How Private Equity is Making Your Life More Expensive

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If you feel like everything from your vet bills to your favorite grocery store chains are getting worse at the exact same moment they’re becoming more expensive, there might be a singular explanation: private equity, the industry funneling billions of shadow dollars through the economy.

I dive in with guest Brendan Ballou, author of Plunder: Private Equity’s Plan to Pillage America and former special counsel for private equity in the Justice Department—baby’s first federal investigation!

Disclosure: Brendan Ballou’s views are his own, not the views of his employer.

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Mentioned in the Episode

• The Secretive Industry Devouring the U.S. Economy by Rogé Karma (The Atlantic)

• “Warren Buffet: Private Equity Firms are Typically Very Dishonest” (YouTube)

• Blackstone CEO’s pay in 2023

• Carried interest loophole (finance.senate.gov)

• The story behind Shopko and Sun Capital (Axios)

• “Two and twenty” model (Investopedia)

• The Toys “R” Us Bankruptcy and Private Equity (The Atlantic)

• What happened when a private-equity firm sought to care for society’s most vulnerable (The Washington Post)

• Profiting off prisons (The Boston Globe)

• Blackstone is back to being a top player in the housing market (Fast Company)

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Brendan:

Every person has ambition and a desire to succeed, the desire to make money and so forth. And the great thing about capitalism is if you do it right, you can channel that into a really productive part of the economy. That’s how businesses get built. That’s how innovations get made. The challenges that you’ve got is when you restructure the laws so that all those same ambitions are channeled to sort of antisocial or less productive outputs. And I would argue that’s something that we kind of have with private equity right now.

Katie:

If you spend any time online, you probably hear the word capitalism thrown around as a catchall explanation. To put it simply why more stuff sucks. Now and in more academic strains of these circles, you might hear the word neoliberalism, which is a philosophical approach to capitalism that emphasizes things like deregulation and free markets.

But my guest today, the author of Plunder: Private Equity’s Plan to Pillage America and former special counsel for private equity in the Justice Department would direct your attention to a particularly destructive manifestation of modern capitalism that operates mostly in the shadows: something called private equity or PE.

Private equity is, well, as you’ll see, it’s extremely complicated, but in its simplest terms, it’s a form of investment that uses a combination of private capital and debt to buy businesses and generate returns. That doesn’t sound too sinister, does it? But buckle up.

My guest would probably tell you that it’s not the profit seeking of the public markets with their stringent requirements for financial transparency that are driving a steep decline in everything from nursing home care to veterinary offices. It’s the hundreds of billions of shadow dollars moving through our economy, unaccountable to the reporting standards of public companies, and still often aided and abetted by the forces and funds of government. The PE industry owns more businesses than all the US stock exchanges combined.

According to Rogé Karma’s reporting for The Atlantic, in 2000, PE managed about 4% of total US corporate equity. By 2021, it controlled five times as much.

And I know what you’re thinking. Wow, the sweet little Money with Katie Show of humble Hot Girl Hamster Wheel beginnings is interviewing the DOJ about private equity—baby’s first federal investigation.

So welcome back to The Money with Katie Show, Rich People where we have come a long way in no small part thanks to people like my guest, Brendan Ballou, whose book Plunder: Private Equity’s Plan to Pillage America and others writing titles like his are helping private equity enter mainstream consciousness in a way that is mostly evaded over the previous two decades. You may know it by its former name, the leveraged buyout, which sounds a whole lot more hostile and a whole lot less dignified than its current rebrand.

And Rogé writes, quote, “Private equity funds dispute much of the criticism of the industry. They argue that the horror stories [note from Katie, like the ones you’re going to hear today] are exaggerated and that a handful of problematic firms shouldn’t tarnish the rest of the industry, which is doing great work, freed from onerous disclosure requirements. They claim private companies can build more dynamic, flexible businesses that generate greater returns for shareholders, but the lack of public information makes verifying these claims difficult. Most careful academic studies [another note from Katie here, he’s linking four different academic papers] find that although private equity funds slightly outperformed the stock market on average prior to the early 2000s, they actually no longer do so. When you take into account their high fees, they appear to be a worse investment than a simple index fund.” Put another way, they claim that the secrecy and the lack of reporting requirements allow them to be more nimble and more creative, but these claims are hard to verify. What isn’t hard to verify are the negative consequences in owned businesses that run the gamut. 20% of large companies acquired through leveraged buyout go bankrupt within a decade, a rate that is 10 times higher than the 2% of comparable companies not acquired by PE firms that do. Or take for instance…

Warren Buffett:

Between being a great analyst or being a great salesperson, the salesperson is the way to make it. If you can raise $10 billion in a fund and you get a one and a half percent fee and you lock people up for 10 years, you and your children and your grandchildren will never have to do a thing if you are the dumbest investor in the world.

