|
Understanding Financial Mania and Systemic Risk
- 'Leveraged Buy Outs', 'Private Equity', 'Hedge Funds'
An interview with Damon Silvers
Courtesy
Multinational Monitor, May/June 2007
Damon Silvers is an associate
general counsel for the AFL-CIO, where he works on corporate
governance, pension and general business law issues. Silvers
led the AFL-CIO legal team that won severance payments for
laid off Enron and WorldCom workers. He is a member of the
Public Company Accounting Oversight Board Standing Advisory
Group, the Financial Accounting Standards Board User
Advisory Council, and the American Academy of Arts and
Sciences Corporate Governance Task Force.
 "...Private equity is a term that was designed to mislead people. The
term encompasses all sorts of investment funds that take controlling
interests in companies that are not public - private companies -
through holding equity in them. And it confuses basically three
kinds of very different investment strategies... A hedge fund is another term that doesn't tell you much
about what it really is. A hedge fund is an informal term for an
investment fund that operates under a Securities and Exchange
Commission (SEC) exemption.If you're running an investment fund,
you typically have to register with the SEC and comply with the
rather extensive set of regulations designed to protect
investors. The exemption is that if you're only taking
investments from sophisticated investors - from large
institutions and wealthy individuals - you have an exemption
from these securities rules..."
Multinational Monitor: What is private equity? Damon Silvers:
Private equity is a term that was designed to mislead people. The
term encompasses all sorts of investment funds that take controlling
interests in companies that are not public - private companies -
through holding equity in them. And it confuses basically three
kinds of very different investment strategies. The first, venture capital, involves investing money in companies
that are in their early stages, with new ideas and technology. The
hope is that the company will ultimately be a big success and
everybody that was involved at the ground floor will get very rich.
That type of investment usually involves no or little debt or
leverage, because people are reluctant to lend money to ventures
pursuing untried ideas.
The second area of private equity is what's called the vulture fund.
Vulture funds invest in companies that are in trouble, often by
buying the debt of companies that are either bankrupt or about to go
bankrupt, and thereby gaining control over them. This is also a type
of investing that, oddly enough, involves relatively little
borrowing.
The third category, which has come to overshadow the other two, is
leveraged buyouts. Leveraged buyouts were a big deal in the late
1980s and early 1990s. They involve buying a company by putting up a
little bit of money as equity and borrowing the rest. When leveraged
buyouts really get going, leveraged buyout investors tend to borrow
at least 80 percent of the purchase price and put up no more than 20
percent as equity. The firms that you read about in the newspapers these days as
"private equity firms" are almost entirely leveraged buyout firms.
Leveraged buyouts got a bad name in the 1980s because they were
associated with enormous job losses, and radical shrinkage and
breakup of companies. Ultimately, they overleveraged, which led to
some of the very big deals of the 1980s either collapsing or being
relatively poor investments for long periods of time.
When this kind of activity got going again in a big way about two
years ago, the deal-making firms decided rather than call it
leveraged buyouts again, they would call it private equity. That
blurred the distinction between what they were doing and, say,
investing in new technology, which most people think is a relatively
good idea.
Multinational Monitor: What is a hedge fund and how does private equity relate to hedge
funds? Silvers:
A hedge fund is another term that doesn't tell you much
about what it really is.
A hedge fund is an informal term for an investment fund that
operates under a Securities and Exchange Commission (SEC) exemption.
If you're running an investment fund, you typically have to register
with the SEC and comply with the rather extensive set of regulations
designed to protect investors. The exemption is that if you're only
taking investments from sophisticated investors - from large
institutions and wealthy individuals - you have an exemption from
these securities rules. In the last 25 years or so, people have used
this exemption to put together investment funds that both buy stock,
called going long in the investment parlance, and take positions
that essentially bet on the stock or the bond or the other
instrument going down, which is called shorting. If you mix short
and long positions, that can potentially be a way of restricting the
risk in your long position. Here's how this might work: An auto company benefits from low
interest rates; more people buy cars when they can borrow with less
expense. You buy the stock of an auto company and then you short
debt instruments which also do well when interest rates are low.
Then, if interest rates rise, your exposure to losses in your auto
stock is hedged by your short position in the credit instrument.
