Private Equity's Opaque World

Brendan Ballou is a federal prosecutor and special counsel at the Department of Justice, where he led the antitrust division's work on private equity. He's also authored a new book, Plunder: Private Equity's Plan to Pillage America.

Motley Fool producer Ricky Mulvey caught up with him to talk about:

• The techniques many private equity companies use to generate short-term returns.
• A key misunderstanding about the fall of in-person retailers.
• Private equity's impact on medical billing, bakeries, and insurance.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on April 30, 2023.

Ricky Mulvey: When you're talking about private equity firms having their companies exit through an IPO. I can't talk about any specific company. But one of the challenges that you've got is, they've been taking a very short-term perspective and potentially selling off the company's assets. The company that emerges through private equity ownership, it's not always this way, but sometimes the company that emerges from private equity ownership may just not be as strong or as valuable accompany as it was when it entered.

Chris Hill: I'm Chris Hill and that's Brendan Ballou. Special counsel in the antitrust division at the Department of Justice and author of the new book, Plunder, private equities plan to spillage America. Ricky Mulvey caught up with Balu to talk about the lesser-known ways that private equity can impact your life, their methods for generating short-term returns, and how a profitable Toys R Us managed to go bankrupt.

Ricky Mulvey: Brendan, this the first time I've voluntarily spoken with the federal prosecutor. I appreciate you joining me for this journey.

Brendan Ballou: Thank you so much for the time.

Ricky Mulvey: I also understand that you've got to say something before we dive into the questions.

Brendan Ballou: Yeah. As I say in all these interviews. I'm speaking personally and what I say, it doesn't necessarily reflect the views of the Department of Justice.

Ricky Mulvey: Let's dive in. There are a lot of ways to raise capital. You got public markets, you've got bonds. Why pick on private equity? Why go after them?

Brendan Ballou: Sure. Well, it's a great question and maybe you've got a very educated audience and financially literate one. But it might be helpful to just set a baseline for what private equity is. Private equity firms use a little bit of their own money, some borrowed money, and some investor money to buy up companies. They try to make operational and financial improvements and then flip those companies for a profit a few years later. That's a really simple idea. But to get to your question, there are some basic problems with the private equity business model. One is that private equity firms tend to invest just for a few years and want to flip companies for our profit in 3, 5 or 7 years time. The second problem is that firms tend to load companies up with a lot of debt and extract a lot of fees from them. The third and this is the part that really interests me as a lawyer, private equity firms are really good at insulating themselves from liability for the consequences of their actions. What that means is when you've got short-term thinking, a lot of debt and insulation from responsibility. It tends to create a lot of bad outcomes for the companies that private equity firms buy.

Ricky Mulvey: I want to get to incentives in a bit. One of the things that is key about private equity is this short-term shot clock. All of them seem to operate on a five-year investment cycle. They want to get in and out in that five-year period. What's the reasoning behind that shot clock? Maybe what are some of the implications of that?

Brendan Ballou: I think it's probably a number of different reasons. Partly just the practice of the industry as a whole, partly because they're getting money in part from limited partnership investors who are going to want to return on their investment in just a few years time. Partly because the whole idea of private equity is that they can get superior returns faster than other investments means that they need to think short-term. The challenge that we've got is when you really think in just a few years time, you tend to make short-term decisions. I always joke if I was trying to maximize the value of my apartment over 20 years, I'd probably redo the kitchen at a inset bookcase. If I was trying to maximize the value over the next week, I burn it down and try to collect the insurance money. Your timeframe affects your decision-making. If you're thinking in just a few years time, often it means you're not investing in research and development. You're not investing in building new operations, new factories, and so forth. You're not investing in your workers and your customers are willing to raise rates are cut quality care. That's more than just theoretical. We see that playing out and a lot of different industries where private equity is active.

Ricky Mulvey: One thing that hits on both of those, which is the incentives and ownership. They're able to essentially claim ownership of a company but not quite be the owner. That was the Carlyle Group, which is one of the largest private equity firms in the world with their acquisition of ManorCare, which was a chains, chain is the right word of nursing home facilities.