Katie:

That was the voice of one Warren Buffet describing in about 20 seconds why the PE model is so lucrative for those running these funds, even if they’re “the dumbest investors in the world.” I love that this man does not mince words, but it all comes down to two things, really, how fund managers are compensated and what they are incentivized to do.

So we’ll get right back to it after a quick break.

If I had to boil it down to its simplest problem, PE firms are not rewarded more when the businesses they invest in do well, because good performance is not a prerequisite for them to make a lot of money. In fact, in some more paradoxical cases, they actually stand to make more money when the business fails, which probably doesn’t seem possible to those of us accustomed to investing our money in publicly traded companies. But when you’re primarily taking a cut of the overall investment dollars you are managing and you’re using leverage, you’ll hear from Brendan today how their predictable playbook enables these perverse incentives to take place in practice. This means they’re often incentivized to prioritize incredibly short-term thinking for the purposes of “extreme value extraction” without concern for the long-term ramifications to a business or its employees.

I, for one, always associated the field with high paying, high profile, high-minded finance like investment banking or venture capital. But PE makes investment banking look like nonprofit work. Jamie Dimon, the CEO of the investment bank, JP Morgan, earned a reported $36 million in 2023. Not bad, but mere pocket change compared to what the CEO of the PE firm Blackstone reportedly earned in the same year: $896 million, compared to 36 million, which was actually a pay cut from the year before when this man took home $1.27 billion. And as if that is not gnarly enough, consider that through the carried interest exemption loophole, which is a little piece of the tax code that allows certain investment professionals to claim that their income is actually capital gains, not wages. The vast majority of that income, that billion dollar pay was taxed at a top marginal tax rate of just 20%. So where’s all that money coming from? Well, we’ll get to that.

Because while you’ve probably never heard of the major players—Carlyle, KKR Apollo—you’ve almost certainly engaged with businesses they own if you’ve ever rented an apartment or purchased health insurance. In fact, you are indirectly engaging with private equity right now. Money with Katie is owned by Morning Brew, which is owned by Business Insider, which is owned by Axel Springer, which is owned by the PE firm, KKR. So that’s awkward.

The funny thing is when I joined Morning Brew, I knew they had been bought by Business Insider, but I was extremely naive to the media environment and the broader business environment in general. I didn’t know that Business Insider was owned by another company that was ultimately primarily owned by private equity. In fact, when I joined, I didn’t even know what private equity was. It was actually a listener of this very show who pointed this out to me.

With that said, please welcome my guest, Brendan Ballou, author of Plunder and former special counsel for Private Equity in the Justice Department’s antitrust division to the show.

Brendan:

Thank you so much for having me here. I should say at the outset, of course, that I’m speaking in a personal capacity and not necessarily on behalf of my employer,

Katie:

I want to begin our conversation with a Midwest grocery store chain called Shopko that filed for bankruptcy in 2019. Can you tell me about how it went from being this sort of beloved regional institution that had been around since the sixties to basically knocking on death’s door?

Brendan:

So Shopko, as you alluded to, was a fairly beloved regional retailer where I grew up in the Midwest. It was sort of one step above Walmart and one step below Target. So it filled a lot of needs in your life. I think it actually was something of a retailing pioneer. I think it was the first big box store to have an in-store pharmacy and things like that. So it was a good chain.

In the mid two thousands, Shopko was bought up by the private equity firm, Sun Capital, and then Sun Capital executed a number of tactics that I think are fairly familiar to people that observe the industry. So one thing that it did was it required Shopko to execute what’s called a sale leaseback. And what that means is, Shopko used to own all of its stores. If you’d walk into the store, Shopko would own that building.

Sun Capital said you actually have to sell those stores and lease it back to yourself. And the reason that you do that is it gets you a quick hit of cash as a business, but now you’re suddenly required to pay every month for something that you used to own, and that’s especially important or especially troublesome if you’re in the retail industry.

