Naked Capitalism’s Private Equity Trust-Busting
By Nanea, who has been in and around private equity
Almost ten years ago, I approached Yves about publishing some posts on private equity. I’d chosen Naked Capitalism because Yves had almost single-handedly kept foreclosure fraud abuses from being swept under the rug. And she had done that as a finance insider turned journalistic guerrilla warrior. She kept persistently explaining how various schemes worked, how officials were trying to bury problems or worse, assist bankers rather than homeowners. And Yves unpacked the ruses so they were accessible to laypeople, not just readers but also important influencers like Congressional staffers, regulators, and business reporters.
If you value this special combination of expertise and tenacity, please go to the Tip Jar now. I’m going to use this post to depart a bit from the usual fundraiser format to continue in the Naked Capitalism tradition of educating readers and the public about the mechanics of financial chicanery, in entertaining if often excruciating detail.
Forgive me for taking a victory lap. Yves was keen about learning about the institutional investing side of private equity and recognized how opaque that was, and further knew well that opacity and complexity are fertile grounds for mischief. These first posts were tutorials to get readers down the curve. I still consider my first, Private Equity: A Government Sponsored Enterprise, to be prescient while also describing the incestuous relationship between private equity firms and their biggest backers, US public pensions funds like the now-notorious-at-Naked-Capitalism CalPERS.
I want to reprise and update some of the points in that post to inform readers but also to underscore how Naked Capitalism offers information and perspective about important but mystifying topics like private equity, an undertaking that the mainstream press shies away from even though private equity firms have emerged as the equivalent of modern day trusts. So if you appreciate this sleuthing, the Tip Jar beckons!
At the time (2012), I was focused primarily on the role that government pension funds play as the dominant source of capital for private equity funds. More recently, we’ve seen the label’s aptness in describing how private equity companies snatched for themselves tens of billions in bailout money from the federal government during the COVID pandemic.
Similarly, the last three Treasury secretaries, starting with Tim Geithner, all joined or founded private equity firms since leaving office (and we should note how, from the moment he joined the Obama administration, Yves pegged Geithner as a man-on-the-make). Retired general David Patreus is on the payroll of KKR, and admiral James Stavridis works for Carlyle, both firms of which are among the largest private equity organizations. Somewhat unbelievably, the CIA itself runs its own private equity shop these days.
Glenn Youngkin, the just elected governor of Virginia, spent most of his career as a major private equity executive, as did Bruce Rauner, the governor of Illinois until a few years ago, as did Mitt Romney. And to be clear, it’s reasonable to assume that all these individuals walked away from their private equity careers with at least $100 million in the bank, if not much more. That particular revolving door spins the other way as well. For example, Deval Patrick, who succeeded Mitt Romney as Massachusetts governor, now works as a senior executive at Bain Capital, Mitt’s old private equity firm.
Back in 2012, investor interest in private equity seemed like the continuation of a trend toward overheating, with $110 billion raised that year in the U.S., predominantly from government pension funds. By today’s standards, 2012 seems like the industry’s salad days, with almost exactly triple that amount ($332 billion) raised in 2019, the last pre-pandemic year. Again, more than almost anyone in the financial press, Yves, through her coverage of CalPERS has documented the hell-bent determination of pension funds to throw money at private equity, almost no matter what the consequences.
Not surprisingly, returns are struggling, as academic study after study (see here and here for some of many examples) has concluded that private equity hasn’t outperformed public equity in more than a decade, and the studies have found that it’s been even longer since the returns were high enough to compensate for the strategy’s riskiness. Yes, you’ve seen this point made in Naked Capitalism posts if you’ve been paying attention. The broader world, however, remains in deep denial about that reality.
For example, almost all institutional investors in private equity (and there are effectively no non-institutional investors) claim to be an exception to this mediocre performance. This is the finance industry equivalent of a bunch of kids locked in a room with a plate of cookies, and all of them professing innocence when the cookies somehow disappear. Somebody’s lying. The FBI has finally taken notice in one prominent case where a large government pension fund has been caught overstating performance, a scandal which, again, has gotten virtually no national attention other than on Naked Capitalism.
Private equity’s ever-weakening performance is unsurprising in light of investors’ willingness to keep raising the stakes by allocating larger and larger portions of their assets to the strategy. Demand keeps going up while supply of attractive companies to buy remains relatively fixed. One consequence has been the necessity of private equity funds paying higher and higher prices for assets. For example, at the time of my original article in 2012, the average U.S. private equity deal was priced at what seemed then like a very rich earnings multiple of 8.6 (EV/EBITDA). At the time, these seemed like nosebleed levels. Yet, in 2019, the same measure stood at 14.6 times earnings, an all-time high.
How does the market for private equity assets support these sky-high prices? Increasingly, private equity managers are trading assets primarily among themselves. This stands in contrast to the traditional practice of bygone days where most successful deals would exit the private equity ecosystem upon sale either to a corporate acquirer or to the public via IPO.
In other words, in the old model, private equity was a “phase” that some companies went through during their development, a phase that was temporary and could be rough on workers and communities but that most typically resulted in the company emerging into a stable ownership structure, no longer at the mercy of owners seeking financial returns at the expense of all else.
However, increasingly, corporate and public investors are skeptical about companies’ health after they have spent time in the hands of private equity owners. As a result, private equity firms often are forced to sell their investments to one another, thus acting as a sort of mutual support club for the sky-high valuations of private equity assets. In fact, by 2018, other private equity funds had become the most common buyer of private equity fund assets, eclipsing IPOs and corporate strategic buyers.
In the last several years, this passing around of investments within the private equity industry has reached new heights of perniciousness, as there has been a collapse of the old taboo against private equity firms selling assets from older funds they manage to a newer fund they also manage. In the past, such transactions were heavily frowned upon given that the PE manager inescapably acts in a highly conflicted role, as both seller and buyer in the same deal.
