just a few years' time, you tend to make short-term decisions. You know, I always sort of joke,

If I was trying to maximize the value of my apartment, you know, over 20 years, I'd probably redo the kitchen and add a inset bookcase. If I was trying to maximize the value over the next week, I'd, you know, burn it down and try to collect the insurance money. Your time frame affects your decision-making. And so, you know, if you're thinking in just a few years' time, often it means you're not investing in research and development. You're not investing in building new operations, new factories and so forth. You're not investing in your workers and your employees, you know, and your customers. You're willing to raise rates or cut quality care. And that's more than just sort of theoretical.

We see that playing out in a lot of different industries where private equity is active. One thing that hits on both of those, which is the incentives and ownership. They're able to essentially claim ownership of a company but not quite be the owner. That was the Carlisle Group, which is one of the largest private equity firms in the world with their acquisition of manner care, which was a string or not a string, a chain, chains the right word, of nursing home facilities. Yeah, so this is actually the example that starts the book, and I think it illustrates a lot of the problems with private equity or the private equity business model. So as you said, Carlisle is a gigantic private equity firm. HCR Manor Care at the time was one of the largest nursing home chains in America. Carlisle bought Manor Care and then executed a number of tactics. They sold the underlying real estate of the place.

They executed what's called a dividend recapitalization, which requires you to borrow the company to borrow money to to pay Carlisle and the other investors. They extracted a lot of money through transaction fees and management fees. And ultimately, the company, the nursing home chain, dramatically suffered. You know, you had health code's violation spike, residents complaining. In fact, at least one resident died. But when their family sued, Carlisle did this really interesting sort of like legal magic trick, which is they said when the family sued for wrongful death,

judge, technically we're not the owner of manner care. Rather, we just advise a series of funds whose limited partners through several shell companies ultimately own manner care. And that was enough to get the case against Carlisle dismissed. And I think what that story illustrates is a lot of times private equity firms are able to essentially, you know, control a company. But when things go badly, they don't have responsibility. What's preventing a judge?

Let's going back to the case of manner care, what's preventing a judge from piercing the veil. Clearly, these funds are run by this private equity company. Clearly, it's this private equity company that's operating as an owner of the business, but they're not the owner. That's where I'm confused in how they're able to pull off the magic trick you described. If you're confused, too, and I think most people that would read these court decisions are confused as well. You mentioned the legal doctrine at issue here, which is called corporate veil piercing. And generally what it means is that investors aren't held responsible for the actions of the companies they invest in. I mean, that makes sense for, you know, Ricky with your 401k plan or Vanguard account,

you know, you've got stock in a bunch of different companies. It wouldn't really make sense for somebody to sue you if one of those companies, you know, breaks the law because you didn't really have much control over what that company did. That said, a private equity firm, you know, by being the majority or sole equity investor in a company, really can control the company's operations, either directly by demanding certain actions or choosing the board of directors or choosing the company's leadership. And so I think this is a really interesting area where the law hasn't really caught up with business practice.

And private equity firms have been able to sort of use that mismatch to their advantage. Let's get into some of the bag of tricks that they use to get those returns on a five-year period, which I'll also mention they seem to be hitting going for singles and doubles with these investments, they're not necessarily going for your 10 baggers, your 100 baggers. And I think that's because of the time period, one of those bag of tricks that you mentioned is dividend recapitalization, where the company borrows money to pay back the original investors who may also have an advisory fee as well. And that played out to the detriment of Toys R Us. That's one of the major reasons that that chain had to go through bankruptcy. Yeah, Toys R Us is a really interesting

example because it got bought up by a consortium of private equity firms in 2007. And sort of the obituary for Toys R Us was, oh, it was Amazon. Amazon killed the store. Actually, Toys R Us was profitable the very last year that it was in business. The challenge that it had was it was servicing more for the debt that it had taken on in order to be bought by the private equity firm as it was in profit. So to go to the specific tactic that you're talking about, a dividend recapitalization, what happens there is private equity firm will buy a business and then essentially direct the business to pay it, you know, a dividend.