Brendan Ballou: Yeah, this is actually the example that starts the book and I think it illustrates a lot of the problems with private equity or the private equity business model. As you said, Carlyle is a gigantic private equity firm. HCR ManorCare at the time was one of the largest nursing home chains in America. Carlyle bought ManorCare and then executed a number of tactics. They sold the underlying real estate of the place. They executed what's called a dividend recapitalization, which requires the company to borrow money to pay Carlyle and the other investors. They extracted a lot of money through transaction fees and management fees. Ultimately, the company, the nursing home chain, dramatically suffered. You had health codes violation spike residents complaining. In fact, at least one resident died. But when their family sued, Carlyle did this really interesting like legal magic trick, which is they said, when the family sued for wrongful death judge, technically we're not the owner of ManorCare. Rather, we just advise a series of funds whose limited partners through several shell companies, ultimately own ManorCare. That was enough to get the case against Carlyle dismissed. I think what that story illustrates is a lot of times private equity firms are able to essentially control a company. But when things go badly, they don't have responsibility.

Ricky Mulvey: Let's going back to the case of ManorCare. What's preventing a judge from piercing the veil? Clearly, these funds are run by this private equity company. Clearly, it's this private equity company that's operating, and is an owner of the business, but they're not the owner. That's where I'm confused and how they're able to pull off the magic trick you describe.

Brendan Ballou: If you're confused, I'm confused too. I think most people that would read these court decisions are confused as well. You mentioned the legal doctrine issue here, which is called corporate veil piercing. Generally what it means is that investors aren't held responsible for the actions of the companies they invest in. I mean, that makes sense for Ricky, with your 401K plan or Vanguard account, you've got stock and a bunch of different companies, it wouldn't really make sense for somebody to sue you if one of those companies breaks the law because you didn't really have much control over what that company did. That said a private equity firm, by being the majority or sole equity investor in a company, really can control the company's operations either directly by demanding certain actions or choosing the Board of Directors or choosing the company's leadership. I think this is a really interesting area where the law hasn't really caught up with business practice. Private equity firms have been able to use that mismatch to their advantage.

Ricky Mulvey: Let's get into some of the bagger tricks that they use to get those returns on a five-year period, which I'll also mention. They seem to be going for singles and doubles with these investments. They're not necessarily going for your 10 baggers, your 100 baggers. I think that's because of the time period. One of those bagger tricks that you mentioned is dividend recapitalization, where the company borrowed money to pay back the original investors who may also have an advisory fee as well. That played out to the detriment of Toys R Us. That's one of the major reasons that the chain had to go through bankruptcy.

Brendan Ballou: Yeah, Toys R Us is a really interesting example because it got bought up by a consortium of private equity firms in 2007. The obituary for Toys R Us was, oh, it was Amazon. Amazon killed the store. Actually, Toys R Us was profitable the very last year that it was in business. The challenge that had had was it was servicing more for the debt that it had taken on in order to be bought by the private equity firm as it was in profit. To go to the specific tactic that you're talking about, a dividend recapitalization. What happens there is private equity firm will buy a business and then essentially direct the business to pay it a dividend. Now the company doesn't actually have the cash to do it, so it has to borrow money. I always say it's a little bit like using somebody else's credit card to pay yourself because somebody else has the responsibility, but you're the one getting the profit. That's happening not just in Toys R Us. I'm talking off the top of my head here, so I don't want to get anything wrong, but I think that we've got multiple billions of dollars in dividend recaps that are happening every year according to at least one study.

Ricky Mulvey: It's also you dive into with Toys R Us is the narrative of Amazon killing retail. And whether it's, I think it's payless shoe stores, one of them, a lot of these discount in-person retailers. Private equity firms were able to benefit from that narrative that, it's e-commerce and Amazon killing them. But in many cases the layoffs can be directly attributed to this style of ownership.

Brendan Ballou: It's really interesting, at least according to one study, private equity firms were responsible for about 600,000 job losses in the retail industry over a decade when the industry as a whole actually added jobs. Now why is that? I think it's a couple of different reasons. Partly in the payless shoe source example, according to the New York Times, it was sheer mismanagement. They put in charge of the company, people that didn't actually have experience in retail or shoes, but finance, people who nonetheless had a lot of operational ideas like shutting down the quality control factory in China. As a result, they started getting shoes that were the wrong size or were misshapen, or having a World Cup plan to distribute flip-flops with countries' flags on it, but the countries weren't ones where they actually sold shoes, the list goes on. Sometimes it's just pure mismanagement. A lot of times it goes back to what you were just talking about, which is the short-term focus, which is if you're trying to get a return in just a few years, you're not going to make the strategic long-term investments that are going to be necessary for a company to survive for decades. To go back to Toys R Us, I know this is a really small example, but there was really interesting reporting about how after the PE firms bought Toys R Us, the stores literally got shadier because they stopped investing in maintenance and janitorial cruise. People would complain that I don't know if you remember, going into a Toys R Us, they'd have these very high ceilings that piles of dust were collecting on the fans and on the gutters because that was just something that the firms decided they didn't need to pay for anymore. There are other examples going on with other retailers but I think it shows how when you take a short-term perspective, oftentimes that may work for you as the investor, but it doesn't necessarily work for the company that you've bought.

