Abstract
Private equity (PE) firms are a key actor in the increasing financialization of the economy since the 1980s and have had profound effects on the nature and consequences of work. Private Equity at Work by Eileen Appelbaum and Rosemary Batt provides a timely and comprehensive overview of what PE is, how it makes money, and how it affects the companies and employees it acquires. The book also evaluates PE’s role in the American economy and outlines a variety of strategies that are needed to address its negative consequences. The authors conclude that while PE benefits its investors, it often does so at the expense of the acquired companies and their workers as they eliminate and degrade jobs.
Since the 1980s, financial considerations have become increasingly dominant in decisions about how to manage and structure organizations, with profound effects on the nature and consequences of work. The rise of financial capitalism, or “financialization,” refers to “a pattern of accumulation in which profit-making occurs increasingly through financial channels rather than through trade and commodity production” (Krippner, 2005, p. 181; also see Arrighi, 1994; Krippner, 2011). This term has been used to denote both the increasing centrality of the financial sector in the economy as well as the greater emphasis put on financial considerations in decisions regarding how to operate nonfinancial organizations (Epstein, 2005).
The growing prominence of financialization reflects a changing conception of the firm from an organization committed to specific product markets and to producing particular goods and services (managerial capitalism) to a tradable bundle of assets (finance capitalism) (Fligstein, 1990). Accompanying this change was the replacement of the stakeholder model of corporate governance (which emphasized the welfare of managers, employees, suppliers, customers, creditors, and the broader community) with the shareholder model of corporate governance that gave primacy to the interests of investors and shareholders. Financial capitalism put pressure on corporate managers to increase profit margins and judged them by their ability to produce financial returns for shareholders. This transition to shareholder value was bolstered ideologically by the popularity of the agency theory of the firm, which held that the directors and corporate managers were the agents of the shareholders (the principals) and their main role was to maximize shareholders’ profits (Jensen & Meckling, 1976).
The financialization of the economy was facilitated by various institutional changes, including the deregulation of financial markets beginning in the 1970s and changes in tax laws that encouraged financial engineering. The changes in the role of capital markets in corporate governance parallel the expansion of market forces in labor and product markets, fueled by the triumph of the neoliberal policy model and the associated decline in the power of labor as a countervailing force (Harvey, 2005). The success of financialization permitted those in the financial sector to extract rents and to shift income from labor to capital, and it resulted in an increase in inequality between this sector and the rest of the economy (Tomaskovic-Devey & Lin, 2011; see also Lin & Tomaskovic-Devey, 2013). It also helped to create a large number of precarious, uncertain, and low-wage jobs in the United States since the 1970s (Kalleberg, 2011).
A key aspect of the financialization of the American economy was the emergence of private equity (PE) firms in the 2000s. These represented a rebranding of the leveraged buyout (LBO) firms active in the 1970s and 1980s, which were a key part of the shareholder value revolution and became popular during the 1980s because they were widely considered a solution to corporate wastefulness and mismanagement and to growing pressures on American firms to increase profits and become more price competitive. Like LBO firms, PE firms are financial intermediaries that raise money from investors and make relatively risky investments in order to generate higher than average returns. They buy out and acquire companies using leverage (i.e., borrowed money), actively manage them, and then attempt to sell them at a profit within a relatively short time period (usually less than 10 years). Because PE firms actively manage the acquiring companies and are the employers of these companies’ employees (despite U.S. law viewing them as investors rather than employers), PE firms have had a major impact on work and employment relations in the United States; since 2000, PE firms have purchased nearly 11,500 companies, representing almost 8 million employees (Appelbaum & Batt, 2014).
PE firms have long been at the center of public debates about the influence of the financial sector on the U.S. economy, and the debate about the nature and consequences of the PE model has been sharply polarized. Supporters argue that PE firms are financial innovators that provide the financial discipline and operational expertise necessary to turn around failing companies and promote job growth. Detractors (especially labor unions and community advocates) maintain that they are financial predators that bankrupt otherwise healthy companies by emphasizing short-run profits at the expense of long-term growth, by burdening them with excessive debt, and by destroying jobs through cost cutting and outsourcing. This view holds that PE firms have played a large role in producing stagnant wages, the loss of health and pension benefits, and increased economic inequality.
Private Equity at Work provides a timely and comprehensive overview of what PE is, how it makes money, and how it affects the companies and employees it acquires. The book also outlines a variety of strategies to address its negative consequences. Prior research on PE firms has focused relatively narrowly on their financial performance and whether they are good for their investors. This book also addresses this issue but additionally examines how PE firms affect the companies and employees that they acquire and their many stakeholders. Appelbaum and Batt use a combination of quantitative and qualitative data—including original case studies and interviews, legal documents, bankruptcy proceedings, media coverage, and existing academic scholarship—to evaluate the evidence on the use of the PE model, and they underscore both its benefits and costs for American businesses and workers.