Now, the company doesn't actually have the cash to do it, so it has to borrow money. I always sort of say it's a little bit like using somebody else's credit card to pay yourself because, you know, somebody else has the responsibility, but you're the one getting the profit. And that's happening, not just in Toys R Us. I'm talking off the top of my head here, so I don't want to get anything wrong. But I think that we've got multiple billions of dollars in dividend recaps that are happening every year, according to at least one study. And it's also that you dive into with Toys R Us is the narrative of Amazon killing retail.

And whether it's, I think it's pay less shoe stores, one of them, a lot of these discount in-person retailers, private equity firms were able to benefit from that narrative that, oh, it's e-commerce and Amazon killing them. But in many cases, the layoffs can be directly attributed to this style of ownership. Yeah, it's really interesting. At least according to one study, private equity firms were responsible for about 600,000 job losses in the retail industry. over a decade, when the industry as a whole actually added jobs. Now, why is that? I think it's a couple of different reasons. Partly in the Payless Shoe Source example, according to the New York Times, it was sort of sheer mismanagement. They put in charge of the company people that didn't actually

have experience in retail or shoes, but finance people who nonetheless had a lot of operational ideas like shutting down the quality control factory in China and as a result, they started getting shoes that were the wrong size or were misshapen or having a World Cup plan to distribute flip-flops with country's flags on it, but the countries weren't ones where they actually sold shoes. Sort of the list goes on. So sometimes it's just pure mismanagement. A lot of times it goes back to what you were just talking about, which is this short-term focus, which is if you're trying to get a return in just a few years, you're not going to make the sort of strategic long-term investments that are going to be necessary for a company to survive for decades.

To go back to Toys R Us, I know this is a really small example, but there was really interesting reporting about how after the PE firms bought Toys R Us, the stores literally got shabbier because they stopped investing in maintenance and janitorial crews. People would complain that, I don't know if you remember going to a Toys R Us, they'd have these very high ceilings that piles of dust were collecting on the fans and in the girders because that was just something that the firms decided they didn't need to pay for anymore. There are other examples going on with other retailers, but I think it shows how when you take a short-term perspective, oftentimes that may work for you as the investor, but it doesn't necessarily

work for the company that you've bought. But something you hit on with Toys R Us is you have people running these retail businesses or maybe even an emergency room that have no experience in the space. They're bureaucrats without the boots on the ground ability. to understand what's going on in these stores? Well, I'm a lawyer, so I don't want to cast aspersions on anybody who doesn't know how to run a company. I certainly don't.

That said, a lot of private equity firms ultimately decide that they do want to have operational control of these. And it's more than just retail. I think you just mentioned hospitals and emergency rooms. One of the really interesting cases is private equity firms buying up physician staffing companies, which are the companies that hospitals use to staff up emergency rooms. And there's a really interesting. lawsuit going on, ultimately that I think the plaintiffs lost, that alleged that, look,

the private equity firm is now actually directing medical decisions on behalf of doctors in terms of, you know, sort of what techniques to use, when to let people into the hospital, what equipment or what medical supplies to use. Their allegation is that this went so far that it actually violated state corporate practice of medicine laws. Now, plaintiffs actually, I believe, lost that specific case, but it's an illustration of where private equity firms are really making operational decisions in industries where the people who run private equity firms don't necessarily have experience. One example in that case would also be dermatology clinics. And the problem for a lot of the doctors is you end up having no other option of where you're going to go because

it's a private equity firm that owns all of the terminatology clinics in one region. And, you know, in some cases, that might inform decisions for the dermatologists to not complete treatment and couple of visits because they're incentivized to have you come in more and more times. Not that I would know. Ricky, it's clear you've read the book very carefully here. I really appreciate it. You know, so you're exactly right. In the dermatology example, one of the most astounding allegations in an article in Bloomberg was that the private equity firm actually directed the use of newer, cheaper needles for the doctors to use that actually broke off in people's skin. For doctors, it's been alleged that private equity firms have become so bad in the dermatology space.

