Joshua Kosman, Predicting The Next Credit Crisis
Private equity firms buy undervalued or underappreciated companies, impose short-term improvements and sell them for a fast profit. Some of the companies they've bought include Hertz, La Quinta, Dunkin Donuts, and Toys R Us. Josh Kosman, a private equity expert, says that the way the firms have been able to buy these businesses — through leveraged buyouts — means the majority of the money for the buyout has come from loans that the firms dump on the company they're supposedly fixing.
Now burdened with debt, many of those companies owned by private equity firms are in danger of defaulting. In a new book, Kosman writes that it's likely half of the 3,188 American companies bought by private equity firms between 2000 and 2008 could collapse. His book is called The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis.
TERRY GROSS, host:
This is FRESH AIR. I'm Terry Gross. My guest, Josh Kosman, predicts that we're on the verge of the next great credit crisis, not because of credit cards or student loans. The credit crisis he's predicting is from the actions of private equity firms. These are firms that buy companies, with the help of huge loans, and typically try to resell the companies or take them public before the loans come due. The companies that have been bought and sold are then often left with the debt. Kosman explores how private equity firms manage to make big profits while nearly destroying some of the companies they buy and sell in his new book, "The Buyout of America."
He says many private-equity-owned companies are defaulting on their debts, and that will mean more people losing their jobs and will have global consequences for the credit market. Private equity firms have purchased companies in a variety of industries, including hospital and nursing home chains, mattress companies, newspapers, radio stations, hotel chains and record companies. Some of the biggest private equity firms are the Carlyle Group, Blackstone Group and Kohlberg Kravis Roberts. Josh Kosman is a financial reporter for the New York Post and a former editor at mergermarket.com and a former writer for The Deal and Buyouts newsletter.
Josh Kosman, welcome to FRESH AIR. Let's start with the basics. What is a private equity company?
Mr. JOSHUA KOSMAN (Author, "The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis"): A private equity company or a private equity firm - there's only about 100 major firms, maybe there's 300 overall. Many of them are in New York, and they are these small groups of people who raise money from - mostly from public pensions to buy companies, and they buy companies by having - just the way that you or I would arrange a mortgage. We'd put maybe 20 percent down and borrow 80 percent. But the critical difference is when they buy companies, they put 20 percent, and then the companies they acquire borrow the 80 percent to finance the deal. So then the companies are responsible for that debt. So basically, private equity firms, which is a fancy way or a nice way of saying a leveraged buyout firm, go around the country, and they buy companies using basically mortgage tactics but where the company takes the risk and not them.
GROSS: You know, when I read that in your book, I actually couldn't believe it.
(Soundbite of laughter)
GROSS: Honestly, like, I really don't understand how that works, that, like, I buy your company, and then you have to pay the debt for me to buy you? Like, why...?
Mr. KOSMAN: It's pretty insane. My first job covering the industry - I've covered the industry for about 13 years - was at a trade publication called the Buyouts newsletter, and I didn't know what a private equity firm was or a buyout was. I just thought it was an interesting job in Manhattan, and it looked like it was worth taking. And it took me, I think, maybe two or three months into the job before I really figured that out, and it shocked me, too.
GROSS: So why is it that way?
Mr. KOSMAN: It's really because of this giant tax loophole, and the giant tax loophole is called interest tax deductibility, and this is how - why LBOs are generally profitable for the private equity firm. Any company can deduct the interest they pay on loans from their taxes. So if you buy a company, and you buy it with all this debt financing, well, now suddenly, you're basically not paying taxes anymore, and because of that, that company then can, in theory, use that money to pay off its debt quickly. Reality is this is not the way it typically plays out, but in theory, that's the way it works.
GROSS: So theoretically, with a private equity company, they buy a company. They use debt to buy the company. The company that they've bought has to pay off the debt, but they can deduct the interest from their taxes.
Mr. KOSMAN: Right.
GROSS: And theoretically, the company that's being purchased should make a profit over time, should be more profitable in the next five years, and then the company that bought this company can sell it at a profit. Everybody wins because the company that's purchased becomes more profitable, the company that bought that company sells the company at a profit. So theoretically, everybody's happy. Is that the way, like, the perfect model looks?
