The Looting of the Corporation: The Corporate Raiders’ Playbook
This is the second in a series on the equity/hedge funds: what they are, and how they plunder successful corporations. The first is here.
Some hedge funds are merely passive investors. They search for good investments (‘going long’) and also for bad investments to bet they will fail (‘going short’, as in the movie The Big Short).
However, some hedge funds do active corporate raiding.
As we have seen in the Bed Bath and Beyond case, sometimes alone, or sometimes in cooperation with other hedge funds, they acquire enough shares to elect their own nominees to the Board of Directors (BOD) of the target corporation or threaten with the very real power to do so. Once in control of the BOD, they ensure all profits are stripped out to them yearly, relying on Milton Friedman’s bogus shareholder value theory. These targets are public companies.
But they can do even more damage by acquiring the shares of a public corporation, using its own assets to buy the corporation, and then taking it private where it can be looted in secret.
The funds that specialize in doing this are appropriately called, Private Equity (PE) Funds.
The Leveraged Buyout
Let’s start at the beginning: how the Private Equity Funds acquire a corporation.
Private Equity Funds use the leveraged buyout. Leverage means ‘on borrowed money’. PE buy the corporations by putting up only some of the PE’s own money (from 10% to 50%), borrowing the rest, and after getting control and taking it private, they make the target corporation responsible for paying back the entire loan. It’s their company now; they can make it pay whatever they want.
Eileen Appelbaum, co-director of the Center for Economic and Policy Research, says, “Wall Street firmswere giddy at the discovery that they could load companies up with debt they’d never be responsible for paying down themselves, and take an ample cut of the proceeds that came from stripping a company bare—and it was all legal”.
Mother Jones reports that in 2020, Private Equity firms managed $7.3 trillion in assets—roughly the value of Apple, Microsoft, Amazon, and Tesla combined. Nearly 12 million workers—one in every 14 employees in the United States—relied on companies run by private equity for their paychecks
The Uniting of The Right and The Left
The abuse of the leveraged buyout is one of the issues that has authors on both the right and the left raising an alarm.
Josh Kosman, quoted above, on the right, captured his opinion of the dangers of the leveraged buyout in the title of his book, The Buyout of America: How Private Equity is Destroying Jobs and Killing the American Economy.
Gretchen Morgenson and Joshua Rosner, on the left, also say it in the title of their book, These Are the Plunderers: How Private Equity Runs—and Wrecks—America.
Both books have hundreds of alarming examples of the equity/hedge funds’ predatory tactics:
The PE Playbook
Their playbook is a tale of plunder and pillage.
They immediately start paying themselves a management, monitoring or advisory fee, which is on top of, not a replacement of, the existing executives’ salaries.
They force companies to sell off profitable assets for immediate cash that is quickly stripped out in dividends. By a favorite maneuver, they have the company sell its real estate and then rent those same buildings. The sale results in an immediate cash bonanza for dividends and buybacks, but long-term future higher costs in rent—when these shareholders will be long gone. And, sometimes a plus: they will be the buyers who get the benefit of the prime locations for redevelopment when the target company goes bankrupt.
Because it distributes generous dividends, the hedge funds will have the company take out loans to meet its operating costs. Often the money is borrowed from a company owned by the hedge fund. The company gives that hedge fund lender a lien on corporate assets ahead of other creditors so the hedge fund gets repaid in priority and there’s little left for other creditors in bankruptcy.
And they have the company borrow to do buybacks at inflated prices.
They justify their actions on the well-accepted Friedman shareholder value doctrine, which is to provide ‘shareholder value’ above all else. Recall that the doctrine says, a corporation has no responsibility to the country which gives it the opportunity to operate; nor to providing employment for that country’s citizens; nor to the workers whose labor is essential to those profits; nor to protect the environment of that country. Its sole responsibility is to create wealth and to pay it to the shareholders.
How To Make Money by Going Bankrupt
According to Pulitzer Prize winning journalist, Gretchen Morgenson, research shows that a Private Equity controlled corporation is ten times more likely to go bankrupt than a non-PE controlled business.
It’s actually quite easy if you are wealthy. Here’s how it goes. They are called engineered bankruptcies for good reason. The controlling shareholders, through the Board of Directors, cause the corporation to seek Chapter 11 bankruptcy protection.
It is critical that Chapter 11 is used so that no bankruptcy examiner who is independent, is appointed to manage the business and report to creditors. For example, Enron was not a Chapter 11 bankruptcy; so the examiner could expose the fraud by the senior executives in detail. Under Chapter 11, the CEO is left in place to run the show.
Then the vultures descend as buyers, hungrily swirling around the corporate carcass. First, the secured creditors, those that have liens on assets, seize the assets subject to their liens. The Private Equity firms have often made themselves secured creditors by giving loans to the target corporation. These loans are needed to operate the business because yearly profits are entirely stripped out in dividends to the PE funds.
Most remaining assets of a corporation sold through bankruptcy are sold at fire sale values. After the sale, the proceeds are divided up among the unsecured creditors.
The controlling shareholder, who knows the entire business operation and the true value of those remaining assets, sometimes disguised through a nominee corporation, will slightly outbid and buy selected assets at a huge discount. Now they have these assets free and clear of all creditors and, especially, pension obligations to workers.
As part of the hedge fund maneuvers, you will see that when the target corporation is brought to bankruptcy, the executive pensions are often, but not always, fully funded, but workers’ pensions always take a hit. That means that workers must make a claim on a federal agency called the Pension Benefit Guaranty Corporation. This body of responsible corporations are forced to increase their contributions to this fund in order to support the Private Equity plunder.
You will recognize many national brands that were bought out by PE firms and that ended in bankruptcy. Here are a few: Toys “R” Us, Sears, J.Crew, Neiman Marcus, Hertz and Chuck E. Cheese.
In the next chapter, we will examine other predatory tactics and we will look closely at the Sears bankruptcy to show how a Private Equity fund can strip the company, put it into bankruptcy and still make money out of the bankruptcy!
It’s insidious how this process works and the outcome is exactly the opposite of what we’re told is the benefit of a capitalist economy: competition and making better products with innovative approaches. The best rise to the top and bloat.