TOPICS > Economy

Potential Risks of Buying Companies on Borrowed Money Examined

July 16, 2010 at 12:00 AM EDT
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As part of his ongoing series of reports on making sense of economic news, Paul Solman looks at what happens when private equity firms use borrowed money to buy companies.
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JIM LEHRER: Now: a second story about the investment business, this on private equity firms and the companies they buy.

“NewsHour” economics correspondent Paul Solman explains. It’s part of his ongoing reporting on Making Sense of financial news.

PAUL SOLMAN: New York City’s Times Square, where tourists still flock, despite a terrorism scare this spring.

But business reporter Josh Kosman is spooked by incendiary devices of a different kind, debt bombs, especially from companies like these that were taken over by private equity firms. Kosman, who has written a book on private equity, “The Buyout of America,” sees a lit fuse almost everywhere he turns, especially in Times Square.

JOSH KOSMAN, author, “The Buyout of America”: Two of the four biggest record companies are owned by private equity firms, EMI and Warner Music. They both have a lot of debt. EMI’s close to bankruptcy.

PAUL SOLMAN: Because it was purchased, says Kosman, with too much borrowed money, as was Clear Channel.

JOSH KOSMAN: They own over 1,000 radio stations [Editor's note: According to SEC documents, Clear Channel owned 894 radio stations in the U.S. at the end of 2009.] and they own a million billboards throughout the world. They are very much struggling.

PAUL SOLMAN: As is another private equity acquisition just around the corner.

JOSH KOSMAN: On 42nd Street, we see AMC Theaters, the biggest movie theater chain in the country. It’s struggling with too much debt.

PAUL SOLMAN: Private equity haunts many a street in New York, including 57th, home to some of the biggest P.E. firms. And they certainly are private, says Kosman.

JOSH KOSMAN: Apollo Management, run by Leon Black, as well as Silver Lake Partners. There is not even a directory in this building. Here is where these guys bring limited partners, pension funds to close the deal to collect money from them.

PAUL SOLMAN: And the pitch is: Give us your money. We will then use that to buy a company, not putting too much of it down. We will borrow the rest. We will spiff up the company. It will be more profitable. We will sell it to other investors. We will all make out.

JOSH KOSMAN: Yes. Most of the country’s pensions are severely underfunded. They need to find ways to increase their rate of return, especially right now, with interest rates near basically zero. So, they get attractive by this pitch.

PAUL SOLMAN: The problem, says Kosman, is that what private equity firms borrow, the companies they buy have to pay back. And, in the last decade, private equity has bought a huge chunk of corporate America.

JOSH KOSMAN: Since 2000, they have bought companies that employ one out of every 10 Americans in the private sector. That’s about 10 million people.

PAUL SOLMAN: And many P.E.-owned, debt-ridden firms are now hurting for cash.

JOSH KOSMAN: The Boston Consulting Group last year predicted half of their companies would default. Let’s say the companies that go bankrupt end up laying off a quarter of their people, a third. You know, you can easily get to more than a million people. That’s a lot of people.

PAUL SOLMAN: In fact, says Kosman, half of the S&P-rated firms that went bankrupt last year, besides banks, that is, were private equity acquisitions, including Chrysler, Simmons, Six Flags, and “Reader’s Digest,” where retirees, including executives, had their pensions slashed by a debt-driven bankruptcy.

Ken Gordon was president.

KEN GORDON, former president, “Reader’s Digest”: I have lost 80 percent of my total pension.

PAUL SOLMAN: Did you ever imagine you might not see that money?

KEN GORDON: Not in my wildest dreams.

PAUL SOLMAN: Same for former editor in chief Ed Thompson.

ED THOMPSON, former editor in chief, “Reader’s Digest”: I lost about $75,000 a year.

PAUL SOLMAN: What was your reaction?

ED THOMPSON: Anger. How could they have screwed up this company to the point where they have to go through bankruptcy

JANE PERSONENI, former head of international advertising, “Reader’s Digest”: When you begin to see these people taking over, it’s like Predator drones are coming in.

PAUL SOLMAN: Jane Personeni, head of international advertising, lost about a third of her pension.

JANE PERSONENI: Am I crying poverty? No, I’m not. But it certainly — it was something I felt I had earned. It was something I thought was going to keep going. And it stopped.

PAUL SOLMAN: Others are near poverty, however.

Stanley Englebardt was a writer for the famous “I Am Joe’s” body part series, including the pancreas.

STANLEY ENGLEBARDT, former writer, “Reader’s Digest”: Although I don’t get big press notices, my role is critical in digestion.”

PAUL SOLMAN: Englebardt lost half his $15,000 annual pension, money he had been using to pay for medical bills resulting from a fall.