These unregistered investment funds pursued this type of strategy,
so they became known as hedge funds - they were involved in
investment strategies that hedged risk. But the truth is that a
hedge fund can do pretty much anything. It can invest in any type of
security and it can invest in any type of strategy. It can make
private equity investments. As somebody once said, a hedge fund is
really a legal category in search of an asset class. Hedge funds and private equity have a couple of things in common.
Hedge funds, like private equity funds, or leveraged buyout funds,
tend to borrow money - they tend to leverage their investments. That
is, they have a pool of money that people have given them to invest,
and they go to a bank, or some other lender, and borrow money to
invest in more assets than they could have had they just taken the
money they had been given by their investors. If the investments do
well and return more than interest costs, then the fund can increase
the rate of return for its investor. So both hedge funds and
leveraged buyout funds, or private equity funds, live off of cheap
debt. But this type of strategy is quite risky, because if your
investments fail, your fund goes bankrupt much more quickly than if
it wasn't leveraged.
The second thing they have in common is that they're both opaque.
Both hedge funds and private equity funds, in general, tell the
government regulators and the investing public relatively little
about what assets they have, which strategies they're pursuing and
what they're doing with the money that they invest.
These two characteristics - the fact that they rely on leverage and
that they're opaque - have led many academics, regulators and
investor advocates to be concerned about the impact of these two
categories of investment vehicles on our market system as a whole.
Multinational Monitor: To the extent these funds are opaque, do the big institutional
investors have more insight than either an average person, or even
an average rich person? Silvers:
Very, very large investment funds tend to know more about
the hedge funds and private equity funds that they invest in than
the average person or the average small institution.
As for rich people, there are rich people and rich people. If you're
a mere millionaire, if you're investing $5 million or $10 million,
you don't know anything anyone else doesn't know. On the other hand,
if you're Bill Gates, or basically if you have hundreds of millions
of dollars to invest personally, then you can play in this league.
If you have very smart people working for you or you're personally
attentive, you can have access to information that other people
don't have.
Because of the networks of wealthy individuals involved in this type
of investing, I think some of those people may actually know more
than the institutions. But it depends on the institution and it
depends on the rich person.
There are certainly institutions that specialize in this area that
are extremely well informed. The most obvious ones and the most
prominent ones have been university endowments: Harvard, Yale and
the University of Texas, which have invested very large portions of
their assets in both hedge funds and private equity funds, have done
very well and are very embedded in information networks around those
funds.
Multinational Monitor: Can you elaborate on how hedge and leveraged buyout funds pose
systematic risks? Silvers:
First, let's talk about dollars. No one really knows
because these markets and this landscape changes very quickly, but
there's probably between $1 trillion and $2 trillion today invested
in hedge funds globally, and probably close to a trillion dollars in
various kinds of leveraged buyout firms. Again, who knows what's
happened since the recent market turmoil, but that's the basic
landscape. These funds have borrowed a lot of money on top of that.
And again, no one really knows exactly how much. But a good estimate
is the leveraged ratio across this whole asset category is at least
50 percent, so you're talking about potentially $4 trillion or $5
trillion invested, controlled and in the marketplace through these
funds. That's enough money to move markets. And it is enough
borrowing to potentially affect the stability of the global banking
system.
On top of that, hedge funds - this is not so much the case with
private equity funds - can do anything they want, literally
anything, unless they've signed a contract with their investors
limiting their investment behavior, which most don't. Other types of
money management, like an insurance company or a mutual fund, must
tell their customers what their investment strategy is and have a
legal obligation to stick with it; mutual funds also have legal
obligations to maintain relatively diversified portfolios. The
implications of that for systemic risk are profound. On a given day,
a hedge fund could make a very large leveraged bet any place it
wishes. It could take a very large leveraged short position in the
currency of any given country; it could take a very large long
position on the stock of any given company, or the bonds of any
given company, or a particular mortgage-backed security. I don't
suggest that any particular hedge fund is doing this, but nothing is
stopping one from doing so if they want to. This ability to
concentrate and leverage risk, and to do so with relatively little
disclosure and to shift what they are doing very rapidly, makes
these funds particularly capable of causing systemic risk. In what manner am I talking about? If a hedge fund borrows money to
take a large position in a security and then that security or that
pool of securities collapses, or it turned out to be worth a lot
less than the hedge fund thought it would be worth, what happens?
