Hardly a day passes when a story does not appear about the growth of private equity investing in the United States. Early in May of this year, newspapers were filled with reports of a major private equity firm's bid to buy 80% of the Chrysler Group for $7.4 billion. The Chrysler transaction is representative of a recent trend in private equity deals; transactions increasingly involve companies in businesses - manufacturing (autos, auto parts, steel), consumer goods (restaurants and food service, merchandise retailing), services (financial services, health care), and technology - that directly affect the lives of Americans whether as consumers or as workers.
These transactions have created an intersection between financial market, performance-focused, private investment and the politically charged questions of plant closings, job losses, "legacy costs," wage and benefit reductions, and executive compensation. Described more plainly, Wall Street has met Main Street. The consequences, for the moment, have been high-profile hearings and expressions of concern in the U.S. Congress, but as yet no formal initiatives to regulate or restrict private equity activity. Some of the popular resistance generated by organized labor interests and others has, however, resulted in the withdrawal of private equity investors from some transactions, including the decision of one firm not to participate in the acquisition of a major U.S. auto parts manufacturer.
This collision of Wall Street private equity investors and Main Street popular concerns sets the stage for a hearing conducted by the House Committee on Financial Services on May 16. Financial Services Committee Chairman Barney Frank (D-MA) presided over the hearing, which was the second in a series held by the Committee on issues surrounding the growth of private equity investment in the United States. Chairman Frank announced the hearing as an opportunity to examine the "real-world" consequences and resulting public policy implications of private equity deals, and what, if anything, Congress should do to address those consequences and policy questions. The key policy issues on which the hearing focused were:
What Are the Economic Effects of Private Equity?
Does the Private Equity Model Create Long-Term Value?
Do Private Equity Transactions Result in a Sharing of Any Value Created?
The witnesses at the hearing included Andy Stern (President, Services Employees International Union), Douglas Lowenstein (President, Private Equity Council), Robert H. Frank (Professor, Johnson Graduate School of Management, Cornell University) and Jon L. Luther (Chairman and CEO, Dunkin' Brands Inc.).
What Are The Economic Effects Of Private Equity?
Most of the hearing centered on the effects of private equity investing on U.S. companies and their workers. The hearing represented an informed policy debate on this topic with some partisan overtones.
Chairman Frank opened the hearing by stating his belief that it is "morally wrong" for what he described as a small group of players to enjoy a substantial increase in wealth that would widen the gap between the top income-earners and the vast majority of American workers. Frank questioned the premise that private equity investments consistently increase the well-being of a company and its employees, and expressed concerns about whether any of the increased value created by private equity accrues to the workers of the target company.
Does the Private Equity Model Create Long-Term Value?
In their testimony, Mr. Lowenstein and Mr. Luther responded to Chairman Frank's challenges. They emphasized the constructive nature of private equity investments. Both indicated that the operating model of private equity firms is to restructure the companies they acquire so as to attract future buyers who will pay a premium over acquisition costs. This, they stated, can only be accomplished by growing the company and adding value. They contrasted this to the alternative approach for dealing with troubled companies - liquidation, either inside or outside bankruptcy, accompanied by the piecemeal sale of company assets and the disappearance of facilities, jobs, benefits, and competition.
In support of this perspective, Representative Deborah Pryce (R-OH) voiced her view that many companies are acquired by financial buyers, like private equity firms, as opposed to strategic buyers, precisely because they are "short-term losers" with no alternative access to capital or resources. She said that "a healthy long-term private company is better than a stagnant public one," and maintained that the focus of government policy should be on decreasing the burdens on public companies and not increasing those on private firms. Representative Edward Royce (R-CA) echoed this perspective, suggesting that the recent popularity of private equity investment is a by-product of the regulatory and litigation burdens that are saddling public companies. Representative Royce cited as examples the requirements of the Sarbanes-Oxley Act and what he characterized as "abusive" shareholder lawsuits.
Do Private Equity Transactions Result In A Sharing Of Any Value Created?
