The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything (Bloomberg)

by Jason Kelly

  Officials at TPG and Nexio declined to comment about the situation. A person familiar with the transaction said that Nexeo had in fact gone to great lengths to ensure that those who switched from pensions to the defined benefits plan got a deal that ultimately would have similar benefits and without the risk of an underfunded pension.

  One way unions and others have sought to ensure private-equity firms act responsibly is through programs like the United Nations Principles for Responsible Investing, which ask investors to sign on and follow certain guidelines around environmental social and corporate governance (known as ESG).

  Like the principles created by the Institutional Limited Partners Association, the UNPRI has become a way to keep an eye on private-equity firms and either encourage or require them to meet certain agreed-upon standards or explain why they didn’t. KKR in 2011 released a companion report to its annual report focused exclusively on ESG issues. Carlyle in 2012 issued its second detailed report on corporate responsibility. The move toward proving they are good environmental stewards has been an especially interesting one to watch, in part because of the personalities involved and in part because of some of their investments, including TXU. There, the company has shuttered a number of coal-fired plants in the wake of the LBO.

  Bonderman has been an active environmentalist for decades, and moving in those circles spurred a friendship with a fellow named Ed Norton, a former deputy director of the Nature Conservancy and the founding president of the Grand Canyon Trust. Norton (father of the actor Edward Norton) was living in Indonesia in 2007 when Bonderman, whom he’d met through the Grand Canyon Trust two decades previous, called and asked to get together during one of Bonderman’s frequent trips to Asia to ask how the firm and companies it owned could improve their environmental performance and how TPG could integrate those issues into due diligence. That meeting led to the elder Norton joining TPG as a senior adviser on environmental issues, where his group develops sustainability policies and strategies, as well as metrics to cut costs and reduce environmental impacts.

  KKR has undertaken an ambitious effort, dubbed the Green Portfolio, created in partnership with the Environmental Defense Fund. Through that program, KKR has pushed the companies it owns to cut costs and improve profits through energy efficiency and waste handling measures. The firm said in late 2011 the participating companies had avoided costs totaling $365 million since 2008.22 KKR’s Mehlman, the former Republican National Committee chairman, is fond of using the term “stakeholders” to talk about the various parties who have an interest in private equity. He has aggressively built out a global unit focused on those issues, prodding companies KKR owns to think about everything from the environment to wellness, all with an eye toward the bottom line. Synthesizing the move to KKR in 2007 with the rest of his career—he also ran George W. Bush’s 2004 reelection campaign—he said, “I’m a mission guy.”

  Stern argued to me that this is the template to use for pushing private equity to think more holistically about ultimately being better employers. Their ideology is to make money. They have proven—as KKR has done with their environmental efforts—that they’re open to doing business in such a way that allows them to both do good and do well. Whether the tycoons ultimately agree with that approach remains to be seen.

  Notes

  1. www.pegcc.org/education/pe-by-the-numbers/

  2. Jason Kelly and Laura Keeley, “Private Equity Seeks to Avoid Scrutiny as Washington Sets Rules,” Bloomberg News, July 27, 2011.

  3. “Private Equity Compensation Report Reveals More Good News.” Private EquityCompensation.com press release. Distributed via PR Newswire, December 19, 2011.

  4. Steven J. Davis et al., Private Equity and Employment, U.S. Census Bureau Center for Economic Studies, Paper No. CES-WP-08-07R, October 1, 2011.

  5. Ibid.

  6. Maeve Reston, “Gingrich, Romney Exchange Blows,” Los Angeles Times, December 12, 2011.

  7. Devin Dwyer, “Axelrod Jabs Gingrich: Higher a Monkey Climbs . . . More You Can See His Butt,” Abcnews.com, December 13, 2011. http://abcnews.go.com/blogs/politics/2011/12/axelrod-jabs-gingrich-higher-a-monkey-climbs-more-you-can-see-his-butt/