So Sun Capital executed the sale leaseback. They also executed something that are called transaction fees and management fees. So fees that Shopko had to pay simply for the privilege of being owned by the private equity firm, and ultimately the private equity firm required Shopko to start doing layoffs. As the business started to spiral, those became more and more until the company functionally ceased to exist. It’s unfortunate because as far as I know, there wasn’t a deep underlying flaw in the Shopko business model, but because of as has been reported, the private equity firm’s actions, it seemed to extract an awful lot of assets from the business.

Katie:

There is something about this model that I think this story highlights so well is that it kind of defies common sense. You would think, oh, if you’re going to buy a business, you want that business to succeed and that in order for you to be successful, the business would have to succeed. But you point out that there is this observable, predictable pattern in the way that private equity will purchase businesses, load them with debt, extract out the existing value, sell them, and then turn a profit. So can you walk us through what I’ll call the standard private equity play by play; what you noticed and how they tend to pull this off?

Brendan:

So just to set a baseline, what is private equity? Private equity firms use a little bit of their own money, some investor money, and a lot of borrowed money to buy up companies. They then try to make financial or operational changes with the aim of selling them for a profit a few years later. As you alluded to in your question, private equity firms use a lot of debt to buy up these businesses, and curiously, it tends to be the company they buy rather than the private equity firm that’s primarily responsible for paying down that debt. It’s a little bit like getting to use somebody else’s credit card. That’s one of the core challenges that you have in the private equity business model, which is the private equity firm buys the business, but the company is the one that’s responsible for paying down the money that it took to buy the business.

Another problem that you’ve got is that private equity firms tend to invest for a very short period of time, two years, three years, five years, and so forth. And how long you invest in something changes your perspective on it.

I always say if I was trying to maximize the value of my apartment over 20 years, I’d redo the kitchen. If I was trying to maximize the value over two weeks, I would try to burn it down and collect the insurance money. How long you own something changes your perspective on it.

And then the third thing that gets to your question is that private equity firms are extremely good at insulating themselves from liability when something goes wrong in the companies they buy. And so what that means is they have control over the business, but if something goes wrong, generally they can walk away.

When you combine all of those problems, reliance on debt, short-termism, insulation from liability, you have a sort of “heads I win, tails you lose” sort of situation in private equity, where private equity firms benefit financially when things go well at the companies they buy, but can generally walk away when things go poorly.

One final point here is I want to be clear, not every private equity firm and not every private equity deal ends in disaster. Only a certain percentage of them do, but enough of them do that. I would argue that there might be some structural problems in the business model that lead to these bad outcomes.

Katie:

Totally. And you hit on this a little bit, but there is one thing that strikes me as really odd about how these deals are structured, that the company being purchased, not the PE firm, is on the hook to pay back the debt that the PE firm takes out to buy them. Why would a business agree to those terms? It feels like there’s only downside here. So I’m curious what put a business in that type of position?

Brendan:

It’s a really good question. It’s sort of the magic trick of the private equity business model that you can buy a business, but you don’t actually have to use your own money to do so.

So why would somebody do this? I think that there are reasonable reasons to do it, and then I think that there are less reasonable reasons to do it. The reasonable reason would be that you really believe in the private equity firm that’s buying. You believe that there’s going to be better management, more access to capital, more access to other portfolio companies. You think you’re buying into sort of a network that’s going to work for you if you’re the business that’s selling to the private equity firm.

The other thing that’s important to remember here is that executives at companies that are bought by private equity firms are often compensated in large part with stock or equity in the company. And so when you have a buyout, that’s a big cash payout to all the stockholders. And so in a sense, this is a situation where executives at a company might benefit tremendously by the deal, whether or not that’s in the long-term interests of the company itself.

Katie:

That makes a lot of sense. I was just with a co-host that—I do a show about entrepreneurship with, and we were interviewing somebody whose company had just been purchased by private equity, and I was like, I’m doing an interview on Friday about this that is going to be very interesting. And she kind of made an offhanded comment like, well, if you’re taking PE money, you’re probably doing it. You need the money. You’re a founder that has no other choice anymore. And I thought that was really interesting.

But this other component of the deal structure that you highlighted is about these extractive fees. And I like the way you put it because you say these are fees, management fees that the business has to pay the firm for the privilege of being owned by them. And I think it gets at this point that it’s not like the PE firm really needs that business to be successful in order to make money on the deal. And in some ways, the success of the companies that they purchase is actually kind of irrelevant. So can you lay out for us how the typical PE firm would make money in a deal like this? How do they get paid?