I actually went on sort of job posting boards for dermatologists. The jobs will actually say, you know, oh, we need a dermatologist in Texas or Florida or wherever it happens to be. And they'll say in all caps, practice is not private equity owned. You know, so even, you know, not just for patients, but for doctors, too, this is an experience that they're trying to avoid. The second item in the bag of tricks that after that dive, you can go so many places with this conversation, Brendan. The second part of the bag of tricks where private equity companies

get returns is sale leasebacks. And I think this is pretty critical as a lot of private equity owned companies, excuse me, might be hitting the public markets, including one like Panera bread. How do these sale leasebacks work? So in a sale leaseback, the private equity firm will direct the company to sell its underlying assets, the real estate or whatever it happens to be, and then lease it back. This happened to a company that I knew very well. I grew up in the Midwest and Shopco was this regional retailer. I always say it's sort of like one step above Walmart, but one step below Target. It was this great store.

And Sun Capital, a private equity firm, bought up Shopco, required Shopcoe to sell all of its stores and then lease the stores back. Now, that was a problem for Shopko because now it had an unending sort of lease obligation, whereas it used to have these assets that it could hold on to, we could borrow against and so forth. It was locked into these leases, I think, for 15-year periods of time that may or may not have been favorable to them. And it meant that essentially Sun Capital got this great infusion of cash.

You know, Shopcoe made this profit from the sales. And then, as I recall, Sun Capital actually got a transaction fee, a percentage of the profit from all these sales, in addition to the overall profit from selling them. So, you know, sale leasebacks are a way to make a quick hit of money. the short term, but it can be a drag on the company in the long term. And so, you know, when you're talking about private equity firms having their companies exit through an IPO, I can't talk about any specific company. But one of the challenges that you've got is they've been taking a very short-term perspective

and, you know, potentially selling off the company's assets. So, you know, the company that emerges through private equity ownership, it's not always this case, this way, but sometimes. The company that emerges from private equity ownership, you know, may, you know, may just not be as strong or as valuable a company as it was when it entered. It's not in fighting shape. And while you may not be able to comment on it, before our conversation, I did look at commercial real estate sites for Panera bread. And right now, if you're an investor with a few million bucks to spare, you can buy a Panera bread and they will operate a sale leaseback right back to

you. And I think that that's something that investors might want to keep in the back of their minds in the event that Panera goes public through an IPO. One, you have a large section on financialization that I want to hit because I think you brought up a really good point and a risk that I hadn't considered before. Private equity companies in many cases, when we think of Blackstone, Carlisle, KKR, they're making large, opaque, and increasingly risky investments. And that is set up, what you would argue in the, or what you did argue in the book, is systemic risk that may not be realized. Yeah. So I think that there's, there are a couple challenges that we've got. One is that private equity firms are just vastly less regulated than other parts of the finance industry.

You know, after the great recession, all the big investment banks converted into bank holding companies, which are regulated by the Federal Reserve, have capital requirements, and so forth. By comparison, you know, private equity firms are, you know, essentially unregulated. They have to file some forums with the SEC and so forth, but nothing like the level of scrutiny that investment banks have. As a result, they're sort of supplanting investment banks in a lot of areas like private credit, you know, which is this alternative to the stock market and sort of almost by definition is more opaque. There have been a lot of criticisms of sort of the private credit market as, you know, people don't actually know the quality of these loans. They're

getting syndicated and passed off from one borrower, you know, one one lender to another. It's sort of like a potential housing crisis, you know, redox. But the challenge that we've got is, you know, it's not that these things are inherently more risky. It's that we don't even know what's going on here, simply because we don't have the regulations around it yet. Well, one of the reasons it may be different, and feel free to correct me, is that kind of what we just described to the bag of tricks, which they're insulated from the companies falling apart. Therefore, at least one explanation could be, so let's say they overbought these businesses and a lot of them go into bankruptcy. Maybe it's not a systemic risk because they don't actually own