  8. Matthew Mosk and Brian Ross, “Fired Factory Worker Calls Mitt Romney a Job Killer,” Abcnews.com, December 28, 2011. http://abcnews.go.com/Blotter/romney-critic-resurfaces/story?id=15244767

  9. Peter Lattman, “Bain Defends Itself Amid Attacks on Romney,” Nytimes.com, March 13, 2012. http://dealbook.nytimes.com/2012/03/13/bain-defends-itself-amid-attacks-on-romney/?scp=5&sq=bain%20capital&st=cse

  10. National Venture Capital Association website. http://nvca.org/index.php?option=com_content&view=article&id=119&Itemid=621

  11. Blackstone conference call, July 21, 2011.

  12. Transcript, “Can America Get Its Entrepreneurial Groove Back?” Brookings Institution, November 15, 2011. www.brookings.edu/~/media/Files/events/2011/1115_private_capital/20111115_private_capital_panel2.pdf

  13. James P. Hoffa, “Wrecking Healthy Companies and Killing Good Jobs Are Lousy Reasons to Get a Tax. Break,” Huffington Post, April 16, 2010. www.huffingtonpost.com/james-p-hoffa/wrecking-healthy-companie_b_540371.html

  14. Service Employees International Union, “Beyond the Buyouts.” April 2007. http://gobnf.org/i/wog/behindthebuyouts.pdf

  15. Service Employees International Union, “Who Owns Times Square?” Distributed by PR Newswire, July 18, 2007. www.prnewswire.com/news-releases/who-owns-times-square-52748002.html

  16. SEIU Local 722, “A Stubborn Union Storms the Gates at Carlyle Group,” February 18, 2008. www.seiu722.org/PressReleases/AStubbornUnion.html

  17. Michael J. De la Merced, “Protesting a Private Equity Firm (With Piles of Money),” New York Times Dealbook. October 10, 2007. http://dealbook.nytimes.com/2007/10/10/protesting-private-equity-with-piles-of-money/

  18. Andrew Ross Sorkin, “Is Private Equity Cheating?” Columbia Business School website, February 18, 2008. www4.gsb.columbia.edu/publicoffering/post/131034/Is+Private+Equity+Cheating%3F

  19. Michelle Hillman, “Blackstone Group, Boston Janitors Reach Deal,” Boston Business Journal, August 15, 2007. www.bizjournals.com/boston/stories/2007/08/13/daily27.html

  20. Judy Woodruff, “Stern Says Obama Ultimately May Ease Tax Rule,” Bloomberg Television, June 23, 2011. www.bloomberg.com/news/2011-06-23/stern-says-obama-ultimately-may-ease-tax-rule-transcript-.html

  21. “Union Members Summary,” Bureau of Labor Statistics, January 27, 2012. www.bls.gov/news.release/union2.nr0.htm

  22. KKR Green Portfolio. http://green.kkr.com

  Chapter 9

  Take This Exit

  Payouts, Dividends, and Consequences

  The founders of private-equity firms aren’t usually thought to be cheeky, but that’s just what the trio behind Carlyle went for in its 2011 corporate holiday greetings. In a video message sent in mid-December to the firm’s investors, Conway, D’Aniello, and Rubenstein “imagined” what would have happened had they not created Carlyle two decades earlier.1

  Rubenstein turns up perched behind a lemonade stand, pitching kids on an opportunity to forego a simple cup in favor of becoming a limited partner in the stand. Conway sits in a telephone call center (a nod to his previous job at MCI), and D’Aniello sells pastries and coffee at Carlyle-owned Dunkin’ Donuts. While investors likely chuckled at the self-directed send-up, they were much more interested in another private message from Carlyle that arrived a few days later. And they got the evidence of why Carlyle was especially feeling its oats at the moment.

  The investor letter is a staple of the private equity industry, one of the few ways that managers communicate in detail on a regular basis. They are meant to be confidential missives, in part because they often disclose private information about closely held companies and reveal the strategy of the firm. The four-page letter, dated December 21st and signed by the three founders, was a technical rundown of the year, with the numbers investors needed to best judge Carlyle’
s performance. In the third paragraph was the money shot. The founders disclosed that for the year, they expected to distribute $17.8 billion to their investors, a record for the firm, and to their knowledge the most any “alternative asset” firm had ever paid out in a single year. The announcement came as welcome news to Carlyle’s clients.