First, the investors in that hedge fund can lose their money very
fast. Then the institutions that lent money to that hedge fund will
find themselves out of luck. If the borrowings are large enough, the
financial stability of the lenders could be implicated. If that
begins, then it's not just that lender and those transactions at
stake. A general doubt could be triggered in the marketplace about
the creditworthiness of hedge funds and the enterprises that lend to
hedge funds.
We have seen something like that go on in the last few months in a
series of cascading credit markets. It turned out that mortgage
pools that were represented to be credit worthy were not credit
worthy. There were defaults in the underlying assets (people could
not pay off their mortgages). Then the people who'd invested in
those funds, and borrowed money to do so, lost a lot of money and in
some cases went under. Then a broader doubt began to grow in the
credit markets about the credit worthiness of other funds that had
similar structures and similar credit ratings. All of a sudden one
day in August, no one was willing to purchase certain types of
asset-backed commercial paper - in markets that a month earlier had
been considered close to completely risk-free.
Credit markets have dried up and businesses have failed over the
last couple of months because of this systemic cascade of doubts
about the credit worthiness of whole sets of market participants,
and then because of actual failures like with the Bear Stearns
funds. And I suspect that we will see more of this in the next
couple of months. How much more, I don't think anybody knows.
Multinational Monitor: What's the incentive for the private equity firms to put the
deals together? Silvers:
To get very rich, astoundingly rich!
It's inherently the case that if you borrow money to buy an asset
and the asset performs well then you'll make a lot more money than
if you pay 100 percent cash - 100 percent equity - for that asset.
Think about a home. Suppose you buy a house for $100,000, put
$20,000 down, and in the course of time the value of the house
doubles. You've made $100,000 profit on your $20,000 investment.
That's a five-fold rate of return. If you buy with cash, you put
$100,000 down, you double it, you've made a two-fold rate of return.
The difference is big.
That principle is what drives leveraged buyouts. If you buy
companies by borrowing money, you can make a lot of money. But
you're taking a risk. The risk is if instead of going up, the value
of your company goes down, or your company starts to lose money,
very quickly the equity in the company will be exhausted and the
company will be bankrupt. If the company was financed largely with
equity, it will have a greater ability to absorb economic downturns. The labor movement obviously is very concerned about what happens
when large pieces of our economy are financed through leverage.
Companies become more vulnerable to economic instability, and so are
workers. And so we have a problem with the widespread use of this
type of leverage in buying and selling real companies that do real
things and employ real people.
This inherent nature of leverage, of debt, is bolstered and
multiplied with all of the tax subsidies that go to private equity
firms.
Payments on corporate debt are tax deductible, whereas payments to
equity are not. This means that, once you take the tax effect into
account, any given company can support much more debt than it can
equity.
A second tax subsidy that has been widely publicized is the carried
interest rule. The private equity guys have structured their
companies in the form of limited partnerships, and have persuaded
the IRS against the obvious evidence that the money the private
equity firms make as management fees should be treated as though
they weren't management fees but actual returns on investments. That
allows them to pay taxes at a capital gains rate on their income
rather than paying income tax rates like the rest of us pay.
The punch line is that the people that run private equity firms,
leveraged buyout firms - who are many of the wealthiest people in
the world - are paying income tax rates on much of their personal
income that is in some cases half the rate paid by most
middle-income people in the United States. That is obviously
something that the labor movement is viscerally opposed to.
Increasingly, on a bipartisan basis, a lot of people in Congress
also think this is just outrageous and ought to be stopped.
Multinational Monitor: How would a leveraged buyout firm put a deal together? What are
the steps? Silvers:
First, you have to have some money to invest. If you're a
private equity manager, you go around to wealthy individuals and
pension funds and university endowments and foundations and you
collect money. Then you have a pool of money, which is structured as
a partnership. You're the general partner and the investors are all
limited partners.