But now, in an effort to keep the party going, institutional investors in private equity have started routinely acquiescing to such conflicted transactions. And how, by the way, does the world know that traditional private equity contracts frowned on transactions between two different funds sponsored by the same PE fund? Once again, the answer is Naked Capitalism, which maintains quite literally the world’s only non-secret database of private equity investment contracts available for public scrutiny.
Blackstone, the largest private equity firm, has been among the most aggressive in moving assets between funds it manages for totally self-serving reasons, and it’s worth offering some details as an example of the kinds of chicanery that occur routinely.
Blackstone owns a suite of businesses that exist to provide services to the real estate properties owned by Blackstone’s real estate private equity funds. As a general rule, investor contracts are written, at least in theory, to block PE fund managers from profiting by owning businesses that they can force their fund assets to buy things from, often at very inflated prices.
Blackstone shamelessly exploits a loophole in this rule, however, which is that businesses owned by Blackstone funds are allowed to profit from sales to businesses or properties owned by other Blackstone funds. On its face, this seems reasonable. For example, if a Blackstone fund owns a soft drink company, that company should be allowed to do business with the hotels owned by Blackstone real estate funds.
What Blackstone has done with some of these real estate services companies, for example, one called Revantage, is to park their ownership in a succession of Blackstone investment funds. The tricky part, however, is that investors will eventually expect to see a return on the assets they own, so it’s necessary to keep the asset moving in a shell game of constantly selling assets like Revantage from one Blackstone fund to another. Here’s how Blackstone describes the situation in a regulatory filing:
Portfolio Entity service providers (author note: this reference includes Revantage) described in this section are generally owned and controlled by a Blackstone fund, such as a Client and Other Blackstone Vehicles. In certain instances a similar company could be owned and controlled by Blackstone directly. Blackstone could cause a transfer of ownership of one of these service providers from a Client to an Other Blackstone Vehicle, or from an Other Blackstone Vehicle to a Client. The transfer of a Portfolio Entity service provider between a Client and an Other Blackstone Vehicle (where a Client may be a seller or a buyer in any such transfer) will generally be consummated for minimal or no consideration, and without obtaining any consent from the L.P. Advisory Committee, the Investor Representative of a Client, if any or the Investors (emphasis added).
What’s the end game of building and repeatedly selling from Blackstone fund to Blackstone fund a business that Blackstone insists is worthless? Well, clearly, it’s not actually worthless.
With Revantage, Blackstone is building a valuable business on the backs of its fund investors, a business that Blackstone is forthrightly stating that they will never be paid for. As some point, when Revantage has reached a sufficient scale outside of just its Blackstone customer base, Blackstone will likely “buy” it from the latest sucker fund conned into believing that Revantage is worth zero dollars. Once in Blackstone’s hands, Revantage will suddenly be an IPO candidate worth billions of dollars. You can’t make this stuff up, and some of it is happening in plain sight.
The overt power that private equity exercises for its own benefit in our economic and political system at this point is absolutely fantastical. And nobody stands in their way. Not the Democratic politicians, who ritually denounce private equity’s carried interest tax benefit for a few days every few years and then flee. And, again, Naked Capitalism is among the only media outlets that routinely alerts readers to the generally performative nature of Democratic eruptions of opposition to the power of big finance.
Certainly not organized labor, which faces huge pension underfunding and has openly embraced private equity since the 2008 financial crisis, after opposing it for decades previously, a shift that Yves has documented on the site. Naked Capitalism readers, more than anyone, know that the largest investors in private equity, institutions like CalPERS, are incapable of even honestly engaging the topic of private equity, having been so mesmerized by the private equity industry. And certainly not the financial or general press, which, unlike Naked Capitalism, finds private equity to be too complex, too secretive, and too much at odds with the truisms in which they traffic. Give to keep this independent voice strong.
You probably won’t be surprised to learn this, but among the skeptical insiders within the private equity industry, Yves coverage of private equity in general, and CalPERS private equity in particular, gets passed around like Soviet-era samizdat. OK, it’s a little self-serving of me to say this, since I have written some things for the site, but it’s true.
Similarly, when I’ve talked to reporters covering private equity, they speak of Yves and Naked Capitalism’s coverage of the topic with near reverence. I was recently talking with an important academic who writes about private equity, and he mentioned in passing how flattered he has been that Naked Capitalism has mentioned some of his work.
Ironically, some of us who are interested in seeing more of a spotlight on private equity sometimes discuss among ourselves that we sense a reluctance on the part of some mainstream reporters to pursue private equity stories because they worry about being unable to offer anything new in light of how extensive Naked Capitalism’s coverage has been. This is especially true with respect to any private equity stories that intersect with CalPERS, where almost all the mainstream press seems to have conceded their collective inability to surpass Yves’ coverage. One could see this phenomenon play out in the recent Daily Poster feature story about problems at CalPERS, where a number of commenters asked why they had even bothered to run a story that broke little new ground compared to what anyone following Naked Capitalism already knew. The Daily Poster’s publisher, David Sirota, was forced to repeatedly reply to comments with statements of homage to Yves and her coverage of CalPERS and acknowledged that he could never hope to surpass her reporting on the topic.
Ultimately, the way I see it, we live in an era where major private equity firms are effectively modern day trusts as powerful as Standard Oil and the other trusts at the turn of the 20th century. These new trusts, like the old ones, are properly understood as threats to broad prosperity and to democracy itself. Almost nobody seems to recognize even the existence of these new private equity trusts, however, with the notable exception of Naked Capitalism readers, I presume. And the first step in dealing with a threat is acknowledging its existance. And for that, we have Naked Capitalism to thank. So have at it at the Tip Jar.