Last spring, an editor at one of the big newspapers asked me to send in an opinion piece if an idea hit me.
Alas, it was a swing and a miss, and it died an ignoble death.
However, the core arguments remain germane today — perhaps even more so. What do you think?
Text is as submitted in May 2020.
End the Value-Extraction Economy
There’s a myth going around. I suspect you’ve heard it. Leaders tell us that U.S. businesses were vibrant and vigorous prior to the onset of Covid-19; that nobody is to blame for the economic fallout.
The truth is that businesses were fragile — a by-product of a decades-long elevation of value extraction over value creation, and a limitless flow of unproductive debt financing.
The U.S. economy has fallen prey to the leveraged buyout philosophy of investment. During its heyday in the 1980s, Wall Street hailed the LBO as a rejuvenator of capitalism, restoring the primacy of profits to sclerotic conglomerates that had grown disdainful of shareholders.
‘Debt is discipline’, and LBO firms pressed management teams to slash costs and generate efficiencies. Redundancies and wage and benefit cuts followed suit, enriching the few whilst consigning the many to a declining standard of living.
Business-building takes time. Operations are more difficult and uncertain than financial engineering. Therefore, LBO firms embraced the ‘dividend recap’, whereby portfolio companies take on additional debt to deliver owners a pay-out. The LBO firm extracts much, if not all, of the equity it invested in the company whilst punting the operational and financial risk to the business and its creditors. A recent example is the office supply company Staples, which last year issued a $3.2 bn term loan, partly to hand over a $1bn dividend. Staples reportedly stopped paying rent in April.
When a company’s credit risk prohibits lenders from providing sufficient leverage to attain a target return on investment, LBO firms can adjust the projected earnings or cost savings of a transaction to make the debt appear less onerous. This exercise in artifice has exploded in popularity — ‘add-backs’ were present in less than 10 per cent of leveraged loans a decade ago, but nearly half in 2019. Firms are now embracing ‘adjusted EBITDAC’ — earnings before interest, tax, depreciation, amortisation, and coronavirus — to access more leverage.
Corporate leaders caught on to the alchemy of LBOs. Goldman Sachs reveals that share repurchases have been a principal source of demand for equities since the global financial crisis, whilst the Federal Reserve Bank of New York finds that corporate debt issuance has primarily been used for acquisitions, dividends, and buybacks. The managerial class has been larding corporate balance sheets with unproductive debt, extracting equity value, and increasing economic fragility.
In a world less detached from illusion, the notion that CEOs would choose the playbook of LBO firms — a playbook that increases the risk of bankruptcy tenfold — seems fantastical. But the managerial class has learned the lesson: strip-mine the value and pass the parcel.
In a sensible world, investors in LBO funds, such as public pensions, would hold these firms accountable. After all, the average returns on buyout funds have been declining for 20 years. Alas, the dreadful state of pensions’ finances all but ensures they will continue investing pensioners’ savings in buyout funds that eliminate the pension benefits of fellow citizens.
As the Federal Reserve floods the market with liquidity and asset purchases, speculators and unproductive users of debt financing will invariably be bailed out once again. And the LBO firms will be near the front of the queue: private equity-backed companies constitute two-thirds of the worst ‘junk bond’ credits.
The Fed must do what it can to prevent a debt deflation. But is its primary tool — credit creation — fit for purpose? Over the last 50 years, credit to the private non-financial sector ballooned from 90 per cent to 150 per cent of U.S. GDP. Last year, the OECD found that only 30 per cent of corporate bonds in advanced economies were rated A or above. Meanwhile, the slowing demand for small-business rescue loans raises questions about the absorptive capacity for the Fed’s incipient direct lending programs.
We are transitioning from a world of efficiency gains to one of resilience and capacity expansion. There is a lot to build, in many places, and there are millions who need work.
As policymakers open the floodgates of stimulus, they should erect guardrails that protect labour and channel financing to businesses that create value. Congress should legislate the leveraged buyout out of existence. In part, that means eliminating the favourable tax treatment of debt whilst offering tax breaks for long-term equity investors. Policymakers should also encourage the development of new structures and intermediaries to invest in productive enterprises and assets. Let’s learn from the past and build a more resilient, inclusive, and prosperous economy for the future.