Then you look for a company which is undervalued versus what your
analysts think it's really worth. Let's assume it's a public
company. You put a bid together for that company. You go to banks
and get a commitment letter from those banks. The commitment letter
says that if for some reason this company is unable to raise money
by selling bonds, then the banks will lend this company the money to
cover the purchase price.
With the commitment letter from the banks, you go to the management
of the company and say, "We'd like to buy your company. We'd like
you and your board to vote to sell the company to us, and we will
pay some premium over what the stock is trading at today. And by the
way, we will offer you guys - the management of the company - the
opportunity to work for us going forward, in the company after we
control it. And we will give you large stakes in the equity in this
company, much larger than you have today in your role as managers in
a public company." The idea is to incentivize management to
recommend to the shareholders that the company be sold at the price
the leveraged buyout firm would like to buy it at. The subtext may
be that the firm would prefer that management sell at a price lower
than what the company might really be worth.
Assuming this approach to the company works and the shareholders
vote the transaction through, then immediately the private equity
firm goes to the bond market and borrows the rest of the purchase
price. But the private equity firm is not the borrower, the company
it has just bought is the borrower. So for every dollar's worth of
shares that the private equity fund buys to take control of the
company, the private equity firm pays maybe 20 cents and borrows 80
cents. Now they own the company.
When they own the company, the private equity firm looks for ways to
make money off the company. What they'll typically do is look for
ways to cut costs. Increasingly, they will also look for ways to
very quickly pay out dividends to themselves as the equity holders.
And sometimes this will involve actually borrowing more money on the
company's credit to pay out to themselves - this is called a
leveraged recapitalization. And it's resulted in companies being
leveraged up over 90 percent.
Then the private equity firm will hold the company until it is
economically advantageous to sell it back into the public markets.
They cut costs, dress up the company to be as attractive as possible
to the public markets and sell it back, aiming for a price
significantly higher than the one they paid. Then they pay off the
loans and pocket the difference for the private equity fund. Private
equity funds say that their timeline for selling back into the
marketplace is three to five years. During this boom period that's
occurred over the last couple of years, in some cases that flipping
period has been less than a year, particularly for some
European-based deals.
This is a cycle. You borrow money, you buy companies out of the
public market, you tinker around with them, and then you sell them
back into the public market. The fact that it is a cycle goes to
show that leveraged buyout (LBO) firms are not a substitute for the
public ownership of large corporations. They are a phenomenon that
lives off of the public markets. They take companies in and out.
They depend for their success on their ability to sell back into the
public markets.
On occasion, you'll hear academics and some in the media talk about
leveraged buyouts or private equity as the new form of corporate
governance. It's nothing of the kind.
It's exactly what was done in the late 1980s. It's not going to
replace the public markets, it's simply going to live off of them as
long as the credit market conditions are advantageous to this type
of business.
By the way, the credit market conditions flipped against them this
summer, and I think we're going to see a lot less private equity
leveraged buyout activity in the next year or two as a result.
Multinational Monitor: What does it mean when you say that the leveraged buyout firms
are trying to find ways to cut costs? Why do they have any better
ideas to cut costs than the company did when it was publicly traded? Silvers:
They'll say that it's because they're smarter, that they
know how to do better with their businesses than the managers who
managed the business before. It may be true that some of these firms
are run by very smart people, but there really isn't much evidence
that, as a group, the people who run leveraged buyout firms know how
to run any particular line of business better than anybody else.
In fact, there's a lot of evidence, built over decades, that
financial management of business enterprises without any sort of
industry-specific talent, is poorer at running businesses than
people who really know the business. Some academics have compared
private equity firms in this sense to conglomerates, which were all
the rage in the 1970s, but did not perform well. A leveraged buyout
firm is just another organization that owns a bunch of unrelated
businesses - why should they be any better at it than the
conglomerates were?
What LBO firms do have - and this is part of the reason why LBOs got
a bad name - is a relatively short-term time horizon, and they're
sophisticated about the capital markets that they operate in. They
tend to be more willing to undertake short-term-oriented business
decisions, because they're not going to have any interest in that
business after their flip date.
This has led a lot of people in the labor movement to view private
equity firms, as a whole, as being relatively more willing to cut
companies' cost structures - meaning their employees, their capital
investment - to levels that will in the long run make the business
not sustainable, in the interest of making the company appear to be
more profitable than it really is on the flip date. To the extent
that the markets can be fooled by this type of activity, it's
certainly in private equity firms' interest to do it.