Ricky Mulvey: But something you hit on with Toys R Us is you have people running these retail businesses or maybe even an emergency room that has no experience in the space. They're bureaucrats without the boots on the ground, the ability to understand what's going on in these stores.

Brendan Ballou: I'm a lawyer, so I don't want to cast aspersions on anybody who doesn't know how to run a company, I certainly don't. That said, a lot of private equity firms ultimately decide that they do want to have operational control of these. It's more than just retail. I think you just mentioned hospitals and emergency rooms. One of the really interesting cases is private equity firms buying up physician staffing companies, which are the companies that hospitals use to staff up emergency rooms and there's a really interesting lawsuit going on ultimately that I think the plaintiffs lost that alleged that look, the private equity firm is now actually directing medical decisions on behalf of doctors in terms of what techniques to use, when to let people into the hospital, what equipment or what medical supplies to use. Their allegation is, this one is so far that it actually violated state corporate practice medicine laws. Now, plaintiffs actually, I believe lost that specific case, but it's an illustration of where private equity firms are really making operational decisions in industries where the people who run private equity firms don't necessarily have experience.

Ricky Mulvey: One example in that case would also be dermatology clinics and the problem for a lot of the doctors is you end up having no other option of where you're going to go because it's a private equity firm that owns all of the terminology clinics in one region and in some cases that might inform decisions for the dermatologists to not complete treatment and a couple of visits because they're incentivized to have you come in more and more times? Not that I would know.

Brendan Ballou: Ricky, it's clear you've read the book very carefully here. I really appreciate it. You're exactly right in the dermatology example, one of the most astounding allegations in an article in Bloomberg was that the private equity firm actually directed the use of newer, cheaper needles for the doctors to use that actually broke off in people's skin. For doctors, it's been alleged that private equity firms have become so bad in the dermatology space. I actually went on job posting boards for dermatologists. The jobs will actually say, we need a dermatologist in Texas or Florida or wherever it happens to be, and they'll say in all caps, practice is not private equity-owned. Even not just for patients but for doctors too, this is an experience that they're trying to avoid.

Ricky Mulvey: The second item in the bag of tricks that after that dive, you can go so many places with this conversation, Brendan, the second part of the bag of tricks where private equity companies get returns is sale-leasebacks. I think this is pretty critical as a lot of private equity-owned companies, might be hitting the public markets, including one like Panera Bread. How do these sales and leasebacks work?

Brendan Ballou: In a sale leaseback, the private equity firm will direct the company to sell its underlying assets, the real estate or whatever it happens to be and then lease it back. This happened to a company that I knew very well. I grew up in the midwest and Shopko was this regional retailer. I always say, it's one step above Walmart, but one step below Target. It was a great store and some capital private equity firm bought up Shopko, required Shopko to sell all of its stores and then lease the stores back. Now, that was a problem for Shopko because now it had an unending lease obligation, whereas it used to have these assets that it could hold onto, it could borrow against, and so forth. It was locked into these leases, I think for 15 year periods of time that may or may not have been favorable to them. It meant that essentially Sun Capital got this great infusion of cash. Shopko made this profit from the sales and then, as I recall, Sun Capital actually got a transaction fee, a percentage of the profit from all these sales in addition to the overall profit from selling them. Sale leasebacks are a way to make a quick hit of money in the short term, but they can be a drag on the company in the long term. So when you're talking about private equity firms having their company exit through an IPO, I can't talk about any specific company, but one of the challenges that you've got is they've been taking a very short-term perspective and potentially selling off the company's assets. The company that emerges through private equity ownership, it's not always this case, this way, but sometimes the company that emerges from private equity ownership may just not be as strong or as valuable a company as it was when it entered.

Ricky Mulvey: It's not in fighting shape, and while you may not be able to comment on it, before our conversation, I did look at commercial real estate sites for Panera Bread and right now, if you're an investor with a few million bucks to spare, you can buy a Panera Bread and they will operate a sale-leaseback, right back to you. I think that that's something that investors might want to keep in the back of their minds in the event that Panera goes public through an IPO. One, you have a large section on financialization that I want to hit because I think you brought up a really good point and a risk that I hadn't considered before. Private equity companies in many cases, when we think of Blackstone, Carlyle, KKR, they're making large, opaque, and increasingly risky investments. That is set up what you did argue in the book is systemic risks that may not be realized.