STANLEY ENGLEBARDT: Medicare and my supplemental insurance always has a certain amount that they don’t cover. So, they kept doing scans on me of various kinds, and all kinds of specialists were called in, and the bills began piling up.

PAUL SOLMAN: Which, if you had your full pension, you would have been OK?

STANLEY ENGLEBARDT: My pension, I would have been able to take care of it.

PAUL SOLMAN: None of the P.E. firms involved in this story with “Reader’s Digest” or with any other company we have mentioned would agree to an interview. But the Private Equity Council’s Douglas Lowenstein, here on the right, did.

DOUGLAS LOWENSTEIN, Private Equity Council: Private equity is imperfect. It does a lot of things well. And, like anyone else, occasionally, it makes a bad investment. That’s it. It’s that simple.

PAUL SOLMAN: Well, not really, says Josh Kosman. Consider Hugo Boss, the high-end men’s clothing label that epitomizes the costs of private equity, he says, even at a profitable firm.

JOSH KOSMAN: Permira, a London-based buyout shop, bought Hugo Boss in 2007. It paid a very high price for it. The company borrowed more than $2 billion to fund the acquisition. The credit crisis happens. Luxury good sales fall for everybody.

PAUL SOLMAN: Yet, behind the scenes, Permira had paid itself a $400 million dividend out of that $2 billion it had Hugo Boss borrow. As a result, says union president Bruce Raynor:

BRUCE RAYNOR, president, Workers United: They look around to cut costs and they find a factory in Cleveland where they are paying workers the princely sum of $12 an hour. The workers have health care and a pension, a few paid holidays, and can live. And they decide, we can find workers who can make that for less.

MAN: We will fight this fight until we secure and save these jobs.

PAUL SOLMAN: When Permira threatened to shut down the only Boss plant in the U.S., union cameras were there to capture the reaction.

CAROL SHAW, employee: I received the letter, and I was kind of shocked when I read what it said about closing up, because I had no — don’t know what else to do. This is the only job I have ever had.

WOMAN: They don’t care about us. So, and that’s sad.

MAN: Are we ready to fight to save these jobs?

WORKERS: Yes!

PAUL SOLMAN: It is the M.O. of many a private equity firm, says Bruce Raynor.

BRUCE RAYNOR: They leverage a company, put much too much debt on the books of the company, making the company long-term unstable. They take money out of the company. They squeeze the company in ways that hurt it.

PAUL SOLMAN: Not surprisingly, Douglas Lowenstein disagrees.

DOUGLAS LOWENSTEIN: Private equity is like — is like buying a house that needs renovation. You improve it. You strengthen it. You make it a better asset. And then you try and turn around and sell it for more money. That is the essence of private equity. If you do the opposite, you lose money.

PAUL SOLMAN: And, yes, sometimes, the deals work, says Bruce Raynor, as with Blackstone’s purchase of Hilton Hotels.

BRUCE RAYNOR: Debt, in my view, is not, in and of itself, a bad thing, if that — if the borrowed money is used to build the business. It’s when the debt is used to enrich a handful of private equity partners, like in the Permira case, that’s when it’s dastardly.

DOUGLAS LOWENSTEIN: They’re getting those fees for identifying investments that they can make on behalf of their investors that they can invest in, add value to, and sell for a profit. And that requires a significant infrastructure. So, getting fee income for adding all that value is entirely reasonable.

PAUL SOLMAN: But the main danger, says Kosman, is that the firms bought in profligate private equity deals now owe so much, they threaten the economy as a whole.

JOSH KOSMAN: Seven hundred billion becomes due between 2012 and ’15. It’s a lot of money. And in that period, 2012 to 2015, the government is going to have to refinance on its own about $800 billion. Investment grade companies, better rated than these guys, are going to have to repay about $1.2 trillion. So, you have a huge debt wall coming in this country, and these guys will be at the bottom of the list, because these are the companies that are the weakest.

PAUL SOLMAN: But private equity owes just 2 percent of all the debt in America, Doug Lowenstein insists.

DOUGLAS LOWENSTEIN: The economy is dynamic. The economy is improving. As the economy improves, companies are stronger. And these firms are in much stronger shape.

PAUL SOLMAN: But, at least for now, Hugo Boss will still be making suits in Cleveland, because the unions’ Bruce Raynor worked out a deal.

BRUCE RAYNOR: By an overwhelming vote, our members ratified a union contract at the Hugo Boss plant in Cleveland that will keep this plant open and keep the jobs in Brooklyn, Ohio!

(CHEERING AND APPLAUSE)

PAUL SOLMAN: The workers, however, who used to average $12 an hour, will now make $10, $10.20 next year, $10.40 in 2012, while the company continues to pay back the $2 billion Permira borrowed to buy it, for the workers, a costly victory to pay off debt they never incurred.