There are some people who believe capital markets can't be fooled
and they sort of take it as an article of faith that therefore
nobody tries this kind of strategy. My own view is that after Enron
and WorldCom, you just can't really credibly say that capital
markets can't be fooled. There's just tons of evidence that they can
be fooled and are fooled every day. And the private equity firms
have an incentive to fool capital markets by dressing up their
companies to look like they're healthy and capable of generating
very high rates of return over a long period of time, when in fact
what's happened is that they've been gutted. The LBOs have
under-invested in both human capital and physical capital, and cut
their employee levels to the point where they can't actually produce
value.
Multinational Monitor: Why do creditors go along with a 90 percent leveraged business
model? Silvers:
I think they're more or less not going along with it now,
but they go along with it during periods of leverage-mania because
it's profitable. When credit is cheap, they can put money into these
deals, get a lot of fees out of them and gain the interest payments. For banks, I think it has a lot to do with the way people are
compensated, and so forth. Bond lenders do what they do because they
are relying more or less on credit ratings. There's not enough data
yet to really be sure what has happened during this mania, but in
the housing market we know that credit rating agencies have been
willing to rate pools of mortgages that were clearly risky as though
they were not risky.
There is a larger issue overhanging all of it, which is that there's
been an enormous glut in fixed-income financing in the last few
years. This has produced what a number of central banks and
international economic authorities have described as a compression
of risk spread. And this is really, in our view, the source of the
private equity, and to a great extent, the hedge fund boom.
It's been possible to borrow money to do things that are quite
risky, like leveraging a company 90 percent, without having to pay
very much to do it.
In theory, if you're going to borrow to do something really risky,
you'll have to pay a very high interest rate because there's a
significant risk that you'll go under and won't be able to pay off
your debts. The kind of people who lend to risky enterprises make
multiple risky loans with high interest rates, knowing that some
will go under and the high interest rates will pay for those which
go under.
The last few years, it's been possible to borrow money for very
risky enterprises with a very low spread to non-risky borrowing, say
a treasury bill. That compressed risk spread has fed this boom.
Where does the compressed risk spread come from? It came from a glut
of dollar-denominated debt investing. And there's two sources of
that. One source is that the Fed has been pumping dollar-denominated
money into our economy since 2001 in an effort to end and hold off
recession. The other source of it is the U.S. trade deficit, which
has produced an enormous pile of dollars in the hands of our trading
partners, in particular China and Japan. In China, which is the
holder of the bigger pile of dollars, the government has concluded
that they wish to reinvest those dollars almost entirely in fixed
income, in debt securities. So there's a trillion dollars in Chinese
sovereign holdings in U.S. dollars being put to work in the debt
markets worldwide. That has fed the private equity boom, the hedge
fund boom and the real estate boom.
Now suddenly, in recent months, this whole process has come to a
screeching halt as a whole chain of lenders, starting in the housing
area, have discovered that they weren't getting adequate
compensation for their risk, and that there's a lot more risk in
these debt markets than they thought.
Multinational Monitor: What has been the scale of private equity in the United States
and globally? Silvers:
There's more than a trillion dollars involved in this type
of investing. It's a global phenomenon. It is significant in the
United States, but much more so in Europe. One academic source has
estimated that 25 percent of the British workforce in the private
sector today works for a company that is owned by a leveraged buyout
firm. That's an extraordinary number, a little hard to believe.
There are similarly high numbers in other European economies. In the
United States, the number is nowhere near that. Our economy is much
bigger and the scale of leveraged private investing in the United
States in relation to our economy is nowhere near where it is in
some of these European countries.
But there is no questions that, as a whole, in the last three or
four years, leveraged private investing has gone from a relatively
minor feature of the world's economy to a very significant one,
particularly in Europe. It's no coincidence that Europe is where the
political war over the behavior of the leveraged buyout firms is at
its most intense. The collapse of the risky credit markets in the
last few months may, at least temporarily, put a stop to this
particular mania, but we just don't know. And there isn't much
information today to be sure what exactly the ultimate consequences
of the mania are likely to be.
