15 Apr, 2008

“Rein in the Destructive Impact of Private Equity Buyouts”

Imtiaz Muqbil

A spokesman for the IUF, a global trades union workers in the hotel and other sectors, says, “Private equity buyouts have been described as a tool for ‘enhancing efficiency in financial markets.’ For workers, the private equity bubbles have been a social disaster.”

In this dispatch:

“Travel & tourism creates jobs.” That mantra repeatedly sounded by industry leaders triggered major boom all through the 1990s. Today, those same leaders are silent even as the jobs they helped create are threatened by a wave of global economic and geopolitical turmoil. That void of “voices” of warning and caution is being filled by unionists and the UN’s International Labour Office. Excerpts from two recent statements:

1. “REIN IN THE DESTRUCTIVE IMPACT OF PRIVATE EQUITY BUYOUTS”

2. “LABOUR MARKETS LIKELY TO BE HIT DURING 2008”

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1. “REIN IN THE DESTRUCTIVE IMPACT OF PRIVATE EQUITY BUYOUTS”

[Peter Rossman, Communications Director, IUF, an international federation of trade unions in the food, agriculture, plantation, hotel, restaurant, catering and tobacco sectors, addressed the Public Hearing on Hedge Funds and Private Equity, Committee on Economic and Monetary Affairs of the European Parliament, Brussels, April 8, 2008. Excerpts:]

The IUF is made up of 373 member trade unions in 122 countries representing some 12 million workers. It is a global organization with a long history. Unlike many of those who’ve been celebrating the leveraged buyout boom of recent years we recall that what we’ve just been through is in fact buyout boom, or buyout bubble, number 2. The first took place in the second half of the 1980’s and was largely confined to North America. When it crashed at the end of the decade, it left behind more than just a few jailed junk bond traders. The LBO’s of the 1980s destroyed a number of American manufacturing companies and were an important contribution to the hollowing out of US manufacturing capacity, one result of which is the US balance of payments deficit which has become a major source of global financial instability. The most famous LBO of the period, the 38 billion-dollar buyout of RJR Nabisco by KKR, resulted in the loss of 40,000 union jobs in the US alone, and billions in lost tax revenues to government through the absurd tax subsidies which reward the massive use of corporate debt.

The RJR Nabisco buyout epitomized the trends of the period, trends which we saw magnified in the second wave: bigger and bigger deals, growing use of leverage, although not as high as the debt multiples of over 10 times free cash flow which characterized the bigger recent deals; and the transformation of real companies with real assets and real employees into a bundle of financial assets to be sold off for cash returns to investors in the shortest possible time. Nabisco today exists only as a collection of scattered brands managed by various food companies as simply another financial product in their portfolios. Its fate in this respect is not unique.

At the beginning of the Clinton administration there was talk about addressing the fundamentals of the buyout disaster through new regulation, but attention was quickly absorbed by the savings and loan crisis and private equity was forgotten. That holds a lesson for today, because the fallout from the subprime collapse risks diverting attention from the very real dangers which LBO debt holds for global financial stability.

Instead of regulation, there followed two decades of global financial deregulation and a loosening of tax regimes. When conditions became ripe again, we had buyout boom number 2, this time on a global scale. The total volume of buyout deals for 2006 has been estimated as high as 725 billion USD. 2007 was set to surpass that, until the credit crunch froze the big deals.

Financial deregulation made it possible for the banks which funded the buyouts to offload their risk through a whole new breed of credit instruments which were largely unregulated. We were presented with wonderful innovations like “covenant lite”, “toggle loans”, PIK notes and so on – all basically instruments for funding debt through more debt. Debt was piled onto the books of the portfolio companies, and debt was diffused through the financial universe, in fact so widely diffused that probably no one in this room can provide a plausible estimate of the outstanding volume of LBO debt, the forms in which it exists, or who owns it. In this respect it is no different than the loans which were packaged and repackaged on the basis of sub prime mortgages. The total volume is somewhere in the trillions.

