Friday, June 17, 2022

The Private Equity Ponzi Scheme: The Trigger For The Next "Great Recession"

SHORT TAKES: Interest Rates Are DEEPLY Political; Upping Social Security Checks

Jonathan Tasini

Jun 16

LONG TAKE

It’s not hard to see why millions of people have a sense of foreboding about their livelihoods and pocket books—if you just spend ten minutes daily absorbing some snippet of media, your sense of dread expands…inflation! supply chains! gas prices! rent prices! stock markets!…

The problem: the transcribers of press releases—also known as “journalists”—almost never put any of this in the following frame:

It’s the rotten economic system that is at the heart of the crisis—the plundering of society’s wealth by a handful of very rich people at the expense of workers.

Gas prices go up—and oil companies are reaping record profits.

Prices go up for food, electronics and other stuff—and CEO pay skyrockets along with corporate profits.

Supply chain “problems” are almost never—if ever—talked about, as I explained last year, as stemming from a conscious decision by free-market politicians and corporate leaders to seek out profits by enslaving people around the world.

Let me take you back briefly to the most recent financial crisis—nicknamed the “Great Recession” by those who suffered very little. It was very much a Great Depression for millions of people who lost their jobs, depleted all their savings and who sunk deep into debt many will never fully recover from.

And you’all know who the culprits were: the vast web of money people, principally bankers, who built a pyramid scheme of risky mortgages. To be sure, regulators were asleep, oversight was almost non-existent.

But, here’s the thing: that’s a feature not a bug of the system. It encourages secrecy, manipulation, opaqueness and complexity—all in the name of pocketing large profits, no matter the cost to the “little people” who don’t fly in private jets, own priceless artwork, or a chalet in the south of France.

And no matter how many times the people pay for this depravity—the savings and loan debacle in the 1980s, the Barbarians at the Gate leveraged buyouts, the Enrons—the scams just keeping emerging, reinvented in another form.

Which brings me to today’s topic: the danger posed by private equity and the real possibility that this band of thieves will fuel the next global economic collapse.

We use the term Ponzi Scheme quite casually to describe financial scams generally, especially in the post-Madoff era. What is it? It’s a scheme that pays off investors with money taken from new investors.

Which essentially is what private equity firms do all the time—these are investment funds, generally organized as limited partnerships, that buy and restructure companies, and do so with very little transparency and almost no public accountability, and they do it with investors money—often, unfortunately, large sums coming from public employee pensions fund who have seen private equity investments as a way to earn higher returns.

The monumental riches private equity managers make comes from something called “carried interest”—which is a share of the profits of an investment paid to the investment manager/private equity manager in excess of the amount that the manager contributes to the partnership, specifically in alternative investments.

It operates as a “performance fee” but it really is just a huge tax dodge—everyone knows what the private equity pirates are banking is what every normal person would think of as “income”. But, the rewards are called “carried interest” which is taxed at the capital gains tax rate (a maximum of 20 percent currently), not the highest income tax bracket of 37 percent (which is obscenely low, to start with).

Now, you may think that my description of private equity as a “Ponzi Scheme” is a description popular only among progressive economists. Nah. Even capitalists say so:

Europe’s largest asset manager has likened parts of the private equity industry to a “Ponzi scheme” that will face a reckoning in the coming years.
“Some parts of private equity look like a pyramid scheme in a way,” Amundi Asset Management’s chief investment officer Vincent Mortier said in a presentation on Wednesday. “You know you can sell [assets] to another private equity firm for 20 or 30 times earnings. That’s why you can talk about a Ponzi. It’s a circular thing.”

Amundi’s point has two aspects. First, private equity firms operate often deep in the shadows—no one knows what the values of their underlying assets are because they aren’t required to report anything until a company is publicly listed (and, then, it becomes public through a Securities and Exchange Commission filing) or if the private equity firm decides to disclose the value.

And, second, where the Ponzi scheme really gets juiced is a really scammy process:

Private equity groups this year struck $42bn worth of deals in which they sold portfolio companies to their own funds, a sharp increase over 2020 in a once-niche type of transaction that can generate handsome payouts to executives.
The deals, known as “continuation fund” sales, involve a buyout group selling a company it has owned for several years to a new fund it has more recently raised. That allows it to return cash to earlier investors within the agreed timeframe, while keeping hold of a company that either has potential to grow or is proving difficult to sell.

