The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis, by Josh Kosman

On vacation in Colorado, we drive through the Littleton shopping mall. There it is, a two-story building, black and empty behind its glass facade. Mervyn’s Department Store. Founded in 1949, Mervyn’s grew to a chain of 189 stores in 10 Western states. But in 2008, Mervyn’s went bankrupt , laying off 18,000 employees without severance or vacation pay. Just an ordinary casualty of the recession? Hardly.

In The Buyout of America Josh Kosman introduces us to the private equity or PE firms. They are a major force behind what Barry Lynn called “the economics of destruction.”

The players:

PE firms. You haven’t heard of most of them, and they like to keep it that way. A few better-known ones are the Carlyle Group, Goldman Sachs, Kohlberg Kravis Roberts, and the Blackstone Group. They are the descendants of the notorious leveraged buyout operators of the 1970s.

Target corporations. These are typically midsize to largish corporations, steadily profitable but not exciting. Often, like hospital chains, they are not especially well-managed.

Investors. These are mostly pension funds, desperate for higher returns to compensate for prior underinvestment. They include public pension funds, like the giant California Public Employees Retirement System.

Banks. These are mostly the big banks, like JP Morgan Chase or Citicorp, eager for loans that they can “securitize” and sell off.

Purchasers of securitized loans. These are also mostly pension funds, seeking super-safe passive investments for the bulk of their portfolios.

US federal and state taxpayers.

The game:

Step one. A PE firm lines up investors, who typically commit to supply funds over a period of up to 10 years. The PE firm promises spectacular returns.

Step two. The PE firm bids for a target corporation. It may put up 5% of the bid while its investors supply the rest.  For the balance of the purchase price, some 70% to 80% of the total, it arranges a huge bank loan, which it puts on the target’s books. The target essentially assumes the debt to buy itself out. Under terms of the deal, the target may pay interest only on the loan for five or six years, before the principal becomes due.

Step three. Because interest on the loan is deductible, federal and state taxpayers pick up a big piece of the loan interest, 35% federal, plus whatever state tax piggybacks on the federal.

Step four. The bank securitizes the loan, combining it with other loans to create what are called “collateralized loan obligations,” or CLO’s. CLO’s are equivalent to the “collateralized debt obligations”, or CDO’s, which banks created from mortgages.  As with the CDO’s, the bank divides the CLO’s into “tranches”, gets Standard & Poor’s or Moody’s to rate the top tranches AAA, and sells them to further investors.

Step five. The PE firm installs its own management, which starts raising prices and cutting costs, including laying off employees and scaling back R&D. The PE firm has three objectives here: first, it must enable the target to pay the interest on its debt.  Second, it must make the target look profitable in the short run so it can sell it when the debt principal comes due in a few years. Third, it seeks to liberate cash to reward itself and its investors during the few years it owns the target.

Step six. The PE firm starts extracting money. It charges its investors a 2% annual fee. It charges the target a 15% “management fee.” It may pay itself a huge dividend. Cerberus Capital Management, which bought Mervyn’s department stores, split the company in two: a real estate division and a Mervyn’s store division. The real estate division promptly jacked up the rent on the store division.

Step seven. The PE firm sells the target, now crippled by debt and underinvestment. Or the target goes bankrupt, like Mervyn’s.


Within a few years, fees and dividends have earned the PE firm many times its original small investment. The PE firm’s investors sometimes do well, but often not, especially when the target goes bankrupt. The buyers of CLO’s from the banks also lose when the target goes bankrupt. Employees lose, both during initial cutbacks and eventual bankruptcy. Customers lose vital services, as when PE-owned hospitals cut nursing staff.  The whole economy loses, as once-competitive firms are weakened or destroyed.

But there’s worse to come. The PE firms went on a feeding frenzy during the bubble years leading up to 2008. They now own over 2000 target companies whose loan principal comes due around 2012. If half these go bankrupt, Kosman estimates, some 2 million of the 7.5 million PE firm employees could lose their jobs. And the collapse of CLO’s could wreak further havoc on the banking system.


An end to interest deductibility, or at least deductibility for buyout loans, would stop PE firms in their tracks. So would limits on corporate debt, or requirements that buyers of corporations hold them for at least five years. Eliminating the “carried interest” loophole, which allows financial managers to pay only the 15% capital gains rate, would also weaken PE firm’s tax advantages.

Kosman isn’t optimistic. Four of the past eight Treasury Secretaries now lead PE firms. New York Senator Chuck Schumer, the “senator from Wall Street,” raises buckets of money from PE firms for Democratic candidates. Efforts over the years to modify interest deductibility have gone nowhere. Even President Obama’s barely-controversial proposal to close the carried interest loophole did not make it into the final financial reform bill.

Meanwhile, with bank lending frozen, the PE firms have found new games. They still have $450 billion in committed funds from their investors. They are using these, with government help, to buy failing banks and tap into cheap government credit. They are also buying from one another, enabling them to charge their long-suffering investors new management fees.

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