The essential point is that a major default in the LBO debt market, with its inevitable chain reaction, could just as easily have triggered the current crisis as the subprime mortgage derivatives. And it may yet happen, seriously amplifying the current crisis.

As Michael Gordon of Fidelity International wrote in a March 31 Financial Times editorial, “Private equity as we have come to know it is all about debt – lock, stock and sinking barrel.” Piling large amounts of debt onto the books of a company taken private, with the goal of high short-term returns, means there is nothing left for investment in the future.

Here are some examples: In 2005 the Danish telecommunications operator TDC was taken over by a group of five of the biggest private equity firms – Permira, Apax, Blackstone Group, KKR and Providence Equity for €12 billion. Over 80% of the purchase price was debt financed.

As a result the company’s debt to asset ratio jumped from 18% to over 90%.The equivalent of over half the company’s assets were then immediately distributed in shares to the new owners and top managers. TDC is no longer a leader in wireless technology.

The Irish telecommunications company Eirecom was acquired by the private equity consortium Valentia in 2001. Eircom paid for the loans through bonds which raised its debt from 25% to 70% of its assets. Capital expenditures declined from €700 million in 2001 to 300 million in 2002 and 200 million in 2003 and 2004. While cutting back radically on investment the company paid a €400 million dividend to Valentia.

In the food sector, Findus, Nestlé’s frozen foods division, was acquired by the Swedish private equity fund EQT, in 2000. At the time of the purchase Findus had 14 plants in Europe with 3,400 employees. Today there are 6 plants – with 2,900 workers. Research staff at the company’s Swedish headquarters was cut from 200 to 40. In 2006, what was left of the company was sold to another financial investor.

The union representative who sat on the management board says, “I lost track of how many loan agreements we signed. EQT had to keep changing banks when they didn’t fulfill the loan requirements. And the company was constantly in the credit rating magazine Justitia for not paying its bills. We couldn’t even buy petrol with the company’s credit cards.”

The private equity firms who did these deals are not “rogue traders” – they are among the biggest and best known buyout funds, and they continue to raise record sums for investment. This is standard operating procedure for what has been highly praised as a successful model for “unlocking value” and efficiently aligning the interests of owners and managers.

Eirecom today is what is known as a private equity “zombie” – the company is worth less than what it owes, and is technically bankrupt . It is not alone. In the UK last year, the number of private equity-owned companies falling into receivership rose by 50%. More than a quarter of the 400 companies disposed of by private equity in 2007 went bankrupt.

Private equity buyouts have been described as a tool for “enhancing efficiency in financial markets.” For workers, the private equity bubbles have been a social disaster. The recent study by the World Economic Forum on the destructive job impact of private equity buyouts simply confirms what unions have been saying for many years from direct experience – both the quantity and quality of jobs suffers under private equity ownership.

The private equity boom has fed the general tendency for companies to return more and more to investors in the name of shareholder value. We have seen an exponential increase in the share of cash flow devoted to dividends and share buybacks at the expense of long term, productive investment. Nestlé, the world’s largest food corporation, last year spent 26 billion CHF on buying its own shares – a year which began with its chief financial officer warning that the company’s capital stock was “dangerously weak”.

For workers, the declining rate of real investment has meant that productivity is boosted in the short-term by extracting more with less; reducing payroll and increased reliance on outsourcing and casualization, which creates long chains of precarious labour. All of this results in a general degradation of working conditions, and it is not sustainable for workers or for companies.

Finance is supposed to be assisting the real economy of goods and services. The quantity of global credit derivatives in circulation now exceeds world GDP by a factor of 8. The value of credit default swaps is over 8 times greater than the corporate bonds they are supposed to be protecting. Staggering amounts of money is pouring into financial markets, yet we see a relative decline in real investment, and in some OECD countries the share of wages in the national income is at its lowest level since the Great Depression. Venture capital – seed money for startups – is a small and declining percentage of the money allotted by private equity funds. The largest European private equity fund specializing in venture capital – 3i – last month announced that it was getting out of venture capital because it was not profitable enough. They will be increasing their allotment to buyouts. Something is clearly very wrong.