Brendan Ballou: Yeah. I think that there are a couple of challenges that we've got. One is that private equity firms are just vastly less regulated than other parts of the finance industry. After the Great Recession, all the big investment banks converted into bank holding companies which are regulated by the Federal Reserve, have capital requirements, and so forth. By comparison, private equity firms are essentially unregulated. They have to file some forms with the SEC and so forth. But nothing like the level of scrutiny that investment banks have. As a result, they're supplanting investment banks in a lot of areas like private credit, which is this alternative to the stock market and almost by definition is more opaque. There have been a lot of criticisms to the private credit market as people don't actually know the quality of these loans, they're getting syndicated and passed off from one lender to another. It's like a potential housing crisis. Redox, but the challenge that we've got is it's not that these things are inherently more risky. It's that we don't even know what's going on here simply because we don't have the regulations around it yet.

Ricky Mulvey: Well, one of the reasons it may be different and feel free to correct me is that what we just described at the bag of tricks, which they're insulated from the company's falling apart. Therefore at least one explanation could be so let's say they overbought these businesses and a lot of them go into bankruptcy. Maybe it's not a systemic risk because they don't actually own the company.

Brendan Ballou: It's a really interesting question because if there is private equity crisis, the way that there was in investment bank crisis in 2008. It's not going to look the same, it's not going to necessarily be that Blackstone, Carlyle or KKR goes bankrupt. It's that a lot of portfolio companies owned by private equity firms are going to go bankrupt. And it's going to take a couple of steps for people to see, it was potentially because of the tactics that private equity firms executed on them. The debt that they loaded up these companies with, that was the cause of this bankruptcy. So even when there is a crisis and I'm not predicting that there is, it's going to be a challenge for journalists like you to help people understand what role private equity might've played in it.

Ricky Mulvey: Please don't call me a journalist, I'm a talk show guy. These companies though, one way it may be a risk that you mentioned in the book and I forget the exact numbers, is that a lot of these companies that the private equity companies were competing for were bought like peak valuations. And what we're seeing right now in the banking industry, what we're seeing right now in the case of a lot of high-growth tech companies, is that it's taking a few years, but you're seeing the collapse of that higher valuation cycle.

Brendan Ballou: It's really interesting, and I think to your point one, private equity acquisitions are absolutely enormous. PE firms spent over $1 trillion buying companies last year. Two, and this is a really important point, when PE firms do it, they do it with a little bit of their own money, but a lot of it is borrowed money and this is a really key point. It's borrowed money that the portfolio company, the company that they buy that is responsible for pain, not the private equity firms. So when Toys R Us got bought by PE firms, Toys R Us was the one that had to take on a lot of debt for the acquisition. Your point, a wad of these acquisitions happen at a time of very low-interest rates. It was a very easy to get money to buy companies. And now, interest rates have risen dramatically and you're starting to see some shaking in the foundation. But the really interesting part is the real danger for this isn't again, at the risk of being repetitive from the private equity firm. It's from the companies that they buy.

Ricky Mulvey: One thing that you mentioned is that there's a huge risk going on in the insurance market, where private equity companies have been purchasing these insurance companies. That they've been making investments that may have pushed what were previously like, let's say safe investments that would be used with an insurance premium to increasingly risky investments. And that could also have some consequences that the finance folks might want to know.

Brendan Ballou: So it's really interesting, the private equity firms, they need money to buy companies historically they've gotten that money from sovereign wealth funds, pension funds and so forth. But they need more, and so they've turned to investing in or potentially buying insurance companies, life insurance companies annuity companies, and so forth. The reason that you do that if you're a private equity firm, is the insurance company. If you've got a life insurance policy, you pay them every month or every quarter for the policy. PE firms can use that money to fund their acquisitions, to fund their various investments. As you said, there have been accusations by industry observers that really two things are going on. One is PE firms may be using that money for riskier investments than insurers traditionally do. The other thing, and this is really interesting is private equity firms have also been allegedly moving the blocks of insurance policies to affiliated Shell companies offshore in Bermuda. The reason that they do that is the Bermuda Shell companies have lower capital requirements. And so what that means is the insurance company and ultimately the PE firm has more money to play with to invest in their projects. But it also means that there's less cushion if things go wrong. To add one last point on that, really tricky part, a recurring theme in this conversation has been, who's got a responsibility here is. If an insurance company fails, it won't necessarily be the private equity firm that has to pay for it, pay for the policies. Rather they'll get absorbed by what are called state guarantee organizations, which these quasi-government pools of money that state regulators set up. So if an insurance company owned by a private equity firm collapses, it's actually going to be other more responsible insurance companies and ultimately their policyholders that are going to be the ones that have to pay.