And:

When selling a company to their own newer fund, private equity dealmakers still stand to receive payouts of carried interest — a 20 per cent share of profits.
They can then receive a second chunk of carried interest cash later, when the newer fund eventually sells the company. Selling companies to their own funds also helps juice private equity groups’ fee income, because they can continue taking fees from the investors in the new fund that buys it, and in some cases from the portfolio company itself.

So, it’s just shuffling assets around from one shell to another just to pocket more money in fees.

The foremost expert challenging private equity is Eileen Appelbaum, who wrote THE book on private equity. I’ve spoken many times with Eileen on the topic (including a conversation we had about the multi-billion medical billing scam). I asked her to opine about the threat to the entire economy from private equity—she sees serious but somewhat less apocalyptic consequences (I’ve edited her responses for length and clarity).

Q: You’ve been watching private equity for some time. Is the PE threat to the overall economy similar to the mortgage crisis that triggered the Great Recession, namely that we don’t know the extent of the problems because of the secrecy and especially because of the huge flow of money in control of a very few extremely rich people?
A: What is going on now is a full court press by PE firms to convince the public that investments in PE are less volatile than stock market investments either directly or via mutual funds and that PE investments hold their value in periods of economic turbulence and stock market declines. They are telling potential investors that this is a really good time to invest in PE as a hedge against volatility and price declines in the stock market.
During the run-up in the stock market, PE firms favored IPOs and were happy to see their portfolio companies sell at the same inflated prices as publicly traded companies commanded. But now, they do not want to face the music and admit that companies that remain in their portfolios are overvalued and will not command the prices at which they are carrying them on their books…In this scenario, a fund with a mature investment that it needs to exit sells the company to another PE fund at a price they agree to behind closed doors, with no transparency and no requirement that they get a third party assessment of fair value for the company being sold. The mature fund typically sells to a younger PE fund with a lot of dry powder it needs to put to work quickly as a result of fundraising records set during the pandemic. The younger fund is willing to overpay to acquire the portfolio company in order to move money out the door. So, a match made in heaven, though investors in fund B that buys the overpriced portfolio company from Fund A may have difficulty exiting this investment at a profit. In these circumstances, PE funds and their portfolio companies appear to retain their value, but these are valuations built on sand.
Who loses from this? If, as is likely, the overvalued company has a debt burden that was set in relation to its very high enterprise value, it may not be able to service the debt in the current environment. And with interest rates rising, it may not be able to refinance it either. The result may be a Toys R Us ending. That was a huge company with 30,000 workers and its demise wreaked havoc on malls and Main streets across the country. Very bad for workers, for communities that depend on the business and so on. But even the collapse of so large a company in the midst of a broader retail apocalypse did not have wide reaching effects on the financial system or the economy…But no, exploding the myth that PE funds and their portfolio companies are impervious to the business cycle and stock market declines will not bring down the economy as the sub prime mortgage crisis did….There are also economic distortions as funds that could have been used for productive investment flow to this game of hot potato, with negative implications for innovation and productivity growth…Not as dramatic as a meltdown, but serious in any case.

I think it’s a far higher risk because of the inherent instability and lack of transparency of PE funds—we don’t know what they are up to.

SHORT TAKES

Interest Rates Are DEEPLY Political

My tardiness in getting out this issue (earning a living gets in the way) gives a chance to say some pointed things about the Federal Reserve Board’s 3/4 percent hike in the Federal funds interest rate.

Interest rate levels are not some natural phenomena like the sun rising in the east and setting in the west.

Those levels reflect political choices and always have to be seen in the context of who is robbing who:

Raising rates means the regular working person cannot afford a car or home (the latter was already out of reach for many folks in many parts of the country).
When Jerome Powell talks in Fed-speak about reducing “labor supply demand” so inflation will come down, he is saying: let’s put people out of work and let’s do that by making it more expensive for companies to get loans and those companies, rather than cut CEO pay, will, of course, then, cut jobs.
When Powell and other elites and transcribers of press releases (formerly known as “journalists”) talk about rising wages, let’s be clear: the federal minimum wage should be around $22/hour. There have been four decades of wage robbery so workers across the board are still catching up to their labor worth.
Two dozen Big Oil corporations more than doubled their profits, pocketing $25 billion more in the first quarter of 2022 over the same quarter last year.
The average gap between CEO and median worker pay in 2021 jumped to 670 to 1, up from 604 to 1 in 2020
The entire “supply chain inflation” problem, which is often cited among the reasons for inflation (in other words, because stuff isn’t available to buy, there is less stuff to go around among people competing to buy said stuff and, so, prices go up) is a capitalist creation: Supply chains, the underpinning of global production, spread across the globe to exploit ppl for slave wages—I explained that here at length.