Multinational Monitor: Should governments impose measures that would make it more
difficult to do these deals? Silvers:
The public policy issues surrounding this are completely
dominated by the political and economic power of the actors in this
game.
In private, as far as I know, there isn't a single economist that
will tell you that the tax subsidy to corporate debt, which private
equity funds live off of, has any basis. I'm not just talking about
left-wing economists; any economist will tell you that the tax
system ought not to favor debt versus equity in the financing of
companies.
A responsible public policy approach would be to ask, do we want to
subsidize debt over equity, and to what levels? Is it really in the
public's interest to maintain a tax system that encourages operating
companies to leverage up to 80 and 90 percent when we know that's
almost certain to lead to companies getting into financial distress
much more quickly and companies being much less able to be
productive and operate through economic downturns?
Similarly, there's just no basis to subsidize the personal incomes
of private equity managers by having them pay capital gains tax on
their income. It's just indefensible.
To the extent that these types of tax subsidies continue, we have a
policy regime that a) subsidizes the income of the wealthiest people
in our society at the expense of the rest of us, and b) encourages
boom-and-bust cycles in private equity, which are almost certainly
not good for the productive capacity of the United States' economy
or of the world's economy.
Those issues should be taken up, and I think are being taken up by
Congress to some degree right now, in an environment where there is
less and less sympathy for straightforward subsidies for the most
wealthy Americans.
I think we are less likely to get measures that deal with the
systemic risk issues involved in both private equity funds and hedge
funds, despite the fact that there's a crying need for that. A
variety of people both in and out of government have been trying to
get that type of regulation in place for some years now. The SEC
took a minor step in that direction a couple years ago and had it
knocked down by the federal courts. But if there isn't some
responsible action, it's likely that something very unpleasant will
happen, and then the issue will be taken up in an atmosphere of
panic.
Multinational Monitor: What are the kinds of policies that might deal with these
systemic threats? Silvers:
The most important one is transparency, both to the
regulators and to the investing public. The hedge funds need to tell
regulators and the people who invest in them what assets they hold
and what strategies they're pursuing. Bank regulators need to know
with a great deal more detail where banks are lending, and how
banks, derivatives markets and hedge funds are interacting with each
other. It would be very helpful to stop the nonsense of having the
Commodities Futures Trading Commission regulate the derivatives
markets, when there are derivatives that are all linked in with
securities.
That's an area where we're just asking for trouble by having that
kind of regulatory incoherence. That combination of things,
transparency and a unified and coherent oversight system on the part
of the regulators, are the two things that most need to be done.
Multinational Monitor: How have the private equity and hedge fund firms responded on
Capitol Hill to efforts to enact some of the controls you're talking
about? Silvers:
As it has dawned on them that people have figured out that
they are taking advantage of outrageous tax subsidies, both the
private equity funds and the hedge funds have in the last few months
thrown a lot of money at Washington. They are seeking to block
changes to the tax rules, including legislation that's been proposed
in the Senate by Charles Grassley, R-Iowa, and Max Baucus,
D-Montana, and in the House by Sander Levin, D-Michigan, and Charles
Rangel, D-New York. Those proposals would, in different ways, put an
end to some of the tax subsidies.
The House bill would put an end to the capital gains treatment of
carried interest income. It's been interesting to watch various
lobbying firms, law firms and PR firms fight over who gets what cut
of all the money that's been thrown at Washington by the private
equity and hedge fund industries.
They have made a series of arguments, which really have no merit,
about how if they have to pay taxes somehow this will hurt the
pension funds that invest in their funds, and if they have to pay
taxes suddenly nobody will take any more risks either in capital
markets or in American business. There's a long list of utterly
baseless arguments they make.
But if you have enough money, you can get people to take utterly
baseless arguments seriously in Washington.
However, we're in an environment right now where I think
increasingly in Congress there's less sympathy for tax subsidies for
the very wealthy, and that's true on a bipartisan basis. I think
that they're going to have a hard time winning this argument. At the
end of the day, they're probably going to lose, at least on the tax
issues. On the transparency issues, I'm not so sure. I worry that
these systemic risk issues have not been adequately addressed and
may not be adequately addressed.
|