Researchers, policymakers, and practitioners engaged in the study of employment relations need to be aware of this important development in financial markets and its direct impacts on work and workers. This essay addresses these issues, using this important book as a point of departure for understanding better the impacts of PE management on the changing nature of work and employment relations in modern capitalist economies. I will focus on the United States, though the PE model has been applied in other countries as well (see, e.g., Appelbaum, Batt, & Clark, 2012).
The PE Business Model
The PE business model is designed to extract maximum value from the companies that the PE firm buys and sells, using often risky financial strategies that involve loading high levels of debt on the acquired companies to reduce the PE firms’ tax liabilities and to cut wage and other labor costs. The PE firm’s general partners (the GPs) alone make decisions about which operating companies the PE investment fund will acquire (the portfolio companies) and how these acquired companies will be managed. PE firms differ from public corporations in several ways: They generally provide higher returns to the limited partners (the LPs, who are the investors in the PE fund, such as pension funds or wealthy individuals); they use greater amounts of debt and financial engineering strategies to obtain higher returns; they are actively involved in the operational business decisions of portfolio companies; and they are not traded publicly on stock exchanges, so they are not held accountable for their actions in ways that public corporations are, and their activities are less transparent because many of the Securities and Exchange Commission’s regulations do not apply to them.
Unlike publicly traded companies, PE firms are also able to undertake more risky investments in their pursuit of shareholder value because any debts or costs of bankruptcy incurred are the responsibility of the portfolio companies and their workers, not the PE firms that own and govern them. This introduces a problem of moral hazard, whereby the GPs are incentivized to engage in risky behavior because someone else bears the burden of those risks: The GPs lose only a small amount if the investment fails but reap huge gains if it is successful. The “2 and 20” model illustrates this disproportionate risk and return relationship: The GPs invest $1 or $2 in the fund for every $100 invested by the LP investors but claim 20% of any profits; the GPs also get 2% of the value of the fund per year as a management fee or 20% over 10 years, regardless of how well or poorly the fund performs.
The PE industry is cyclical and market conditions affect the ability of PE firms to execute this business model. There was a high level of bankruptcy in PE firms during the period after the Great Recession, for example, which increased their difficulty in obtaining credit in financial markets and in recruiting LP investors. This led them to branch out into alternative investments (adding hedge funds for example) and to diversify geographically (e.g., to emerging markets in Brazil, China, and India). In addition, PE firms are not as able to rely on leverage-based financial strategies in middle market companies (those with a value between $25 M and $1B) and so here PE firms rely more on implementing smart business strategies and providing expertise in logistics, marketing, and work organization. Achieving outsized returns in middle market companies is trickier for PE firms, as it requires specialized industry expertise rather than the application of standard financial engineering strategies, and the results are often bad, especially for the portfolio companies and their employees.
How well do PE funds perform for their investors? This is a difficult question to answer, as there is a paucity of reliable publicly available data due in part to the lack of transparency associated with the PE industry. The indicator of performance most commonly used by PE firms (especially when courting potential investors), the internal rate of return, is deeply flawed because returns to investments in PE funds tend to be highly volatile. This indicator is also susceptible to being manipulated by the GPs. Using more academically accepted measures that compare PE funds’ performance relative to that of other types of assets, Appelbaum and Batt conclude that only the top 10% to 25% of PE firms outperform the stock market by a reasonable margin. These top-performing funds are generally only available to the largest and earliest investors (such as CalPERS), however, and the return is probably not enough to justify the additional risk for most pension funds. This is especially problematic for pension funds given their high standards of fiduciary responsibility to their beneficiaries; their dilemma is made more difficult (especially in economic downturns) because the GPs completely control the investment decisions, for which the limited partners are legally responsible.
PE’s Impacts on Work and Employment
PE firms are not alone in using financial engineering to create shareholder value; financialization strategies are also used by large public corporations. Both types of firms utilize cost-cutting strategies and financial engineering such as stock buybacks to increase their stock prices. Nevertheless, PE firms are likely to have especially great impacts on work and employment relations associated with PE firms’ acquired companies (see Batt & Appelbaum, 2013). The concentration of ownership in PE firms means that the GPs are more likely to determine the operational strategies of the acquired companies. The intense cost pressures associated with the drive to generate higher than average returns are thus more likely to lead to cost-cutting strategies such as downsizing that leads to job loss and subcontracting, outsourcing, and offshoring, all of which tend to be associated with jobs that are more precarious and pay lower wages and provide fewer benefits. (This kind of “fissuring” is similar to the franchise model in which primary firms maintain control over operations while shifting responsibility for labor and employment relations to franchisees, who often pay less and have worse fringe benefits; Weil, 2014.) Appelbaum and Batt’s qualitative evidence based on specific cases shows that employees of PE-owned companies experienced losses in jobs or wages and benefits, as the PE firms sought to meet their investment targets and service their debt loads through cost-cutting strategies and work intensification.
