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Private Equity Firms Gone Wild

by EILEEN APPELBAUM

The $166 million settlement reached in October by creditors against private equity companies Cerberus Capital, Sun Capital Partners, and Lubert-Adler/Klaff was among the largest against private equity firms accused of stripping assets from a company they owned and driving it into bankruptcy. The complaint against the private equity owners of Mervyn’s, a major mid-tier department store chain with 30,000 employees and 257 stores when it was carved out of retailer Target in 2004, alleged that illegal actions by the private equity owners undermined Mervyn’s viability as a going business. The private equity firms were accused of engaging in a fraudulent transaction when they split off Mervyn’s valuable real estate assets and later sold them without compensating Mervyn’s for the loss of its property.  The private equity owners were also accused of breaching their fiduciary duties to Mervyn’s and its creditors by requiring Mervyn’s to pay them a dividend at a time when the department store chain was essentially insolvent.  All of this despite the fact that it is illegal for owners to strip a company they own of assets and resources and drive it into bankruptcy.

The private equity owners did not admit guilt when they settled with Mervyn’s creditors, but the size of the settlement suggests that justice was served, at least for Levi Strauss and the other vendors. But the legal remedies in cases like this come too late, if they come at all, for the workers and communities that depend on the private equity-owned companies to create jobs, provide an anchor for other businesses, and support local programs that cement the retailer’s relationship with its customers. The remedies come long after the company has been driven into bankruptcy, and even, as in the Mervyn’s case, liquidated.

Mervyn’s is not an isolated case. Private equity firms that acquire companies with valuable real estate assets—in retail, restaurants, nursing homes, golf courses—often split the company into a ‘prop-co’ that owns the company’s valuable property assets and an ‘op-co’ that operates the business and is required to lease those assets back at high rents. Requiring companies acquired for a private equity firm’s portfolio to make dividend payments to their private equity owners is another widely used practice that transfers resources from the company to private equity investors. In the leveraged buyout of the company, private equity owners typically put up very little equity and dividend payments will defray—or even repay—this equity investment, leaving the private equity owners largely disinterested in the subsequent success of the business they own.

The law provides vendors, creditors, and similar actors who have been wronged through asset stripping or dividend payments with legal recourse after the fact to recover what is owed them. But this is little comfort to those who depended for their livelihoods on the now-bankrupt company. How much better if the legal system could proactively deter owners from stripping companies of valuable assets or helping themselves to cash that the company needs to remain viable?

Here are two policy changes that could alter the incentives facing private equity firms and do just that.

A legal requirement that private equity firms enter into a ‘prenuptial’ agreement with companies they acquire could deter the type of asset stripping common in takeovers of retail and other asset-rich businesses. If a portfolio company could not meet the new obligations imposed on it by the transfer of its assets and remain a viable business for a prescribed number of years—say five to 10 years after the transfer occurred, those assets would be fully pulled back into the bankruptcy estate to pay creditors and provide some financial relief for workers whose jobs were destroyed. No long years of litigation, no slap on the wrist settlements. Even the large Mervyn’s settlement amounted to less than half the $400 million that the company’s private equity owners reportedly earned.

Restrictions on dividends that private equity firms can collect during the first two years of ownership from companies they control will assure that the companies have the resources they need to improve performance and flourish. Aggressive actions by private equity owners to increase their returns by having a portfolio company borrow to pay them large dividends can drain liquidity from the company and increase its risk of default. These dividend payments are frequently financed by further debt loaded onto portfolio companies, often in the form of high yield junk bonds. Prohibiting all debt-financed dividends in the first two years and only allowing distributions from portfolio company profits during that time period provided the company’s net assets remain at or above the level of the initial equity payment after the distribution can address this issue.

Placing limits on the aggressive actions of private equity firms that enrich themselves and their investors by transferring wealth and resources from portfolio companies they control will only enhance the ability of these companies to improve efficiency and operational performance. And this, after all, is the rationale the private equity industry gives for its leveraged buyouts of operating companies.

Eileen Appelbaum is a senior economist at the Center for Economic and Policy Research.

This article originally appeared on Economic Intelligence.

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