the company. It's a really interesting question, because if there is sort of private equity crisis, the way that there was an investment bank crisis in 2008, it's not going to look the same. It's not going to necessarily be that Blackstone or Carlisle or KKR goes bankrupt. It's that a lot of portfolio companies owned by private equity firms are going to go bankrupt. And it's going to take a couple of steps for people to see, oh, it was potentially because of the tactics that private equity firms executed on them or the debt that they loaded up these companies with. That was the cause of these bankruptcy. even when there is sort of a crisis and I'm not predicting that there is, it's going to be

sort of a challenge for journalists like you to help people understand what role private equity might have played in it. Oh, please don't call me a journalist. I'm a talk show guy. These companies, though, one way it may be a risk that you mentioned in the book, and I forget the exact numbers, is that a lot of these companies that the private equity companies were competing for were bought at peak valuations. And what we're seeing right now in the banking industry, what we're seeing right now in the cases of a lot of high-growth tech companies, is that it's taking a few years, but you're seeing sort of the collapse of that higher valuation cycle. Yeah.

It's really interesting. And I think to your point, one, private equity acquisitions are absolutely enormous. PE firms spent over a trillion dollars buying companies last year. Two, and this is a really important point, when PE firms do it, they do it with a little bit of their own money, but a lot of it is borrowed money. And this is the really key point. it's borrowed money that the portfolio company, the company that they buy, that is responsible for paying, not the private equity firm. So when Toys R.S got bought by, you know, PE firms, Toys R Us was the one that had to take on a lot of debt for the acquisition.

So to your point, you know, a lot of these acquisitions happen at a time of very low interest rates when it was very easy to, you know, get money to buy companies. And now, you know, interest rates have risen dramatically and you're starting to see some sort of shaking in the foundation. But the really interesting part is the real danger for this isn't, again, at the risk of being repetitive from the private equity firm. It's from the companies that they buy. One thing that you mention is that there's a huge risk going on in the insurance market where private equity companies have been purchasing these insurance companies and that they've been making investments that may have pushed what were previously, like let's say safe investments that would be used with an insurance premium to increasingly risky investments. And that could also

have some consequences that the finance folks might want to know. So it's really interesting. The private equity firms, you know, they need money to buy companies. Historically, they've gotten that money from sovereign wealth funds, pension funds, and so forth, but they need more. And so they've turned to investing or potentially buying insurance companies, life insurance companies, annuity companies, and so forth. And the reason that you do that, if you're a private equity firm, is the insurance company, you know, if you've got a life insurance policy, you pay them every month or every quarter. for the policy. And PE firms can use that money to fund their acquisitions, to fund their various investments. As you said, there have been accusations by industry observers that really two things

are going on. One is PE firms may be using that money for riskier investments than insurers traditionally do. The other thing, and this is really interesting, is private equity firms have also been allegedly moving the blocks of insurance policies to affiliated shell companies offshore in Bermuda. And the reason that they do that is the Bermuda shell companies have lower capital requirements. And so what that means is the insurance company and ultimately the P.E. firm has more money to play with to invest in their projects. But it also means that there's less cushion if things go wrong.

And to add one last sort of point on that, the really tricky part, you know, sort of a recurring theme in this conversation has been who's got responsibility here is if an insurance company fails, it won't necessarily be the private equity firm that has to pay for it, pay for the policies. Rather, they'll get absorbed by what are called state guarantee organizations, which are these sort of quasi-government pools of money that state regulators set up. So if an insurance company owned by a private equity firm collapses, it's actually going to be other more responsible insurance companies and ultimately their policyholders that are going to be the ones that have to pay. One competitive advantage of these companies that you alluded to is that their political connections. And before we get into this part, I think this is not a partisan thing.

