What is the impact of private equity on companies and workers?
Eileen Appelbaum, PhD.
Center for Economic and Policy Research www.cepr.net
SUPER RETURN U.S. 2012
June 7, 2012
Boston, MA

• PE investments illiquid, more highly leveraged

Use of leverage => must yield predictable cash flow

PE model is opposite of ‘patient capital’

Op-co, Prop-co model in retail, restaurants, nursing
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Financial markets may not recognize negative effects of dividend recaps and failure to invest

Top executives:
• Handed debt structure
• Put up some of own wealth, promised great riches
• Must meet shareholder targets
• Fired if they fail to deliver quickly –> aggressive cost cutting
– Acharya & Kehoe 2008 found 39% of CEOs replaced in first 100 days, 69% in four-year period
– Like hangman’s noose, focuses mind on short-term profit maximizing

1. Operational engineering
– Improve business strategy, access to superior management
– Invest in capital, technology, worker skills; engage work force
– Company grows organically, employment increases
– PE firm has greater access to capital to finance investment in technology or strategic acquisitions
• Examples: hospitals, family-owned businesses
• Distressed investing may rescue companies from bankruptcy
– Evidence on operating gains is thin – need to know more
• Bankruptcy filings, press reports provide info on failures
• Even sympathetic academic studies are not persuasive

1.
x
2. Transfer from workers to shareholders
– Layoff workers, intensify work for those that remain
– Reduce wages and benefits to increase predictable cash flow
– Shift work from union to non-union facilities
3. Transfer from portfolio company to PE owners
– Dividend recaps transfer resources, don’t enhance value
– Op-co/Prop-co: Op-co pays rent, Prop-co sells real estate to REIT
• Asset stripping => Op-co unable to weather economic volatility

4. Transfer from taxpayers to PE – taxpayer financed capitalism
– Leverage alters debt structure, reduces tax liabilities
– Magnifies returns, but increases risk of financial distress/bankruptcy
– Use of tax arbitrage reduces state, federal tax payments
(Badertscher/Katz/Rego 2011)
5. Breach of trust (Schleifer and Summers 1988)
– Stable enterprises depend on implicit contracts shareholders/stakeholders
– Reneging on implicit contracts gives quick boost to bottom line
– But undermines trust necessary to long-term sustainability
6. Bankruptcy for profit (Ackerlof and Romer 1993)
– PE firm takes portfolio company through bankruptcy, emerges as owner
– But with write down of debt, transfer of pension responsibility to PBGC

( Davis, Haltiwanger, Jarmin, Lerner, & Miranda 2011 )
Impact on Establishments
– Employment grows faster in PE targets prior to acquisition
– “…clear pattern of slower growth at targets post buyout … differentials
cumulate to 3.2% of employment in the first two years post buyout and
6.4% over five years.” (p. 17)
– “Slower employment growth at PE targets post buyout entirely reflects a greater pace of job destruction” -- half due to closings (pp. 17-18)
– In retail, employment falls by nearly 12% in PE targets relative to controls – effect of prop-co/op-co model and asset stripping

Impact on Firms
– Continuers and deaths: “Summing these two components yields a twoyear employment growth rate differential of -5.49 percentage points for PE targets, a large difference” (p. 23)
– Adding in greater job growth for targets than controls at greenfield establishments (+1.87) ”yields a differential of -3.62 percentage
points for targets” (p.23)
– Only when acquisitions are included does the employment growth differential shrink to less than 1%
– “Finally, bringing in the role of acquisitions and divestitures reduces this differential to -0.81 points” (p. 23)

Strömberg 2008: Compares PE and publicly traded firms
– For LBOs completed between 1970 and 2002 (before financial crisis)
• 7% became bankrupt while in PE hands
• Twice annual bankruptcy rate of publicly traded: 1.2% vs. 0.6%
– 1980s boom: Many LBOs ended in default or bankruptcy
(Kaplan & Strömberg 2009, Wright et al. 2007)
Hotchkiss/Smith/Strömberg 2011: Highly leveraged firms
– 2,156 firms, half PE-owned and half not, Jan 1997-Apr 2010
– Quarter of sample had a default between 2007 and 2010 (p. 9-10)
• 12.3% for 2001 LBOs, 31.6% for 1997 LBOs
• 25% default rate: 2007 – 2010Q1

• PE has potential to improve portfolio company performance
– Better access to capital markets and managerial know-how
• But laser-like focus on maximizing short-run shareholder returns, high leverage, short time horizon to exit
– Leads to decisions that enrich investors and company execs without due regard for long-term competitiveness of companies
• Regulation + reform of tax code can reduce risk of financial distress and incentives for opportunism & self-dealing

References
• Acharya, V. and C. Kehoe (2008). “Corporate Gevernance and Value Creation: Evidence from Private Equity.” http://www.ecgi.org/competitions/roi/files/Acharya_Kehoe_v5.pdf
• Ackerlof, G. A. and P.M. Romer. (1993). “Looting: The Economic Underworld of Bankruptcy for Profit.”
Brookings Papers on Economic Activity, 24:1-74.
• Appelbaum, E., R. Batt and I. Clark (2012). “Financial Capitalism, Breach of Trust and Collateral Damage,” paper presented at Across Boundaries: An Interdisciplinary Conference on the Global Challenges Facing Workers and
Employment Research, London School of Economics, December 13, 2011. http://www.cepr.net/index.php/publications/reports/financial-capitalism-breach-of-trust-and-collateraldamage
• Badertscher, B., S.P. Katz & S.O. Rego (2011). “The Impact of Private Equity Ownership on Portfolio Firms’
Corporate Tax Avoidance,” Manuscript.
• Davis, S., J. Haltiwanger,, R. Jarmin, J. Lerner, and J. Miranda. (2011). “Private Equity and Employment.” NBER
Working Paper 17399. Cambridge. MA: National Bureau of Economic Research. Available at http://www.nber.org/papers/w17399
• Hotchkiss, E., D.C. Smith, & P. Strömberg (2011). “Private Equity and the Resolution of Financial Distress,”
Manuscript.
• Schleifer, A. and L. H. Summers (1988). “Breach of Trust in Hostile Takeovers,” in A. J. Auerbach, ed., Corporate
Takeovers: Causes and Consequences: 33-68. Cambridge, MA: National Bureau of Economic Research.
• Strömberg, P. (2008). “The New Demography of Private, Equity.” The Globalization of Alternative Investments
Working Papers Volume 1: The Global Economic Impact of Private Equity Report 2008, World Economic Forum,
January: 3-26.
• Wright, M., A. Burrows, R.. Ball, L. Scholes, M. Meneleman & K. Arness (2007). “The Implications of Alternative
Investment Vehicles for Corporate Governance,” Cited in A. Watt (2008). “The Impact of Private Equity on
European Companies and Workers: Key Issues and a Review of the Evidence,” Industrial Relations Journal 39(6):
548-568.