The fact that the world’s biggest banks drove themselves off a cliff yet managed to save their hides and even profit from the exercise while leaving ordinary citizens to pick up the tab is ample reason for citizens and the small cohort of non-captured regulators and politicians focused on their continuing misdeeds.
But as a result, an even more powerful set of financial players, namely, private equity firms, is continuing to expand the scope of their activities with little scrutiny and pushback by the press and public interest groups. For instance, when it was much smaller that it was today, and branded first as “raiders” and then “leveraged buyout firms” in the 1980s, the industry was the driver of the now-well established trend towards rewarding CEOs lavishly for cutting headcount and other expenses, relying on financial engineering rather than investing in the business of the business, and fixating on short-term results rather than long-term indicators of corporate health. The raiders initially focused on too-fat-and-happy companies, stripping out bloat and breaking them up to sell the constituent pieces for more than the former whole.
But as more and more capital was deployed into this strategy, stock prices rose to reflect the possibility of a takeover, forcing the takeover artists to engage in more radical makeover when they succeeded in closing a deal. And big companies mimicked these strategies defensively, to make themselves less attractive to these marauders.
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By the 1990s, the executive class realized the raiders had done them a huge favor as the LBO artists had legitimated ideas like paying CEOs like entrepreneurs, heavily in stock (which as we’ve since learned has simply bloated compensation levels and produced an unhealthy fixation on managing investor perceptions and reported results over investing in performing operations and developing new products. As we’ve also chronicled, the “companies exist to maximize shareholder value” is an idea promoted by economists, and not a theory grounded in the legal obligations of management and boards, that became popular around this time and provided intellectual cover from this shift. Thus private equity firms have been the drivers of the continuing trend of “sweating the asset,” which is finance-speak for squeezing workers and suppliers for the benefit of investors and top managers. And that, as Huffington Post points out today, has been a major driver of income inequality.
In other words, to ignore private equity is to ignore the moving forces behind the restructuring of the relationship between capital and labor over the last 35 years. Yes, Reagan breaking the air-traffic controllers’ union and the right wing’s persistent and effective attacks on labor were another critical part of this trend. But LBOs reshaped values and priorities in Corporate America in less than a decade, an astonishingly short period of time.
And the industry only grows in power. As of mid 2012, it had over $3 trillion globally in assets under management. With leverage, this translates into over $6 trillion of buying power. By way of comparison, the total capitalization of the US stock market at that time was roughly $21 trillion.
And the cincher? Private equity kahunas are the top targets for political fundraising. While they do have top hedgies as competition in terms of the size of their personal balance sheets, PE firms are constantly doing deals, and thus provide a huge fee stream to investment banks and top law firms. Thus politically-oriented private equity players can pull on a large network of well-heeled professionals who would be foolish to turn down their requests for political contributions. The proof? Look at the first members of the board of Obama’s library. Two of the three are in or have strong ties to the private equity industry.
Gillian Tett in the Financial Times gives us an update on how these firms are extending their reach yet have managed to remain almost entirely unsupervised by regulators. US readers are no doubt aware, for instance, of their massive move into the rental of single-family homes and how many reports of abusive practices have surfaced in their short tenure as landlords. Tett writes:
What is really striking is the volume of non-bank financing that is quietly being supplied to western economies with minimal regulatory scrutiny – a trend on which my colleague Henny Sender has reported extensively. The “non-bankers” who provide it now matter as much as the bankers, and they appear to be having more fun. Results released in the past two weeks by asset management groups illustrate the point. Last decade, Goldman Sachs’ return on equity peaked at 40 per cent. Last year it was just 11 per cent. Meanwhile, KKR’s return on equity was 27.4 per cent in 2013 – a margin that the banks can only dream of.
These groups’ recent profits were boosted by sales of companies they acquired several years ago. But today they are branching out beyond turnround activity, partly because there are fewer new deals around, and jumping into areas that were the terrain of banks: credit and property.
The only reason non-banks can turn a profit by extending credit is that banks are no longer supplying credit to risky endeavours, such as small companies
Only a quarter of Apollo’s $160bn-odd business is now focused on private equity. It has recently gobbled up so many corporate loans and bonds that its credit portfolio has exploded to more than $100bn, compared to just $4bn seven years ago. At Blackstone and KKR the switch is less dramatic: according to Bloomberg’s calculations, credit is just a quarter of their portfolios. But they are shifting focus too. Just last week, Blackstone announced plans to start extending mortgage credit as part of its property business.
Now admittedly Apollo has a different profile than other so-called private equity firms. Its founder Leon Black came out of Drexel. The firm has long been a big player in real estate and distressed investing, both of which involve higher levels of leverage than more conventional PE strategies, so it isn’t fully representative of the industry as a whole. KKR and Blackstone are better indicators of where the industry is headed, and even a 25% credit product level is impressive (and not in a good way).
Of course, a $100bn credit book is still smaller than that of JPMorgan. It is bigger than many midsized American banks, however. And the asset managers’ economic footprint is expanding in other ways too. Blackstone’s portfolio companies, for example, now have 600,000 employees and $79bn of revenue…
This may not be entirely desirable. Non-banks are swelling in size because they do not face the same regulatory burdens as banks, allowing them to turn a profit on business that banks now find uneconomic. This worries regulators. The US Office of the Comptroller of the Currency recently warned that the activities of non-banks has fuelled a boom in risky corporate loans – and warned banks not to “skirt rules” by teaming up with non-banks to create more credit.
Tett ends on a cheery note, arguing that the PE firms don’t have the maturity mismatches that banks do by relying on short-term funding like deposits and the interbank market. But the investors in PE funds are overwhelmingly retirement funds, particularly government funds (as in those of public employees). Should we really take cheer that PE funds can dump any mistakes on hapless and locked-in pension funds and walk away scot free? Illiquidity and a lack of aligned incentives are not sound principles (PE firms make money even when their deals crater, as Josh Kosman demonstrates in his book The Buyout of America). And we’ve already seen the the PE model is based on transferring value from ordinary people rather than creating it. It’s hard to see why we should sit by and allow them to expand that model into new markets.