Brendan:

So the ordinary compensation for a private equity firm is what’s called the two and 20 model, which you might’ve heard of in investment banking. It means that they get 2% of all the money that they manage, the money from pension funds and sovereign wealth funds that they’re going to use to buy businesses. They get 2% of that every year, and then they get 20% of the profits from the companies that they buy after they reach some sort of threshold.

So there is an incentive to make a company profitable, but as you suggest in your question, there are other ways that private equity firms get compensated. Like we said, there are transaction fees, which is a fee that you get when the portfolio company executes a big deal or sells off assets and so forth. Management fees, which are fees you pay every quarter or every year to the private equity firm just because the private equity firm owns you.

And the really important thing to remember here is the private equity firm only gets 20% of the profits of the company, but it gets 100% of the fees. And so that kind of creates a soft incentive to extract money quickly out of the business whether or not that helps with the long-term profitability of that business.

Now, I want to be clear, not every private equity firm is maximally extractive. I’ve seen a lot of different tactics for different private equity firms, but the challenges that we’ve got is the laws that we’ve got around debt, around investment horizons, around insulation from liability, incentivize, ultimately, I would argue somewhat more extractive tactics.

Katie:

Yeah, that makes sense. I mean, the incentive structure certainly seems like you would be fighting against the human nature and greed the whole way because if you can get away with it, and that’s what your investors want, I mean it’s on individuals to not kind of go down that route.

Brendan:

It’s a really good point that you make, which is every person has ambition and a desire to succeed, the desire to make money and so forth. And the great thing about capitalism is if you do it right, you can channel that into a really productive part of the economy. That’s how businesses get built. That’s how innovations get made. The challenges that you’ve got is when you restructure the laws so that all those same ambitions are channeled to sort of antisocial or less productive outputs. And I would argue that’s something that we kind of have with private equity right now.

Katie:

We’ll get right back to this conversation with Brendan after a quick break.

I want to talk about the executives and the differences in outcomes because you write in the book about Toys “R” Us and I found this story particularly sad. They were sent through by the PE firm that purchased them, one of these what we’ll call strategic bankruptcies, and the employees who were promised severance pay to work through the holiday season ended up getting treated as unsecured creditors in the bankruptcy, which means that they were basically given a pittance. They got, I think you reported $60 each. What was notable about what happened to Toys “R” Us? Can you break down a little bit of an explanation of the varying outcomes in a deal like that one?

Brendan:

What was notable to me or what was surprising is if you’re a millennial, you remember Toys “R”Us, there’s the jingle about being a Toys “R” Us kid and all this kind of stuff. It’s part of our childhood. And I think before I started researching this and learning about it, I sort of thought that Toys “R” Us was just swept up in the e-commerce wave, that it wasn’t able to adapt. Amazon beats it. It’s just a story of old businesses dying and new ones replacing them. I think that is part of the story, but in fact, Toys “R” Us was profitable, I believe up until the final years of its operation after it had been bought by private equity firms and was making a pivot to online retailing until it was bought up and ended up having to spend several hundred millions of dollars every year just servicing the debt that was used for the private equity acquisition of the business. And so what that meant is the private equity purchasers had saddled the company with so much debt that it was hard for it to pivot to the next generation of toy selling.

Now to your point about the employees, I think this was a really tough story. As you said, it was publicly reported that many of the employees were treated as unsecured creditors and got as little as $60 for their time working there. At the same time, it was at least alleged in civil litigation, although I believe it was settled privately that the executives paid themselves several million dollars immediately before the bankruptcy filing. And that’s something that’s generally something you’re not supposed to do in bankruptcy.

And again, I want to say that these are mere allegations. They were in a civil lawsuit. We don’t know what the ultimate conclusion was, but it was alleged that the CEO in fact lied to one Toys “R” Us employee about whether or not he would be getting severance. She emailed him expressing her distress about her stores closing, and he said that he would not be getting extra compensation, at least as alleged that was false. So I think that that was a situation where the private equity acquisition of the business really prevented toys us from pivoting into the modern era. And the people who ultimately suffered weren’t the executives, it was the lowest level employees.

