Gaining Wealth and Prestige Through Meanness

All of this, presumably, Friedman would approve.

Friedman has many admirers and adherents, not least among the wealthy. I have little doubt that he is much admired among the class of people who run private equity funds.

And that is why we see all the practices he approved of being applied by private equity funds.

Plunder

Reading Brendan Ballou’s book, Plunder: Private Equity’s Plan to Pillage America, was to experience a continually reinforcing series of feelings of outrage, like going down a YouTube rabbit hole. It was even difficult to put the book down. Except that this rabbit hole conforms with logic, not wild speculation. Because of the Milton Friedman philosophy so widely embraced by many heads of financial firms, the practices that Ballou highlighted can only be the logical consequences of that philosophy.

Therefore, although the examples Ballou presented are undoubtedly cherry-picked – perhaps there are other examples that might have presented private equity in a better light – it is fully believable that those examples are typical of the industry.

The standard practice is for a private equity firm to purchase a company that it thinks can be milked for greater profit by dint of financial engineering and improved operating efficiencies. But as Ballou says,

…the idea of “operational efficiencies” belies a certain arrogance in the private equity industry, the idea that in three to seven years, well-educated dilettantes can run a company better than those who’ve often spent a lifetime doing so. “What they thought was that people who live here are stupid, and that’s the way they treated us,” a former employee of Payless ShoeSource told The New York Times, after the shoe seller was bought by [private equity firm] Alden Global Capital. “It didn’t matter how great you were in your field or what other stuff you had done, it was, ‘You live in Kansas, so you’re an idiot.’” This arrogance – forged in business schools, sharpened by industry conferences and its own propaganda – allows private equity to convince the world, and perhaps itself, that it really is a “superior form of capitalism” and to disguise the ways it really makes its money.

And the financial engineering that the private equity firms apply might better be called “government engineering,” or “regulatory engineering,” since so much of it involves taking advantage of government programs like Medicare and Medicaid or the government-run Pension Benefit Guaranty Corporation (PBGC), or loopholes in regulations.

This practice is virtually the definition of “rent seeking” – extracting profits from a zero-sum game rather than a positive-sum game. And what profits! Ballou explains that “While the CEO of the investment bank JP Morgan [Jamie Dimon] made a little over $80 million in 2021, the CEO of private equity firm Blackstone made over ten times that: $1 billion.”

Being a zero-sum game means that a private equity CEO’s $1 billion comes not from adding value to overall economic growth, but from other people’s pockets. Ballou’s examples show exactly whose pockets that $1 billion comes from: little people, with little power to resist the pickpocketing, such as prisoners, nursing home residents, mobile home dwellers, residents of small towns with strained budgets, emergency room users, and others like them.

The leaders of the largest private equity firms, Ballou says, are “some of the richest people in America: the cofounders of KKR, Apollo, and Blackstone are worth $7 billion, $9 billion, and $29 billion, respectively.”

Private equity has been growing enormously. Ballou reported that “KKR had $15 billion in 2005 in assets under management; today, it has $459 billion. Blackstone had $79 billion in 2007; today it has $731 billion.”

There is nothing wrong with some people becoming fabulously rich, in fact it is an almost unavoidable consequence of a few entrepreneurs succeeding in launching products that are successful beyond their wildest dreams. Those riches are because of the “consumer surplus” the product provides to its purchasers – the added value. Think the iPhone, the microwave oven, the Ford Model T, the television, the Google search engine, the world wide web, the ATM. These creators are fully entitled to their profits, however large, because they are at least matched by the added value realized by consumers.

But if that wealth comes merely from rent seeking – from manipulating government programs and regulations and financial gimmickry – and provides no consumer surplus at all, then it is an abomination. This appears to apply broadly to much of the practice of private equity.

The strategy

The typical private equity practice described by Ballou is to buy up firms operating in a particular sector, then roll them up into a chain of operations using third-party services also owned by the private equity company. Sell the property of the companies purchased to raise money to pay the private equity owner dividends and to help shield the company from having to pay liabilities, since it depletes its assets. Require the purchased company to borrow money, for repayment of which the purchased company is liable, to pay the private equity owner dividends, consulting fees, and “transaction fees,” which themselves include a fee to the private equity owner for the borrowing transaction itself.

Then wring more profit out of the company by reducing its costs – firing employees, pushing services down to lower-paid workers (for example from doctors to nurses) – and increasing revenues, for example by changing the way patients in a medical clinic are treated, and reclassifying their illnesses in such a way as to extract higher payments from Medicare.

Examples

Ballou detailed many cases of private equity business practices. Here are a few representative examples.

Privatization of government services led to companies owned by private equity firms providing telephone services in prisons, for rates of $12 for a 15-minute call and more. The private equity-owned firms also provided video calling services, whereby a visiting family member could connect with a prisoner by video call instead of in person. But the video call-providing companies urged the prisons – often successfully – to not even allow in-person visits but to require video visits instead. Of course, the prices charged by the video-providing firms for video calls were exorbitant. Prisons also contract out health care to companies owned by private equity, with the result that private equity-owned health care in prisons is abysmal.

Chains of healthcare companies owned by private equity reduced the number of employees so that the quality of services suffered and employees such as doctors and nurses had to work harder to the point of overwork. They also pushed employees to produce more revenue. Says Ballou, “Doctors in private equity–owned dermatology practices, for instance, complained that they were pressured to meet quotas for procedures, sell acne creams and antiaging goods, and make expensive referrals.”