Mr. KOSMAN: That's the way that the perfect model looks, but it rarely ever works out that way. Typically what happens is the company is more profitable in one sense, its earnings increase, usually because the private equity firm is starving the company a bit of capital because that's - a private equity firm, and I should have said this at the start, they're in the business of buying and selling companies within four or five years. So there's no long-term interest. So typically - and a Davos study shows this. Private equity firms eliminate more workers than their direct competitors, and at the same time, they usually decrease investment in research and development and capital expenditures. That helps the companies they buy pay off their debt more quickly. And you know, typically, you know, while the companies become more profitable short-term, until that pressure causes them to be less competitive, what it also - but you know, at the same time, the company still has interest to pay on the debt. It may have to take - may be able to take it off your taxes, but you still have to pay the interest. So typically, these companies actually are much less profitable than when they buy them.
GROSS: Give us an example of an industry in which there's been a lot of private equity buys, and the industry, the whole industry in a way, has been squeezed with a lot of layoffs and cuts within what the business does.
Mr. KOSMAN: Sure. An easy example is the mattress industry. Private equity firms bought Sealy and Simmons about a decade ago - actually, it's 2009, so let's say 15, 18 years ago - and then they bought and sold them between each other, but buyout firms acquired, or private equity firms - and private equity firms, by the way, I should also note, these are the same guys who were the leveraged buyout kings of the 1980s, the exact same people often, but when leveraged buyouts got a bad name, when Michael Milken went to jail, when movies like "Wall Street" were made, they underwent a marketing change and very cleverly started calling themselves private equity firms, but they're one and the same.
In the mattress industry, private equity firms bought Sealy and Simmons, the number one and number two brands by a mile. They stopped really competing against each other. They cut costs, and they raised the prices of the mattresses. They started focusing only on the top end and stopped even making mattresses really for middle-income people that cost less than $1,000. So basically simplifying this over time, as they bought Simmons and sold it to another PE firm three or four years later, and same with Sealy, the buyers -the sellers would make a lot of money, and the buyers felt, well, we can keep raising prices because there's no competition. We own Sealy, and we own Simmons. It's different firms, but they both have the same aim: to make a short-term profit, not to beat each other up on price. What happened over time was they couldn't raise the prices anymore, and the prices were raised double the price of inflation, double the rate of inflation. They cut the beds in half, so you came up with no-flip mattresses. That cut their manufacturing costs, but it also...
GROSS: Wait, wait, let's explain for a second.
Mr. KOSMAN: Sure.
GROSS: I thought great, no-flip mattresses, you don't have to go through the work of flipping it, and the bed's kind of extra-good, so you don't have to flip it, but there's another reason why you don't have to flip it.
(Soundbite of laughter)
Mr. KOSMAN: That's right. Initially, they made the mattresses thick. They kept putting - creating thicker and thicker mattresses so they had an excuse to keep raising and raising the prices. So they thought, both Sealy and Simmons both had the same thought. The private equity firms that owned them both thought, well, why don't we cut costs significantly and cut the beds in half and introduce these no-flip mattresses.
Simmons did it first, early this decade. Sealy stood back. Sealy even made a statement when Simmons did it, saying we would never offer a no-flip mattress. That's why you should buy our mattresses. Simmons's sales didn't rise, but their earnings went through the roof. The private equity firm that owned Sealy at the time, which was Bain Capital - the same firm that Mitt Romney owned during that period, the Republican presidential candidate - decided okay, well, we'll change tack. You know, even though our market share is growing, their earnings are going through the roof, and that's what we care about. So then they introduced no-flip mattresses, and now and for the last six or seven years, Sealy and Simmons only offer no-flip. There are no two-sided beds anymore.
GROSS: But are their no-flips any better or worse than the two-sided ones?
Mr. KOSMAN: Well, they certainly have less of a life. You can't flip them, so just like a tire, you know, when you rotate your tire, you know, beds that used to last 15, 20 years on average - and those were Sealy and Simmons beds - now these beds last six, seven years. So it's a much cheaper bed. And what ended up happening in the middle of this decade is Tempur-Pedic came out of nowhere. And Tempur-Pedic offered a very nice sleep on a - I guess they call it, you know, it's those foam beds, and those mattresses, on the high end, which is all that Sealy and Simmons at this point were now competing in, they started to really outsell Sealy and Simmons. And that puts - and then Sealy - for Sealy and Simmons, not only were they losing market share, now their earnings were starting to fall.