Katie:

That also occurs to me as a bit of a pattern. It’s sad, it’s really sad what happens to longtime employees of these businesses. And I think it becomes even scarier when we are not talking about toys. We’re talking about healthcare, nursing, home care, animal care. You open the book with a story about a nursing home chain called Manor Care, and I would love to hear a little bit more about why that story jumped out at you enough to be the opening anecdote in the book.

Brendan:

Yeah, this was a story that I think captured a lot of the problems with the private equity business model. So Manor Care was once the second largest nursing home chain in the United States, and in I believe 2007, it was bought by the private equity firm, the Carlyle Group. Carlyle then executed several of the tactics that we’ve been talking about, sale leasebacks, cutting staff and so forth.

And health code violations at the nursing homes started to spike at least one resident died in a facility because of alleged understaffing as alleged and subsequent complaints, a woman had to go to the bathroom by herself, she fell, hit her head on a bathroom fixture ultimately died of subdural hematoma.

But when her family sued Carlyle for wrongful death, Carlyle was able to get the case against it dismissed saying that it was not the technical owner of the nursing home chain, rather it merely advised a series of funds whose limited partners through several shell companies owned the chain, and that was enough to get the case against it dismissed. And I think that that’s an important story because it shows how a private equity firm can often execute operational control over a business, but when things go badly at that business, oftentimes they can walk away.

Katie:

It’s so bleak. It is so freaking bleak. The vulnerable population targeting, I’m going to say, I’ll call it targeting, you’re an attorney so you don’t have to call it targeting, but there is a bit of a pattern of focusing on businesses that sell things to poor and or vulnerable people as opposed to rich ones because as I think you noted in the book, well, poor people don’t really have a recourse. If quality declines, they can’t really go somewhere else. And so this goes even for the incarcerated population, which is a truly captive customer base in the most literal sense. Can you share more about what you found about presence in prisons?

Brendan:

Yeah, that was something that really surprised me, and it goes exactly to what you were just saying is when I started this project, I really thought that private equity firms would primarily target industries that service the rich because that’s where the money is. But in many examples, it seemed that they focused on industries that targeted the very poor for exactly the reason that you said, which is they are often a captive audience. You can raise prices or cut the quality care without consequence.

And so you see a lot of private equity interest in nursing homes in for-profit colleges, in mobile home parks, and as you say in prisons, prisons is one of the areas where I think the private equity business model reaches its most extreme form. Private equity firms have bought up prison phone companies, so the companies that incarcerated folks use to call their families or lawyers, they bought up prison cafeterias and commissaries prison healthcare services and so forth.

And these stories have been pretty extraordinary. When you’re talking about prison phones, you have 15 minute phone calls that can cost $15 or more when you’re talking about prison commissaries and cafeterias, you have allegations of people eating dirt covered food and meat that is literally labeled on the box not fit for human consumption.

When you’re talking about healthcare, you have stories about one incarcerated woman having to give birth by herself in her prison cell because of an understaffed or indifferent hospital staff ultimately employed by a private equity firm. And so I think that prisons are the most extreme form of the private equity business model, but I would emphasize that those same tactics that lead to bad outcomes extend to all the other kinds of businesses or at least many of the other kinds of businesses that we’ve been talking about.

Katie:

You describe the playbook as this twining of big business, and this is the part that surprised me, big government that finds profits by creating and exploiting legal gaps in obscure government programs. So in other words, it’s not just an exploitation of people in these very vulnerable situations, but it can also manifest as a siphon of government resources as well, which as we know belong to the public government. Resources are the people’s resources, because the government gets their money from us. Can you give me an example of how something like this might happen?

Brendan:

Sure. A couple of points. I always say the challenge with the private equity business model is not the people in private equity, it’s the laws and regulations that surround it. And I always sort of say lawyers like me tend to invent bad business models every 20 years. Right now, I’d argue it’s private equity. 20 years ago it was subprime lenders; 40 years ago was savings and loans; 60 years ago was conglomerates; 100 years ago, it was trust. It’s just something that we do and I think one of the interesting things about how that happens is private equity firms have been really successful less in operating businesses and there have been success stories, but a lot of failures, but more in developing the laws and regulations in the industries that they buy to their benefit. One of the most extreme examples, or one of the examples in which they’ve been most successful has been the obscured carried interest loophole.

