Macey Versus Lenzner

http://www.futureofcapitalism.com/2012/01/macey-versus-lenzner

A professor at Yale Law School, Jonathan Macey, has a piece in the Wall Street Journal defending private equity and pushing back against Robert Lenzner's article in Forbes that was mentioned here the other day.

Though I share Professor Macey's enthusiasm for capitalism and economic freedom, and I've admired his past writing about insider trading, I think Professor Macey takes his defense of private equity a bit farther than the facts warrant.

Professor Macey writes:

Because private-equity firms are, by definition, equity investors, they make money only if they improve the performance of their companies. Private equity is last in line to be paid in case of insolvency. Private-equity firms don't make a profit unless their companies can meet their obligations to workers and other creditors....

Or take Hertz. Ford sold Hertz to private-equity investors in 2009 for $14 billion. These investors were able to take the company public less than a year later at an equity valuation of $17 billion. The Hertz success story is consistent with the empirical data...

...By law, a company cannot pay a dividend unless it is solvent. It also is illegal for a director to authorize a dividend that would render a company insolvent. Corporate boards as a matter of standard practice are extremely careful about paying dividends. This is especially true for companies with board members who are sophisticated and wealthy private-equity investors, because they face personal liability for authorizing the payment of dividends by an insolvent company....

...Equity investors do not get paid until the creditors do.

But a July 2006 Wall Street Journal article (free link here courtesy of the Pittsburgh Post-Gazette) by Greg Ip (since decamped to the Economist) and Henny Sender (since decamped to the Financial Times) told a different story.

The article begins:

When a trio of private investment firms acquired Burger King Corp. in late 2002, the chain was unprofitable. But immediately, it started paying off for the investors.

At the time of the acquisition, Burger King paid its new owners -- Texas Pacific Group, the private-equity arm of Goldman Sachs Group Inc. and Bain Capital -- $22.4 million of unspecified "professional fees." Burger King also started paying the group quarterly management fees for monitoring its business, serving on its board and other services. The total reached $29 million by this year.

In February, after three years of restructuring efforts under the new owners, Burger King announced plans to sell shares in an initial public offering. Three months before the sale, Burger King paid the owners a $367 million dividend. The company justified it in part by saying it had produced cash "in excess" of its needs -- and then borrowed to make the rich payment.

Wrote Mr. Ip and Ms. Sender: "In many of their deals, the private-equity firms have turned the buyout game on its head. In the late 1980s, it was a high-risk, high-reward business that sometimes took years to pay off. Nowadays, buyouts can often generate income for the firms almost immediately, long before a significant turnaround in the company has occurred. And since acquired companies frequently borrow money to pay off the new owners, many are left saddled with debt."

The 2006 Journal story by Mr. Ip and Ms. Sender went on: "A slew of companies -- Burger King, Warner Music Group, mattress maker Simmons Bedding Co. and Remington Arms Co. -- have paid their private-equity owners large dividends mostly financed with debt. In late June, the parent of Hertz Corp. borrowed to pay a $1 billion dividend to Clayton, Dubilier & Rice Inc., Carlyle Group and Merrill Lynch, which acquired the company last December. They reaped that bonanza even though the rental-car company swung to a loss in the first quarter, primarily due to higher interest payments on debt incurred to complete the deal."

As for Professor Macey's Hertz "success story," it may have been a success for the private equity investors who exited and for the investment bankers who earned fees underwriting the public offering, but it's not clear that it's been such a success so far for those shareholders. The Hertz IPO was actually in 2006, not in 2010 as Professor Macey's article claims; it priced at $15 a share, and HTZ, which doesn't pay a dividend, is now at around $13 a share. Some success story. The Washington Post had coverage back in 2006 pointing out that "Hertz's three owners have paid themselves a $1 billion dividend and plan to use more than $400 million of the $1.6 billion in anticipated IPO proceeds to pay themselves another one. And, after the stock sale, the three investors will still control nearly three-quarters of Hertz, which would be valued at about $18 billion, including about $12 billion of debt."

The Economist had a piece (unsigned, but probably by Mr. Ip) in November detailing other ways that private equity investors, far from being last in line or waiting until a turnaround is a success before getting paid, charge fees to the companies they own:

Transaction fees, which buy-out firms charge firms when they buy them (and yes, you did read that right), went up by at least 25% on average for 2009-10 deals that were $500m or larger, compared with deals done between 2005 and 2008. Deals between $500m and $1 billion, for example, had an average transaction fee of 1.24% of the deal amount in 2009-10, compared with 0.99% in 2005-08. "Monitoring" fees, which portfolio companies pay their private-equity owners each year for advisory services, also went up.

Deal fees essentially enable buy-out firms to get paid twice to do their job—first by investors and then by their portfolio companies. They even charge fees when they exit investments. When Nielsen, a market-research firm, went public earlier this year it had to pay around $101m to its seven private-equity owners to end their "advisory" agreements. Absurdly, some private-equity firms even charge portfolio companies fees for helping them refinance their debt—when they're the ones to pile on leverage in the first place.

I'm not saying that the private equity guys in any of these deals did anything wrong. If they own the companies, they can do what they want to them, including charge them fees, or borrow money for the purpose of paying themselves fees. The lenders and the IPO or other buyers next down the line are all grownups. But taking a hard or careful look at these practices isn't necessarily an attack on capitalism, either. Just because it's illegal for an insolvent company to pay a dividend (or a "fee," which may be subject to different law, which may have something to do with why it's called a fee rather than a dividend) doesn't mean it's never done, and in some cases it's not so clear-cut whether the company is or isn't solvent, or the situation may change over time.

Mr. Macey writes, "Unlike some other investors who trade in debt and derivatives, private-equity firms make money by investing in businesses that make things and provide services. This industry should be applauded, not attacked." Aren't investors in corporate debt also investing in businesses that might make things or provide services?

Some of the recent attacks on Mitt Romney and Bain Capital have surely been driven by politics, by envy, or by a hostility toward or confusion about markets or capitalism or business. But Greg Ip and Henny Sender (and even Bob Lenzner, though his piece used some considerably more inflammatory and broad-brush language) are not Michael Moore, and if Mitt Romney is going to run for president based on his record of success in the private sector, my own view is that the issues raised by the 2006 story by Mr. Ip and Ms. Sender, and by the November 2011 Economist piece, are within bounds.

by Editor  |  Jan 13, 2012 at 1:31 am Related Topics:  Politics receive the latest by email: subscribe to the free futureofcapitalism.com mailing list