Chains of nursing homes owned by private equity reduced services and numbers of employees to such an extent that there were very serious health problems and deaths, much more than in nursing homes that were not owned by private equity. Firms owned by private equity paid numerous fines to settle lawsuits on behalf of those who were poorly cared for – and they paid fines in other areas where private equity operated too – but those fines could be absorbed as the cost of doing business.

For-profit colleges owned by private equity spent much more on high-pressure recruiters than on education, and produced results in terms of the jobs that students could get after graduation that were much worse than colleges not owned by private equity. Their high profits were made possible by government loan guarantees.

Mobile home parks owned by private equity were serviced poorly and saw their fees for the land they occupied soar over time, which also reduced the value of the mobile homes that they owned, which were mostly not in fact mobile but fastened in place, so that they were captives of the private equity-owned companies – just as prisoners were literally captives of the private equity-owned companies that charged them exorbitant rates for phone calls and video calls.

Private equity companies sometimes engineered bankruptcies in the companies they bought to fob off pension obligations to the government-run PBGC.

This list goes on and on. The pattern is clear; private equity buys companies that serve customers who have little alternative, or little power to resist the extra charges and poorer services that those companies impose after they have been bought by private equity firms.

Let’s get political

In 2011, there was a prolonged protest against Wall Street that called itself Occupy Wall Street. An e-friend of mine at the time living in New York was sympathetic. She is a mathematician who had worked for a prominent hedge fund, finding it a rather disgusting way to make money – or rather, to pursue making money, because it wasn’t always successful, except, of course, in extracting fees from its investors.

She went to a meeting of the Occupy Wall Street group and found that although they were passionate about their protest, most of them had no idea exactly what Wall Street practices they were protesting against – they simply didn’t know enough about the financial world. They just thought something was drastically wrong if there was so much difference between the money that Wall Street executives made and ordinary Americans.

Now shift to the recent Republican National Committee meeting. I listened to an interesting New York Times “The Run-Up” podcast about it. The New York Times correspondent on the podcast attended the meeting and interviewed several participants.

One participant that he interviewed was very much into Trumpism, though he owned that it didn’t necessarily have to mean that Trump himself had to be the leader of the movement. But one thing that interviewee said stuck with me. He referred disdainfully to the part of the Republican Party that he was against as the “Mitt Romney elite.”

Now, Mitt Romney did make his money – reported at the time of his presidential candidacy in 2012 to be $250 million – in private equity at the firm Bain Capital.

I have no idea what Romney did at Bain Capital – perhaps it was private equity at its best, which, if there even is such a thing, is unfortunately not covered in Ballou’s book. But it is clear from his book that much of what private equity does is the practice of appalling meanness directed against its ultimate customers, who are in general poor people with little power to resist private equity’s pickpocketing.

It’s not only Romney. As Ballou observes, Timothy Geithner, Obama’s treasury secretary, is now president of private equity company Warburg Pincus. (It was Geithner’s operation in 2008 that awarded Goldman Sachs a 100% bailout of its credit default swaps, money that Goldman couldn’t collect from the bankrupt AIG that had sold them the CDSs.) And many other prominent politicians found jobs in private equity – Ballou mentioned former Speaker of the House Paul Ryan; Jacob Lew, another Obama treasury secretary; former Speaker of the House Newt Gingrich; and David Petraeus, former general and CIA director. And the recently elected governor of Virginia, Glenn Youngkin, was previously in private equity.

We know that there is a “revolving door” in Washington DC. Ballou noted that “when someone in government is lobbied by a private equity firm, the person doing the lobbying may be a friend or a former boss. It also means that those currently in government know that, quite likely, they have a home to go to when their time in public service comes to an end.”

By no means do I want to single out Romney himself as the symbol of it, because I believe him to be a decent man – but this is the “Mitt Romney elite” for you. And we know that, when Romney was caught on video during his presidential campaign in 2012, delivering a speech to a group of wealthy donors – his compatriots – he said, “There are 47 percent of the people who will vote for the president [Obama] no matter what. All right, there are 47 percent who are with him, who are dependent upon government, who believe that they are victims, who believe the government has a responsibility to care for them … [M]y job is is not to worry about those people. I'll never convince them they should take personal responsibility and care for their lives.”

This showed an astounding degree of contempt for the 47%, a large proportion of whom were later Trump voters.

Could these people be right about the “elite”? Yes, I’m afraid they are. But like the passionate activists of Occupy Wall Street – except that one set of people is designated as “on the extreme left” and the other “on the extreme right” – they have approximately the right target, but it’s a scatter-shot; they aren’t clear about exactly who among their target demons are actually guilty, and what they are guilty of.

Brendan Ballou helps us to understand that in his book. I hope that many people will get the message.

A criticism

As I was reading the book, I kept thinking, “Is this all there is to private equity?” I find it very hard to believe that all private equity is buyout funds, and that what they buy is companies that fall into the categories that Ballou covered.

“Private equity” is a nebulous term. Surely it includes funds that do other things as well. And some of those funds just might be doing good things, things that aren’t engaging in rent seeking or a zero-sum game.

Unfortunately, Ballou said nothing about those other kinds of private equity. I would have very much liked to learn about them, but they aren’t in the book.

What Ballou should have done is present a taxonomy of funds labeled “private equity.” Then he should have identified which part of that taxonomy he was covering in the book. It might have sapped some of the strength of his condemnation, but it would have provided a more accurate impression of the entire industry.

Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, managing partner and special advisor at M1K LLC. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.

Read more articles by Michael Edesess