GROSS: What's the state of Sealy and Simmons now?
Mr. KOSMAN: Now they're both in a really tough state. Simmons just got bought by - went bankrupt, and it got bought by Serta. So that means Simmons, a company that's been around for more than 100 years, doesn't exist anymore. A quarter of their employees were laid off in the last year, and now - I shouldn't say - the private equity firm that owned Serta bought them and says they'll keep them independent, but that's a little hard to buy.
As far as Sealy, they were veering towards bankruptcy, and their private equity owner, Kohlberg Kravis Roberts, put in some more money in the company to keep it going, but Sealy is also having some problems, though they're probably a step above where Simmons is.
If you look at it historically, though, Sealy's market share around 1990, when the first buyout of Sealy happened, was about 28 percent. Today, they're at about 20 percent. So I certainly believe that private equity firms, you know, from the time of 1990 through today, have not done Sealy any favors, although those private equity firms, by buying and selling Sealy to each other, have generally made huge profits but in the process have hurt the business.
GROSS: So let's look at the hospital industry. You say that the hospital industry has been especially hard hit by private equity takeovers. Why the hospital industry?
Mr. KOSMAN: They like the hospital industry, and in some ways, although it's a very different product, it's like the mattress industry. They want to - you know, the private equity firms like to put out this myth that they help restructure businesses. They buy companies by putting companies in debt. Banks would never lend money to those companies unless they felt those companies would likely be able to pay that money off. So they are looking for companies that are healthy, usually that are not fast growers and that they think will have dependable cash flow no matter what happens.
So if they cut employees, cut research-and-development spending, if they starve these companies, that these companies, at least in the short term, won't be hurt competitively. That was the theory with mattresses, and that's also the theory very much in the hospital industry, that if you buy a hospital, and it's the only game in town - you buy a hospital chain, but if a lot of their hospitals are the only game in town, well, then, patients, if they're getting worse service probably won't leave for a while, and that's really the theory. And patients usually leave when doctors leave, and doctors typically do not leave a hospital very quickly. They're pretty conservative in the way they -their relationships with hospitals.
GROSS: Here's what I'm wondering: These are not hostile takeovers. So if you're a nursing home or a hospital chain or a large music company, why would you let a private equity firm buy you, knowing that it's going to put you into debt, knowing that your company is likely to be squeezed in order to show profits on the books in the short term? Why would you want that? Why would you allow that?
Mr. KOSMAN: It's a very good question, and I think the sellers in most cases don't realize much of what we're talking about. Very little has been written about the destructive nature of private equity. Certainly, the investment bankers that help sell companies, it's not in their interest to put that out there. That's even if they really have put it together.
I believe that - I've talked to some sellers who somewhat regret what they did, and I spoke to them for the book. Some of them didn't make the book, they didn't want to be on record. But the sense I get is when you're selling a business, you're looking for the most money you can make, and if a private equity firm offers the most money, and sometimes they certainly do, that's what you're focused on.
In a pretty revealing interview to me, the CEO, the former owner of a company called Alpha Shirt in Philadelphia, in your town, spoke to me, and he explained himself as - he had run this family business that basically imprints shirts. They buy shirts from Hanes, imprint them and then - and they're a huge company. And he said when he was ready to sell, his sons weren't ready to run the business. They were just teenagers. He was ready to get out. It was his father's business and his father's business before that, and they offered the best price, and you know, he didn't do a lot of due diligence. He didn't really call around, although he was given the names of other owners who have sold their companies to private equity firms.
GROSS: You predict that the buyout of many companies by private equity firms is going to cause a big credit crisis similar to the mortgage crisis. Let's look at some of the reasons why you predict that. Yeah, go ahead.
Mr. KOSMAN: Sure. Private investors this decade, for these private equity firms, used the same cheap credit that caused the housing bubble to buy 3,100 U.S. companies. Those companies employ one out of every 10 Americans, about seven and a half - it was 10 million people. They've resold some of those companies, so say today it's about seven and a half million people.