Now, that’s a very boring phrase, but what it is is it basically means that private equity executives typically pay lower tax rates than certainly I pay, most middle income people pay, and there has been a 15 year bipartisan effort to try to eliminate the carried interest loophole. Barack Obama campaigned against it back when he was a US Senator and tried to end it when he was president. President Trump actually tried to end the carried interest loophole and President Biden did as well. All three have been unsuccessful. It speaks to the extraordinary power that private equity firms have when it comes to lobbying.

A final point on that is one of the really interesting things is that private equity firms have just been really good at bringing in some of the most successful people from government to work for them. Whether you’re talking about former Secretaries of the Treasury or State, former Secretaries of Defense, a couple of Speakers of the House or Vice President, all of these folks really come to private equity, and I think that sort of political firepower has certainly shown to be successful in all these sorts of debates.

Katie:

Yeah, that’s so-called revolving door. There was another example…I think the carried interest when I heard about that, I learned about it for the first time I think sometime last year, and I was stunned that that is a thing. The other really egregious example or use case that you highlight in your book is the Pension Benefit Guarantee Corporation. This government agency that is supposed to step in and clean up the mess if something goes horribly wrong so that employees who are supposed to have pensions don’t totally lose everything. And the way that that has been manipulated in these strategic bankruptcies and these very extractive kind of, I’m going to go in and surgically get the value out and I’m going to leave the Pension Benefit Guarantee Corporation as kind of the bag holder.

Brendan:

So the Pension Benefit Guarantee Corporation, basically probably the easiest way to get at this is through a story. So Sun Capital, which we were talking about earlier, which bought up Shopko, also bought up the diner chain Friendly’s, which was the sort of iconic diner chain in the Northeast that started during the Great Depression. It was these two brothers that started it in Massachusetts. They grew it into this national chain and it was ultimately sold to this private equity firm.

Ultimately, the business collapses under private equity ownership. Sun Capital pushes it into bankruptcy, but Sun Capital does this really interesting thing in bankruptcy, which is Sun Capital doesn’t just own Friendly’s, it’s also Friendly’s largest lender. And the reason that you do that is in bankruptcy generally the owners lose power and the lenders gain power. And so if you’re both the owner and the lender, sun Capital was able to sell Friendly’s from itself to itself, which is this weird sort of move, why would you do something that complicated?

Well, the reason that you do it goes exactly to the organization that you just mentioned, the Pension Benefit Guarantee Corporation, which guarantees the pension benefits of insolvent plans. And what this meant was that Sun Capital was able to keep control of Friendly’s, it kept owning the company, but was able to push off all the pension obligations that it had to employees and retirees and so forth onto the Pension Benefit Guarantee Corporation. And so I think it’s another example of where private equity firms are really good at using or pushing laws and regulations to their financial benefit, even if the businesses are hurt, even if customers are hurt, even if employees are hurt.

Katie:

And so you would think or so I thought. I go, oh man, well, these poor people with pensions and the poor taxpayers that are having to pay out these pensions that the business should have been paying, that is instead going to billion dollar compensation packages for the leaders of PE firms. There is a big complication here, which is that pension funds are some of the largest investors in private equity, and when I heard that, I immediately pictured a snake eating its own tail. Tell me more about this. Is this a closed system?

Brendan:

Yeah, it’s really interesting. I think that it’s potentially self-destructive in a couple of different ways. So one is exactly what you just mentioned, which is private equity firms buying up businesses and then pushing off pensions onto these quasi government agencies, and at least one Harvard study suggested that this had happened at least 50 times over a 15 year period. So it’s not uncommon.

Another way in which pension funds may be undermining themselves by investing in private equity is that most pension funds, many pension funds are union pension funds. They’re the pension funds of teachers, firefighters, government employees and so forth. Sometimes private equity firms buy up businesses with the explicit goal of engaging in anti-union activities. So there are a couple examples of private equity firms being funded by pension funds and then using that exact same money to engage in union busting.

I think that there’s one final area where pension funds kind of have a snake eating its own tail sort of aspect to it, which is the more research that comes out suggests that private equity firms might not actually be that good of an investment, at least for these pension funds.

So the promise of private equity has been that you would get higher returns than investing in the ordinary stock market, but there’s new academic research out there that suggests that when you factor in all the different kind of fees that we’ve been talking about, private equity firms might not actually be that good of a deal for the pension funds. So I think that there’s a lot of different ways in which pension funds might actually be getting hurt by private equity.

