Sprawling corporate deals by private equity companies promise prosperity, but often deliver peril. Meanwhile the sector skirts legal responsibility for its actions. That’s the main takeaway of Brendan Ballou’s bestselling book Plunder: Private Equity’s Plan to Pillage America.
Ballou previously served as special counsel for private equity in the US Justice Department. “It was during my time at the DoJ that I began to unravel the strategies that allow these firms to wield substantial influence over the American economy, often at significant public cost.”
Ballou recently shared his thoughts in an exclusive interview with Investment Officer in Washington D.C.
IO: What example best illustrates your concerns with private equity?
Ballou: “A prime example would be nursing homes, specifically Carlyle’s acquisition of HCR ManorCare. This scenario illustrates a distressing pattern: Carlyle acquired the second-largest nursing home chain in the U.S., loaded it with debt, and reduced staffing levels, which led to a significant increase in health code violations.
“Tragically, when a death occurred at an understaffed facility and the family sued for wrongful death, Carlyle managed to have the lawsuit dismissed by distancing itself from direct ownership; technically, their clients owned the nursing home as they merely advised the funds that owned the chain.
“That story illustrates my criticism of the private equity business model. It shows how private equity firms are often able to exercise control over business, yet private equity firms are unique in their ability to skirt legal responsibility for the actions of their portfolio companies.
“Whatever the merits of that legal structure from an investment perspective, private equity is oftentimes harmful from the perspective of having successful and responsible businesses.”
IO: How common are these kinds of situations?
Ballou: “It’s alarmingly common and represents a core issue with private equity. These firms often control the operations of the businesses, appointing CEOs and board members. Yet, due to how American corporate laws are structured, it’s challenging to hold them accountable.
“Lawsuits against a private equity-owned company and the firm itself are rare because plaintiffs anticipate unsuccessful outcomes. Additionally, ownership by private equity firms is often obscured, leaving many unaware of the true owners, complicating legal accountability further.”
IO: The title of your book implies that the pillaging is premeditated. Is that what you meant to argue?
Ballou: “Let me be very clear about one thing: In my interactions with private equity professionals, I’ve found them to be generally friendly and professional, without malicious intent. However, the current legal and regulatory frameworks incentivize short-term, extractive practices that, while profitable, can be damaging to the businesses they acquire.
“Post-Great Recession, the regulation of traditional banks increased significantly, leading many financial activities to shift towards less-regulated private equity firms. These firms, operating like shadow banks, are largely free from the stringent oversight that governs other financial institutions.
“Whether or not there’s a master plan or plunder, there are strong incentives towards plunder or extraction. Research has shown that in the US, over a 10 year period, non private equity companies had about a 2 percent bankruptcy rate. Private equity owned companies had a 20 percent bankruptcy rate, which suggests that private equity owned companies are about 10 times as likely to default.”
IO: Private equity provides high returns for investors. Most of them have a fiduciary duty to seek the highest possible returns for their clients. Should they stay away from private equity?
Ballou: “Actually, there’s a growing body of research that suggests that when you consider all of the management fees and other fees associated with private equity investments, private equity may not be a better risk adjusted investment than ordinary stocks.
“That’s an unanswered academic question, and we’ll have to see whether PE delivers its promised returns, especially in a higher interest rate environment.”
IO: If they stay invested, are they complicit in the plunder?
Ballou: “Asset managers, particularly those managing pension funds, face a complex dilemma. While private equity might offer high returns, the associated risks and fees may not justify these investments over the long term, especially considering the potential for adverse social impacts like union-busting activities. It’s like a snake biting its own tail.
“Pension funds need to weigh their investment choices carefully, considering both immediate returns and long-term societal effects. The challenge that we’ve got with private equity is that it is not an extreme form of capitalism, but rather a perversion of capitalism.
“This is a business model that if it expands, could really be a drag on our economy as a whole. It’s a transfer of money from productive parts of our economy to less productive parts.”
IO: Couldn’t the same be said for every dollar that moves from the real economy to the financial economy?
Ballou: “There’s always a role for capital in our economy, and private capital plays a crucial part in helping businesses grow and innovate. However, academic research suggests that we have already exceeded the point at which finance as a percentage of our GDP is maximally beneficial to our economic growth.
“What pension funds might want to be considering here is the following: are they willing to invest in a business model that ultimately is going to slow down the growth of the economic process that improves all of our lives?”
IO: What impact do you foresee with the broadening of private equity investments to a broader public, the retail investors?
Ballou: “Expanding private equity to a broader audience increases capital flow into a less-regulated sector. Furthermore, the inherent illiquidity of private equity investments poses significant risks for ordinary investors seeking more flexible financial arrangements, potentially leading to unfavorable financial situations during times of need.
“Some of them might be forced to pull out money at really inopportune times, that’s going to hurt them. And so in that sense, I’m concerned about what the expansion of private equity investments can both do to our economy and to ordinary investors.”