Union representative Andy Stern acknowledged the value created by private equity investment, but asked whether we are " sharing value." He spoke of today's world as "America's gilded age," noting a negative trend in middle-class wages and savings, despite workers' higher overall productivity. He also cited increases in transaction fees received by investment bankers and fund managers in connection with private equity deals. Representative Michael Castle (R-DE) responded to Mr. Stern's concern by noting the lack of empirical evidence showing private equity deals to be responsible for such economic inequality. Professor Frank alluded to research suggesting a long-term increase in jobs with companies acquired by private equity firms in the European markets. Mr. Stern in response conceded a need to "keep watching" before taking any legislative action.
Areas Of Potential Congressional Focus
At the hearing and in other congressional forums, more specific questions have been raised and more specific proposals suggested for action regarding private equity investments. Among them are:
Should the tax laws be amended to limit the favorable treatment of private equity investment? This question includes whether "carried interest" should continue to be treated as capital gains, taxable at reduced rates, and to what extent earnings from off-shore funds maintained by private equity firms should be taxed.
Should laws be enacted to deal with the interaction between private equity investors and organized labor, both in terms of negotiations with unions already representing employees at companies being acquired and in terms of efforts to organize facilities of nonunion acquisition targets. In some industries, such as steel, the relationship between private equity acquirers and union leaders has been quite positive and productive, while in other industries, such as auto parts, there has been some substantial conflict. The Chrysler case will involve one of the most significant and complicated negotiations yet undertaken, involving the current owners, the acquirers and the unions, touching on the lives of hundreds of thousands of current employees and an equal or greater number of retirees, and involving billions of dollars in benefits.
Should Congress act to impose regulatory requirements on private equity firms or to require changes in the way they invest or in their ability to close plants, move operations offshore, or cut jobs or benefits?
On these and other matters that might be the subject of legislation, there was, not surprisingly, little if any consensus among the witnesses. Perhaps more important, the Committee Members present were divided as to the need for and advisability of regulating private equity firms or their investments.
As he concluded the hearing, Chairman Frank indicated that the Committee will hold one more hearing to examine the use of derivative investments in the financial sector. At that point the Committee will consider whether to proceed further.
The House Banking Committee's hearing and its focus on private equity investment and its consequences are part of the larger universe of political concerns about economic and social policy. The Democratic and Republican leaders of the Senate Finance Committee have already undertaken a review and analysis of the tax treatment of hedge funds and private equity funds, with an eye toward restricting or eliminating perceived tax benefits. Other committees are examining questions involving health care benefits, pensions and job security. The current strength of the U.S. economy is acting as a partial brake on actual legislation, since legislators legitimately fear that the wrong action might have substantial adverse consequences. However, the scrutiny of private equity and the resulting criticisms reflect the fundamental debate that is going to be a major issue in the 2008 elections and beyond - the serious concern over income disparity in the United States and whether American workers will be forced to compromise their standard of living in the face of global economic competition.
Ultimately, the cumulative effect of major transactions, the pressure of foreign competition (particularly from China, India and other developing countries) and the need to raise tax revenues to finance augmented government programs may on their own be sufficient to trigger new legislation that will affect private equity investment. The question is whether such legislation will be so extreme that it effectively ends such investment as an attractive use of capital. If the debate on this issue can continue to be conducted on a level that avoids populist sloganeering, that should not be the result. Legislation may change the terms, conditions and profitability of these investments, but it will not go too far.
Barry Barbash is a Partner and head of the Asset Management Practice Group at Willkie Farr & Gallagher LLP. Mr. Barbash is a former Director of the Securities and Exchange Commission's Division of Investment Management. Russell Smith is Special Counsel and head of the Government Relations Practice Group in the Washington, DC office of Willkie Farr & Gallagher LLP. Mr. Barbash and Mr. Smith were assisted in the drafting of this article by Jane H. Kim , an Associate in the Asset Management Practice Group, and Brandon Boey , a summer associate in the firm's Washington, DC office.