So private equity firms are the largest employers in the country when you combine the companies they own by a mile, bigger than Wal-Mart, bigger than anybody.
The Boston - the cheap credit that was used to buy these companies, a lot of the debt on that is starting to come due just now, and it will do so over the next few years. The Boston Consulting Group, a pretty conservative organization, predicts that half of those companies will default on their debt by the end of 2011. If that comes to pass...
GROSS: That's half of the companies that were purchased by private equity firms?
Mr. KOSMAN: That's right. That's right, so half of that - exactly. So if half of those companies, so roughly 1,500 U.S. companies, end up filing for bankruptcy, and those companies fire about 50 percent of their workers, not the most aggressive estimates, you've got about 1.9 million people unemployed. That's a huge hit.
Now, beyond that, you know, and that obviously reduces consumer spending, means more home foreclosures, all sorts of problems, the companies that are - will be falling into - will be defaulting owe about $1 trillion in debt. And if a significant amount of those loans become worthless, that'll cause a freeze in lending. To compare, about a trillion dollars in debt in companies is similar to, in 2007, when subprime mortgages in this country were about $1.3 trillion. So it's - the numbers are pretty close. And even if the economy recovers more than it has today, many of these companies will collapse anyway because they're under such tremendous pressure. But I certainly do believe that the way we are right now, the economy is today, it created such a bubble to allow private equity firms to buy companies using cheap credit, paying very high prices, putting little money down, that just like the housing market, unfortunately, a lot of these companies the private equity firms bought in this bubble are due to collapse.
GROSS: Another comparison to the housing market, the now-famous CDO is collateralized debt obligations, which is basically mortgage debt that was sliced and diced and packaged and sold and resold in the form of, you know, exotic instruments, as they say.
There's an equivalent for the private equity companies. They have CLOs, corporate loan obligations. So explain how CLOs compare to CDOs and why that might cause a problem.
Mr. KOSMAN: Sure. It's very similar. The same hedge funds that were creating CDOs, which caused the mortgage market to boom, also created what were called collateralized loan obligation funds, which made it much easier for companies to borrow money to finance these LBOs. Same situation where hedge funds would come in - mostly it was hedge funds. It was also banks. They would buy a pool of loans to support LBOs, just like they would buy a pool of mortgages. Maybe they'd buy a pool of 150 to 200 LBO loans, slice them up and resell them to places like sub-Saharan African countries, Montana's state government, selling this off as this is very safe because it's 150 to 200 loans, and even if a few default, you're going to get paid, guaranteed. And Standard & Poor's and Moody's, the rating agencies, gave these CLOs, just like they gave CDOs, triple-A ratings. So they gave them very much their stamp of approval, saying these are very safe investments, and in the mortgage markets, as we know now, these are far from safe, and unfortunately in the LBO market - and which has a huge impact on this country because these are 3,000 companies that employ one out of every 10 of us, unfortunately a lot of these companies are going to collapse, and a lot of these CLOs also will prove to be nearly worthless.
GROSS: So has there been any problem yet? Have people lost money on their CLOs, or is this something that you think might happen sometime in the future, maybe?
Mr. KOSMAN: I think mostly this is something that very likely will happen and is starting to happen but has not happened yet. I mean, this year kind of quietly, for the last 12 months, we've had an 11 percent default rate in this country. That's near-historic highs. And half of the companies that have defaulted, it's about 175 companies so far, have had private equity involvement. Those are companies like Chrysler, like Reader's Digest, like Simmons mattress that we talked about before. So unfortunately, the tsunami of defaults is already starting.
GROSS: You write about how private equity firms are really connected to powerful people who are, or have been, in government. You mentioned several former Treasury secretaries have gone from the Cabinet to private equity. Name some of the Treasury secretaries who are in private equity now.
Mr. KOSMAN: It's really amazing. Four of the last eight Treasury secretaries are in the private equity industry. They include James Baker, include Nicholas Brady, Paul O'Neill and John Snow. And John Snow, in some ways, may be the most interesting case and show how those private equity connections can really help, where those Washington connections can really help a private equity firm. Cerberus, a PE firm, hired John Snow as chairman months after he left Bush's administration - meaning the second Bush, George W.