It happens on both every each and every side, which is that private equity companies, one way they've perhaps been able to insulate themselves and gain in. investment dollars is because they've been so politically connected, whether it's with the FCC with prison telephone companies or private education systems where for-profit colleges are able to get federal funding for online programs with grossly low graduation percentages. Why don't we pick one and maybe describe how these companies have used political connections in order to secure a steady stream of cash? Sure. So maybe the best way would be to think about surprise medical billing. which is an issue that affects virtually every American.

So just to set a baseline, a surprise medical bill is you go to your doctor, you go to the ER. It's one that you think is a network, but it's staffed by somebody that's actually out of network. And you get, you know, instead of paying $10 or $50 or $200, you know, you're paying $100,000 or something like that. There are a handful of companies that have essentially built their business around doing surprise medical billing by staffing doctors in such a way that, you know, They're guaranteed or likely to bill out these surprise bills. And those companies have been bought by private equity firms. The business model of these companies depends on surprise medical billing, even though that has serious, serious consequences.

I think one in five Americans' fears, you know, sort of ruined by medical debt. There has been sort of repeated efforts to address this in Congress. And the power that these companies and their private equity owners had in the process was just extraordinary. You know, contributing many, many millions of dollars to friendly candidates, spending many millions of dollars through these dark money groups to sort of bully senators and Congress people into voting against reform. There was a sort of compromise legislation that was nearly ready to go until a private equity

firm donated $31,000 to one of the key elected officials who blew up the compromise. Ultimately, some legislation has passed that partially addresses the issue. The challenge is it doesn't actually end surprise medical billing. It just sends it to arbitration. And it exempts like a really key industry for Americans and for private equity, which is ground ambulances. I think, you know, pretty much anybody from our generation is terrified about taking an ambulance because of the horror stories that we've heard. And, you know, the really sort of surprising part is private equity hasn't even stopped with lobbying, even though it won in large part. You know, as the current administration is considering rulemaking on this, they've contributed.

many thousands of dollars to elected officials who have since written to the administration to try to sort of interpret the legislative history in a way that favors private equity. So that's just one of many examples. I'll just say, you know, private equity and investment firms have contributed something like $900 million to federal candidates since 1990. So we're talking about just an extraordinary amount of money. And I think it's been extraordinarily effective. As we wrap up, many of our listeners are, I think, in business school. Maybe they're studying finance marketing. And private equity firms, these large ones, have become the new investment banks in sort of the most prestigious place you can go after your college or MBA program. Do you have like a don't do drugs kind of speech about working

in private equity for them? Well, I should be clear, you know, my critique of the private equity business model is not a critique of the people in private equity. You know, I've talked to some of them. They've been very friendly and very nice. It's not to say that the people who work in private equity are good or bad. it's that we have a fundamentally flawed business model and flawed incentives that lead to bad outcomes for consumers, for workers, for our economy as a whole. I think for the folks that are starting out their career and thinking about where to go, I think it's a really deep question that you always have to ask about, how do I want to spend my time? Do I believe that I'm contributing to society here? At some level, it's almost aesthetic in that in my heart, I don't think most people want to spend their day looking at Excel, which is not to say that Excel isn't interesting. But I think people want to be, you know, figuring out how a factory works, you know, figuring out how to sell like a beautiful new product, engineering something important, you know, really building a core part of the economy.

I just say, you know, for folks that are thinking about this, look broadly. You know, there are a lot of exciting ways to have fulfilling careers in, you know, in this country. One I have to add is that if you're working at a company that was recently acquired by a private equity company, something's probably going to happen, especially if you're, you know, you're in an office job. They're going to say it's not for layoffs, but someone's going to roll in and ask you exactly how much time it takes for you to complete your tasks. Bump that up and make sure you're working, working at least 50 hours a week. Brendan Ballou, I am delighted to recommend this book, Plunder, Private Equity's Plan to Pillage America to our listeners. I found it absolutely engaging. I learned so much from it. Thank you for your book, and thank you for your time on Motley

Full Money. Thank you so much. As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy ourselves stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.