  Private equity only works if the money actually gets back to the investors who committed it in the first place, in a reasonable time frame and with a healthy return. That’s why private-equity managers justify their enormous fees at the end of the day: because they can deliver returns investors can’t find anywhere else. When and how the money comes home to roost is one of the most contentious running arguments in and around the industry and provides the most fodder for critics.

  A private-equity fund usually has a life of about 10 years, and during that period investors expect to put money in and get it back on a regular basis. Most companies bought by a fund aren’t held for the duration of the fund, but bought and sold within five to seven years, sometimes less. Even though a holding period is measured in years rather than months, weeks, or days for some mutual funds (or minutes or seconds or fractions of seconds, as it is with some hedge funds), the clock is ticking from the moment a private-equity fund buys a company.

  The goal is an “exit,” an event that leads to a distribution of profits to the investors, with a cut going to the manager. The investors get 80 percent of those profits, and the private-equity firm gets 20 percent, the piece known as carried interest. Those exits can be accomplished in a number of ways, and we’ll get to them. But let’s talk first about how the buyers can reap fees and profits while they still own the company.

  The sheer volume of money that flows to the private-equity managers is at the heart of most every criticism they face—from employees, unions, executives, and politicians—and in their honest moments, the buyout managers themselves concede this. It is undeniably an extraordinarily lucrative business and the amount of wealth makes for a skeptical world at large. One of the areas that became increasingly hard to defend as the industry matured, and the mechanics of the business became more apparent, were the fees beyond management and carried interest.

  The main targets were transaction fees and monitoring fees, both fairly descriptive terms. The former is a fee levied by the firm on the company when the deal happens; the latter is for providing usually unspecified advice to the company. Investors were especially incensed by this practice when they realized that the managers were charging these fees and not sharing them with the limited partners. In the Institutional Limited Partners Association guidelines that helped galvanize investors in 2010 and 2011, the authors took aim at these sorts of fees directly. “[W]ealth creation from excessive management, transaction or other fees and income sources . . . reduces alignment of interest,” according to the second version of ILPA’s private-equity principles, released in early 2011.2 The ILPA guidelines called for such fees to accrue to the fund rather than go directly to the private-equity managers. That way, if the managers insisted on charging them, they’d at least get the traditional breakdown of 20 percent to the private-equity firm, with 80 percent going to the limited partners.

  A study by researcher Preqin and law firm Dechert in late 2011 showed that increased scrutiny and criticism around the fees had done little to slow their use. The researchers mined data around deals over multiple years and found that while monitoring fees and transaction fees dropped off during the financial crisis, they came roaring back during the recovery. They also found that of the 72 firms they surveyed, about 20 percent of respondents said that all or a substantial portion of the fees went to the private-equity manager.3

  There’s another way to take money off the table before a manager actually buys or sells a company. A dividend recap is something akin to a second mortgage, and in a lot of ways just as potentially treacherous. When a family opts for a second mortgage, sometimes they have a compelling reason; it may be the only way to pay for college or medical bills. But sometimes it’s for a new car or flat-screen TV or fancy vacation.

  Either way, it’s more debt, and that’s how it is for a company, too. Through a dividend recapitalization, the owner of the firm is changing its balance sheet (recapitalizing) in order to create a payout (dividend). In all the talk about alignment of interests, this is one place where the argument seems to break down. The investors in the private-equity fund are generally happy with a dividend recap on paper. After all, this is one of a handful of ways they get a profit distribution. The managers of the private-equity fund are happy. They’ll likely get either closer to earning their carried interest, or if the fund is far enough along, 20 percent of the dividend will go right to them. So far, so good.

  But what about the company? Debt has to be paid back. Thus more cash has to be diverted from hiring new employees and expanding business lines and opening new factories toward paying off loans.