Ricky Mulvey: One competitive advantage of these companies that you alluded to is their political connections. And before we get into this part, I think this is not a partisan thing. It happens on every side, which is that private equity companies, one way they've perhaps been able to insulate themselves and gain investment dollars are because they've been so politically connected. Whether it's with the FCC, with prison telephone companies, or with private education systems. Where for-profit colleges are able to get federal funding for online programs with grossly low graduation percentages. Why don't we pick one and maybe describe how these companies have used political connections in order to secure a steady stream of cash?

Brendan Ballou: Sure, so maybe the best way would be to think about surprised medical billing, which is an issue that affects virtually every American. So just to set a baseline surprised medical bill is you go to your doctor, you go to the ER. It's one that you think is a network, but its staff by somebody that's actually added network. And you get, instead of paying $10 or $50 or $200, you're paying $100,000 or something like that. There are a handful of companies that have essentially built their business around doing surprise medical billing, by staffing doctors in such a way that they are guaranteed or likely to bill out these surprise bills. And those companies have been bought by private equity firms. The business model of these companies depends on surprise medical billing, even though that has serious consequences. I think One-in-five Americans fears ruin biomedical debt. There has been repeated efforts to address this in Congress and the power that these companies and their private equity owners, had in the process was just extraordinary. Contributing many millions of dollars to friendly candidates, spending many millions of dollars through these dark money groups to bully senators and congresspeople into voting against reform.

There was a compromise legislation that was nearly ready to go until a private equity firm donated $31,000 to one of the key elected officials who blew up the compromise. Ultimately, some legislation has passed that partially addresses the issue. The challenge is it doesn't actually end surprise medical billing. It just sends it to arbitration and it exempts like a really key industry for Americans and for private equity, which is ground ambulances. I think anybody from our generation is terrified about taking an ambulance because of the horror stories that we've heard. The really surprising part is Private Equity hasn't even stopped with lobbing, even though one enlarged part. As the current administration is considering rulemaking on this, they've contributed many thousands of dollars to elected officials, who have since written to the administration to try to interpret the legislative history in a way that favors private equity. So that's just one of many examples. I'll just say private equity and investment firms have contributed something like $900 million to federal candidates since 1990. So we're talking about just an extraordinary amount of money. And I think it's been extraordinarily effective.

Ricky Mulvey: As we wrap up, many of our listeners are, I think in business school, maybe they're studying finance, marketing and private equity firms. These large ones have become the new investment banks and sort of the most prestigious place you can go after your college or NBA program. Do you have like a don't do drugs speech about working at private equity for them?

Brendan Ballou: Well, I should be clear, my critique of the private equity business model is not a critique of the people in private equity. I've talked to some of them. They've been very friendly and very nice. It's not to say that the people who work in private equity are good or bad, it's that we have a fundamentally flawed business model and flawed incentives that lead to bad outcomes for consumers, for workers, for our economy as a whole. I think for the folks that are starting out their career and thinking about where to go. I think it's a really deep question that you always have to ask about how do I want to spend my time? Do I believe that I'm contributing to society here at some level, it's almost aesthetic and that in my heart, I don't think most people want to spend their day looking at XL. Which is not to say that XL isn't interesting. But I think people want to be figuring out how a factory works. Figuring out how to sell like a beautiful new product, engineering something important, really, building a core part of the economy. I just say for folks that are thinking about this, look broadly, there are a lot of exciting ways to have fulfilling careers in this country.

Ricky Mulvey: One I have to add is that if you're working at a company that was recently acquired by a private equity company, something's probably going to happen, especially if you're in an office job. They're going to say it's not for layoffs, but someone's going to roll in and ask you exactly how much time it takes for you to complete your tasks. Bump that up, and make sure you're working at least 50 hours a week. Brendan Ballou, I am delighted to recommend this book plunder private equity is planned to pillow J.America to our listeners. I found it absolutely engaging. I learned so much from it. Thank you for your book and thank you for your time on Motley Fool Money. Thank you so much.

Chris Hill: As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.