Katie:

I know our audience is one that’s really interested in home ownership, which is an area where private equity has created a lot of disruption and I think more public disruption, more people are aware of it. You’ll see memes about, oh, Blackstone buying its millionth single family home, and it’s a bit of a side door for getting the general public interested in this and going, well, wait, what are these firms? What are they really doing? Why are they buying up a bunch of homes? Can you walk us through the landscape of PE in real estate?

Brendan:

Of course, and this is such an important story because I think private equity firms have really helped transform the nature of home ownership in America. So after the 2008 financial crisis, the primary federal regulators, Fannie Mae and Freddie Mac, started selling off foreclosed homes, but they didn’t sell them individually. They started selling them in large tracts that only big investors could buy, and those big investors, by and large, were private equity firms. This really changed everything before the great financial crisis.

I don’t think there was a single company in America that owned more than a thousand residential homes by the mid-2010s, Blackstone was buying as much as a thousand homes in a single day. It was absolutely extraordinary. What that means is that really whole cities and neighborhoods have been transformed because oftentimes these private equity firms are not aiming to improve the homes and then sell them again.

They want to buy the homes and then turn them into rentals, and so that reduces the housing stock in a lot of different communities. It turns a lot of would be owners into renters, and it also kind of changes the politics of home ownership.

One of the interesting things that I saw was Blackstone spent several million dollars lobbying against new laws in California that would extend tenant protections to residents in single family homes. And so what you see here is that combining assets through having these sort of larger and larger landowners, they’re also able to accumulate political influence. And I think that ultimately is to the detriment of renters, and I think it’s to the detriment of homeowners and it’s largely because of private equity.

Katie:

It’s so funny, you mentioned something earlier about when capitalism is done correctly or when you’re channeling that ambition in a positive way, it leads to productive capacity in the economy and that it can be a good thing. And I appreciate that you highlight the fact so explicitly that private equity is, in your estimation, actually bad for capitalism. That is to say, even if you are a listener who is as competitive and cutthroat and pro capitalism as they come, you are the biggest fan of free markets, you wear it on a T-shirt under all your clothes, you should also be very wary of PE’s effects on the economy. Why is that? Is it because it has a kind of distortive effect? Is it because it’s making things worse? Talk us through what you would tell someone who’s a little bit skeptical.

Brendan:

It’s a great question. So private equity firms and their lobbyists tend to describe themselves as an extreme form of capitalism, and they mean that as a compliment; that they are heat seeking missiles for profit. I think that would be fine if it were true. The challenge that we’ve got is that private equity is less an extreme form of capitalism and more, I would argue a perversion of it.

And it goes to those fundamental problems that we were talking about, about reliance on debt, short-term thinking and insulation from liability. In a working free market, if a person controls a business, they should be responsible for what happens in that business. But the way that we’ve structured our laws right now, oftentimes that isn’t the case. And so you’ve got a system where private equity firms, that’s because of who runs them and more because of the laws and regulations that surround them.

These firms are able to capture the benefits from these businesses that they buy, but walk away from the detriments. And so I think it’s a challenge of really just changing our laws as we’ve done in the past. Like I said, we keep inventing bad business models and hopefully we fix them eventually. It’s a matter of changing our laws that we align incentives, right? Because it’s good that people have ambition. It’s good that people want to use build businesses and innovate, but we need to have our laws and regulations structured so that all that ambition is channeled in productive ways rather than unproductive ones.

Katie:

And I think we’ve really thoroughly explained how and why and when things go wrong. I’m curious in your mind, does private equity have any redeeming qualities? I feel like this breakdown, we have painted a clearly predatory and extractive system. Are there any instances that you are aware of functioning in a way that is a net benefit to society, and what role do you think that it should be playing here?

Brendan:

Yeah, absolutely. So there are certainly examples of private equity firms buying up businesses that then succeed. The academic research out there suggests that about one in five private equity owned businesses go bankrupt, which means that four out five don’t. That said the same research says that only about two in a hundred regular businesses go bankrupt over the same period of time, so it’s about 10 times as likely that a private equity owned business is going to go bankrupt than a non-private equity owned one.