And GMAC - a Cerberus-owned company - and Chrysler, both got into trouble, both looked for bailout funds. And in the case of GMAC, the government, in the last days of the President Bush's administration, allowed GMAC to convert from an auto leasing company, basically, to a bank. As a bank, GMAC then could receive TARP funds. And this was even though GMAC did not have enough capital in reserve to meet typical bank holding requirements. And at the same time, much of their business was in auto financing, which is not well diversified, which doesn't make for a good bank.
And now, since they got that special status, it's amazing. The government has bailed out GMAC - I think, two or three times - to the tune of more than $12 billion to a company that, you know, arguably should have been never allowed to receive TARP money and, I would probably say, is not that important to our country. Why can't someone else set up an auto leasing business?
GROSS: There are tax loopholes that private equity firms benefit from that you would like to see closed. What changes would you like to see made?
Mr. KOSMAN: The biggest one is interest tax deductibility. In the late �80s, it is something that Congress considered, and that is the ability of a company to not pay taxes on the interest it pays on its loans. I would like to see that -you know, that loophole was there. It wasn't a loophole. It was intended so that companies could borrow money to build a plant, to buy new equipment. It wasn't intended so you could borrow money to finance a takeover. If you eliminated interest tax deductibility just for corporate takeovers, which would really only impact the private equity firms, you would do a lot to make LBOs unprofitable.
And buyouts have - I think there is a track record that the core practice doesn't work, and if you ended this tax loophole, if you ended the interest tax deductibility on corporate takeovers, you would basically make LBOs unprofitable and you would basically end the industry.
GROSS: The Obama administration is basically looking into that.
Mr. KOSMAN: Yes. I'm very pleased to see that the president has appointed Paul Volcker to consider the whole tax code, and interest tax deductibility is on the table. I would think they would take a serious look at it. I believe I'm the only one so far that I've seen that's come up with at least an estimate of how much the government has lost because of this loophole. And this decade, it looks like they'll lose about $70 billion from companies that pay much less in taxes because they take on all this debt.
A study that came out after I wrote the book shows that private equity-owned companies pay about half in taxes, about half - their tax is rate is about half of their competitors'. It was a great study. It was done by a Notre Dame professor. So, I think the government can certainly raise - by closing the loophole, it'll generate a lot more money, certainly tens of billions, maybe even a hundred billion. And the only purpose of this deductibility is to allow LBOs to happen. And I think in the 30 years that the LBO industry's been around, they certainly haven't proven that they've helped companies.
GROSS: How do you know that the companies that have gone under or are struggling now, companies that were bought by private equity firms, how do you know that they weren't going to struggle or go under anyway? Or maybe they would've gone under sooner. Or maybe the ones that are struggling would have gone under, and, you know, the scenario's actually better than what it would have been, even though it's a bleak scenario.
Mr. KOSMAN: In most of these cases - well, in almost all of these cases, private equity firms like to say that they help restructure companies. Reality is the companies they buy need to be healthy to begin with or they can't do the LBO. Those companies are taking on so much debt to finance their own sales that these are healthy businesses. So I think in most cases - I mean, I will certainly take a step back. I'm one journalist who did two years of homework. But I think in the evidence that I saw, I think there is a lot of evidence that private equity firms hurt companies.
Their returns to their investors, to the pensions, is under the Standard & Poor's 500. So they're buying companies on leverage, like if we bought houses on leverage. And yet their returns are worse than the S&P 500. And if you just bought stocks in the S&P 500 and levered them up, you'd make three, four times the money that private equity firms do. So they don't even make good returns for their investors. So, I think - you know, to me, on many different levels, it's pretty clear that they don't improve companies. And I believe the companies that they acquire need to be - almost all the time, need to be healthy to begin with or they can't acquire them. So these are not companies that were necessarily veering towards bankruptcy.
GROSS: Well, Josh Kosman, thank you so much for talking with us.
Mr. KOSMAN: Sure. Thank you very much for having me. I appreciate the interest.
GROSS: Josh Kosman is a financial reporter for the New York Post. His new book about private equity firms is called "The Buyout of America." Transcript provided by NPR, Copyright NPR.