Moreover, PE-owned companies tend to have a higher risk of financial distress and bankruptcy, both because of their use of higher debt levels and because they are more likely to act opportunistically to increase shareholder value by reneging on implicit contracts and institutional norms of reciprocity and trust. Appelbaum, Batt, and Clark (2012) illustrate the latter by four cases in different industrial, occupational, and national contexts: Mervyn’s department store chain went bankrupt largely due to its breach of trust with vendors after it was bought by a consortium of PE firms; the UK-based PE-fund Hands failed to turn around the music company EMI largely because it broke trust with the established artists on whom the company depended for developing an on-going pipeline of new music; the takeover of rent-controlled apartment complexes in Stuyvesant Town/Peter Cooper Village in New York City by PE firms failed because it violated the trust between landlords and tenants; and the takeover of the chocolate company Cadbury in the United Kingdom by a PE firm breached its 150-year commitment to the community of Bourneville and laid off large numbers of people. These cases show vividly that PE shareholder returns do not necessarily result from value creation but are due to the PE firm reneging on implicit contracts that benefit shareholders at the expense of workers and long-term investments.
Reliable quantitative statistics on the jobs created or destroyed by PE are also scarce, though Appelbaum and Batt report on a small number of rigorous quantitative studies that indicate that PE-owned companies have had lower net employment growth after buying out the acquired companies than comparable publicly traded companies, even though the acquired companies had higher employment growth prior to the acquisition. For manufacturing firms (for which productivity data were available), PE-owned companies had generally higher productivity than comparable publicly traded companies, but the reasons for this are unclear and could come from downsizing or work intensification as well as greater investments in technology (either prior to or after acquisition).
The impacts of PE firms on labor management relations and collective bargaining is more equivocal, and Appelbaum and Batt present examples of both constructive and destructive relations between PE firms and unions. But even in cases where PE firms cooperate with unions to rescue failing companies, PE investors benefitted at the expense of workers. For example, while the investment banker Wilbur Ross worked with the United Steelworkers in the early 2000s to restore several steel mills to profitability, his profit of $4.5 billion in less than 2 years was about 14 times his investment and equaled what the retirees lost in their health and pension plans. Hence, “no matter what the attitudes of private equity toward labor, employees experienced losses in jobs and/or wages and benefits” (Appelbaum & Batt, 2014, p. 233).
Conclusions
The rise of financialization reflects the shift of political power from labor to capital. The political and economic conditions that led to the emergence of PE created the legal framework that makes it possible for the PE business model to operate. Within this structure, the interest of PE firms lies in making money for the GPs and LPs, not necessarily in creating or preserving potentially healthy companies or workers’ jobs. While PE firms are sometimes successful in improving the operations and growth of small- and midsized companies and in turning around failing companies, they more often have significant negative consequences for the acquired businesses and their workers as well as for certain investors such as pension funds.
Appelbaum and Batt offer a variety of policy recommendations that would limit the negative effects of PE that result from financial engineering, while preserving its beneficial impacts. These include policies to improve transparency and accountability by adding more reporting requirements, as well as changes that would reduce the excessive use of financial engineering strategies such as prohibiting dividend payment to PE investors for the first 2 years and eliminating tax incentives to load portfolio companies with excessive debt and asset stripping. A key step is to reduce the moral hazard problem by curbing the “2 and 20” compensation formula and carried interest tax loophole. With regard to workers, they advocate updating the WARN Act to give employees of PE-controlled companies advance notice of plant closings, requiring service-linked severance pay for acquired companies’ employees, and holding PE owners accountable for portfolio companies’ pension liabilities by extending the Employee Retirement Income Security Act (ERISA) and updating the bankruptcy code. These policies are not likely to make much difference to PE partners that make money by adding value to their portfolio companies, but they would decrease rent-seeking and risk-shifting behavior associated with financial engineering strategies.
Appelbaum and Batt recognize the challenges involved in implementing these changes given the considerable lobbying and political influence of the financial services industry in Washington. Nevertheless, they point to partial successes such as the Dodd-Frank Act that was enacted despite significant resistance from Wall Street. This suggests that it is indeed possible to mobilize the electorate and pass key reforms that would reduce the negative impacts of PE firms on the economy and workers. Nevertheless, the challenges to implementing these policy recommendations should not be underestimated. The shifts in political power that made possible the financialization of the economy, in general, and the PE model, in particular, can only be reversed by a fundamental change in the nature of the political and social contract that was disbanded over the past four decades. Such a change would enhance both the competitiveness of the American economy and the quality of work experienced by many individuals.
Footnotes
Declaration of Conflicting Interests
The author declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding
The author received no financial support for the research, authorship, and/or publication of this article.