I think the challenge that we’ve got is really figuring out how to get private equity firms to take responsibility for their actions and to think for the long term. There are examples of this happening. One example that I was looking at was a private equity firm that bought up a timber mill that had been shut down, invested for the long term, used equity rather than debt, stayed involved in the business, helped to revive not just the timber mill but the town that surrounded it, which is a great success story. We need more of those, but the way that we do that is by fixing the gaps in our laws and regulations, not by simply hoping that people change their basic human nature.

Katie:

And you do a really good job, I think, of leaving us with a message of hope and a lot of books like yours, I think they’re often not written by people that are so close to the laws and regulations and to the government side of things, and so it’ll lay out a really clear case for what’s wrong, but it kind of struggles at the end to be like, so what do we do about it? And you lay out point by painstaking point, government agency by government agency, here’s what we could do to rectify all the wrongs from the SEC, to the FTC, to the Consumer Financial Protection Bureau, the Department of Labor. At a high level, how you would describe the major chess pieces that kind of would need to be moved into place…if you had a magic wand and you can pick three, what are you doing?

Brendan:

It all goes back to those basic flaws. How do you get private equity firms to think for the long term, to use less debt, to hold themselves responsible for their actions? There are things obviously that Congress could do to fix those three basic problems. There are things that federal regulators could do, whether like you said, it’s the SEC, Federal Reserve, Treasury, and so forth.

But I had also emphasized that there’s an opportunity for action at the state and local level states should be thinking about are there certain extractive tactics that private equity firms engage in that we won’t allow in our state, or if we allow and something goes bad, we’re going to hold that private equity firm responsible. In a world where you’ve got a divided Congress where it’s hard to pass bills and so forth, I think cities and states can be thinking about this and really protect the people that live there and help make a better economy.

Katie:

What about at the individual level? Maybe a listener who is sitting in their car right now going, oh my God, the hospital that I work for is owned by private equity and I’m seeing some of this stuff happen in my own workplace or in my own industry. How do you direct individuals who might be interested in advocating for changes?

Brendan:

And I think it can be so hard for people listening to this sort of thing. It can seem like such an overwhelming problem. It’s omni the presence, so it’s hard to figure out what can I focus on? I’d suggest that the first thing people do is try to get informed about what’s happening in the industries that you care about.

There are a number of organizations that are doing great work on this, whether it’s the Private Equity Stakeholder Project, Americans for Financial Reform, the American Economic Liberties Project, Google, any of them get on their email list. It’s a great way to learn about this stuff.

To the extent that you’re seeing specific problems in an industry…I’m not a hard guy to reach. You can always find me on Twitter or LinkedIn, but I probably speaking in a purely personal capacity probably can’t be terribly helpful, but I can at least try to give you some advice for somebody who can be. But it’s really great when people are engaged on this stuff because ultimately this will fix this industry because people want it to be fixed.

Katie:

That’s incredible. That’s a very generous thing of you to offer. And to round us out, I know that you had mentioned that there is new research that shows maybe this investment isn’t actually the good of an investment in your estimation with the current climate and the current interest rates, I mean, do we think that things are shifting a little bit just by nature of the fact that it is more expensive to borrow money now and people are kind of starting to look at this model and go, is the wool being pulled off of our eyes?

Brendan:

It’s really interesting. I think you’re exactly right in that higher interest rates are changing the business model in that the whole business model works only if it’s really easy to borrow money to buy up these businesses. And that’s changing, and you’re seeing a lot of news reports about private equity firms struggling in this environment, but you’re also seeing news reports about private equity firms pivoting into new businesses like private credit. And so I think that the big private equity firms are innovating to go beyond private equity. They don’t even call themselves private equity firms anymore. They’re alternative asset managers. And so I think private equity unquote is going to evolve in lots of new ways, and it just means that we’re going to have to write a second book pretty soon.

Katie:

Speaking of, before you go, I noticed that you dedicated your book to your mom.

Brendan:

Yes.

Katie:

Why is that?

Brendan:

My mom was a community organizer in St. Paul, Minnesota, and she was a single mom and helped to agitate to make sure that people couldn’t lose their heat in the Minnesota winners if they couldn’t pay for it. So that seems like a pretty good reason to dedicate a book to her.

Katie:

I love it. My heart just swelled six sizes. Thank you. Thank you so much for being here. This was truly a pleasure.

Brendan:

Thank you so much. I am really grateful for the time.

Katie:

That is all for this week. I will see you next week. Same time, same place on The Money with Katie Show.

Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact checking comes from Kate Brandt.