  Then there’s a philosophical point. Private-equity firms often can recoup their initial investment, and more, through a dividend recap, and continue to own the company. While casino analogies are generally both provocative and insufficient when it comes to describing investing, it seems fitting in this case. They are at the blackjack table and have won a few hands. They can take back the initial stake and put in their proverbial pocket. Any gains from here on out are essentially won playing with house money.

  Kenneth Hackel, whose Connecticut firm advises institutional investors, has been a vocal critic of dividend recaps. In his estimation, the main problem is that it redirects more free cash flow to debt payments rather than something that could actually improve the business. “This is all about greed,” he said. “This does not improve the company on any metric that really counts.”

  In an article on Forbes.com in late 2010, Hackel laid it out this way: “By virtue of leveraging of the balance sheet while getting nothing in return, both investors and employees are much worse-off. No jobs in research, no machinery, technology, or productive plant were put in place as multibillion-dollar checks were mailed out.”4

  Private-equity managers, not surprisingly, disagree with the criticism over dividend recaps. They argue they are being good stewards of their investors’ capital and have a responsibility to return their money, with a profit, to those backers in a timely manner. They also shoot down the implication that their alignment of interest chain is broken since they are not selling any equity in such a transaction. Blackstone’s Tony James put it this way to me: “It’s not a gimmick. Investments do mature at times when the market doesn’t give you a way out.” He said lenders won’t do a recap deal if the sponsor doesn’t have a significant portion of equity remaining in the company. “In that sense it’s no different than an IPO. They are exactly the same, exactly the same emotional alignment.”

  While it’s logical, it still makes folks uncomfortable, probably because a dividend recap usually means additional debt, and making money by borrowing money simply doesn’t feel right. Romney’s presidential candidacy spurred a flurry of stories that included details about dividend recaps in 2011. In at least one example of a Bain deal gone bad tied to Romney’s tenure, the recap apparently was what helped push the company into bankruptcy.

  The company in question was Dade International, which Bain bought in 1994. Michael Barbaro of the New York Times in 2011 analyzed the deal, showing how Bain essentially saved the company, then did very well by its investors through the Dade transaction by making eight times its original investment. Yet the company eventually filed for bankruptcy, after Bain engineered a $242 million dividend for itself and its investors. The Times story quoted the former president of Dade, who earned $1 million from the dividend, questioning the practice in retrospect.5

  The story of that takeover achieved meta-status in December 2011, when Times columnist Andrew Ross Sorkin noted that the company was one of the ones most often mentioned in profiles of Romney. Sorkin pointed out that the Dade deal was in fact one where Bain saved the company
from bankruptcy and set it on a path to health, only to cripple it with more debt via a recap.6 Fortune writer Dan Primack, one of the most-followed voices writing about the industry and a frequent critic of dividend recaps, took it a step further, arguing that Sorkin shouldn’t grant Romney any quarter just because Bain initially did some good at Dade. He drew a stark analogy whereby someone fed and clothed a homeless person, only to later rob him when he begins to earn money again, and watch him die of starvation.

  “Was my action morally acceptable because he would have starved years ago without my help? Dividend recaps often are the worst of private equity, contributing to the industry’s reputation as destructive financial engineers,” Primack wrote.7

  Siding with Hackel and Primack as a dividend recap doubter suggests that just because an investor can do something doesn’t mean he should. In other words, as managers’ ownership of the broader economy deepens, so too does their responsibility to think beyond purely financial returns.

  Dividends are one way that private-equity managers take their money off the table, distributing it to their investors while keeping their proscribed cut. That’s just an interim step in most cases. There’s still the matter of exiting the investment completely. There are three general ways to do that, with slight variations: selling the investment to another company, selling it to another investor like a fellow private-equity firm, or taking it public. All have their pros and cons. How pro or con you are probably depends on where you sit at the table.

  Selling out for cash seems to be the cleanest way to get out. You agree to a price, you get the money, the company gets a new owner. Your limited partners get their money back and, hopefully, a profit. Carried interest flows to the private-equity firm.