Which brings to mind the apocryphal view of the bank robber Willie Sutton who when asked why he robbed banks said: “because that's where the money is”.

The solution to inflation is to change the entire economic model not sock it to working people.

Upping Social Security Checks

Speaking of disinformation: if you’ve heard it once, you’ve heard it a thousands times—the Chicken Little cry that “Social Security is going broke”. Well, it isn’t true—and it’s high time to kick those monthly payment amounts higher, which is part of a proposal unveiled last week that I think got lost in the January 6th hearings.

I’ll get to the proposal in a moment. Some reality checks:

The annual report of the trustees for Social Security makes clear that Social Security can pay 100 percent of promised benefits through 2035. After that, if absolutely nothing is done, then, the Fund can still pay out a very high percentage of benefits (75-80 percent).
Of course, PLENTY CAN BE DONE to significantly increase the revenues to the Social Security Trust Funds, especially getting rid of the taxable maximum on earnings which today stands at $147,000. Which means above that amount rich people, CEOs and every upper-middle class person making a healthy six-figure salary do not pay a single dime into Social Security. This is the shining example of class warfare and the middle finger the well-off display to regular working people.

So, Bernie Sanders and Rep. Peter DeFazio (who is retiring from Congress) have gathered together a passel of colleagues to proposed a Social Security Expansion Act that would “expand Social Security benefits by $2,400 a year and fully fund it for the next 75 years past the year 2096 – all without raising taxes by one penny on over 93 percent of American households”, per Sander’s press release.

The proposal would:

Extend the solvency of Social Security for 75 years by requiring the wealthiest American households to pay their fair share of taxes. Today, because of the earnings cap on Social Security taxes, a CEO making $20 million a year pays the same amount of money into Social Security as someone who makes $147,000 a year. This legislation would lift this cap and subject all income above $250,000 to the Social Security payroll tax. Under this bill, over 93 percent of households would not see their taxes go up by one penny.
Expand Social Security benefits across-the-board for current and new beneficiaries. Under this bill, Social Security benefits for current and existing recipients would be increased by $200 a month.
Increase Cost-Of-Living-Adjustments (COLAs). This bill would more accurately measure the spending patterns for seniors by adopting the Consumer Price Index for the Elderly (CPI-E). Older Americans, by and large, are not going out on spending sprees buying big screen TVs, laptops, or the latest high-tech gadgets. Rather, they spend a disproportionate amount of their income on health care and prescription drugs and that would be reflected in the formula for calculating COLAs under this legislation.
Require millionaires and billionaires pay their fair share into Social Security.
Currently, workers have 12.4 percent taken out of each paycheck and contributed to the Trust Fund, half paid by the employer and half by the worker. This bill would require the wealthy pay the same 12.4 percent on their investment and business income, by increasing the net investment income tax by 12.4 percent and applying it to certain business income not already covered by payroll taxes.
Improve the Special Minimum Benefit for Social Security recipients. This bill will help low-income workers stay out of poverty by updating the Special Minimum Benefit to make it increase and indexing the benefit level so that it is equal to 125 percent of the poverty line or about $17,000 for a single worker who had worked their full career.
Restore student benefits up to age 22 for children of disabled or deceased workers, if the child is a full-time student in a college or vocational school. This legislation restores student benefits to help educate children of deceased or disabled parents that were eliminated in 1983.
Combine the Disability Insurance Trust Fund with the Old Age and Survivors Trust fund to help senior citizens and persons with disabilities.

And the math is supported by the Office of the Chief Actuary of Social Security, who writes in a June 9th 2022 detailed letter, “Under the proposal, 100 percent of scheduled benefits are projected to be payable on a timely basis throughout the 75-year projection period”.

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