In closing, here is an example which brings into relief the issues raised.

In 2001 the private equity firm Permira, put €450 million into a deal to buy the German chemical company Cognis for €2.5 billion. In the year prior to this takeover, Cognis had an after-tax profit of €109 million. Following its takeover by Permira and a dividend recapitalization, Cognis was so burdened with accumulated interest payments that despite rising sales it registered aloss of €136 million in 2006 . Yet Permira and Goldman Sachs have already taken €850 million out of the company.

The debt was refinanced in May 2007 by issuing new loans and notes worth some €1.65 billion. Cognis has been hit by rising raw material prices and may not survive.

Look at how this works. A financial company advises Cognis on its own takeover and pockets millions in fees. That same financial corporation, together with a private equity fund, takes the company private and funds the operation with debt, getting their money back quickly through dividends, and then piles more debt on the company. All of these actions violate elementary standards of diligence, and in fact should be illegal. The consequence is an uncertain future for the company and its workers and a flood of dubious paper rated double and triple A by the rating agencies even though no one has a more precise idea of its actual market value than they do for a collateralized debt obligation derived from a subprime mortgage.

Workers want secure, long-term investment that can bring about decent jobs through work which is socially and environmentally sustainable. We want investment in education, training and research, and we want to know that quality retirement and health systems are available for all to enjoy. Those are goals which are presumably shared across the democratic political spectrum. What we see today is a regulatory and tax regime which takes us in the opposite direction, and a threat of global financial meltdown. That is why we strongly support proposals for a thorough regulatory review and appropriate action to rein in the destructive impact of private equity buyouts.

Surely another form of finance is possible.

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2. “LABOUR MARKETS LIKELY TO BE HIT DURING 2008”

[Juan Somavia, Director-General of the International Labour Office, addressed the International Monetary and Finance Committee and Development Committee, annual meetings of the International Monetary Fund and the World Bank, 12-13 April 2008]

Stability and progress in the world of work is threatened by instability and setbacks in the world of finance. Uncertainty about the cost of access to credit is spreading from the epicentre of the initial turmoil in the housing finance sector of the USA to other parts of the economy and other countries. Forecasts of the scale, depth and international reach of the slowdown are increasingly gloomy with the IMF World Economic Outlook projecting global growth for 2008 and 2009 at 3.7% and an increasing risk that the outturn could drop below 3%, equivalent to a global recession. The impact on labour markets is apparent in the USA and seems likely to hit other countries during 2008. A global survey of businesses’ hiring activity indicates that many are considering holding back on hiring.

The scale of the financial restructuring now underway and the severity of the credit squeeze make the current financial crisis perhaps the most severe since 1945 and may result in markedly slower growth in the USA and other industrialized countries for as much as two to three years. I hope that measures taken by the Federal Reserve and the Administration and Congress will avert a deep and prolonged slowdown and that action by other industrialized countries most directly affected will prevent its spread.

Although important economies in the developing world may have some resilience to the effects of the credit squeeze and slower growth in industrialized economies, the IMF World Economic Outlook points out that “the overall balance of risks to the short term global growth outlook remains tilted to the downside”. It warns that “the greatest risk comes from the still unfolding events in financial markets, and particularly the concern that the deep losses on structured credits related to U.S. sub-prime mortgage and other sectors could lead to a mutation of a credit squeeze into a full blown credit crunch with a severe impact on economic activity”.

The ILO has followed with great interest the policy debates and actions of central banks and finance ministries over recent months in view of the importance of monetary and fiscal policies to creating a conducive environment for the international community’s objectives of full and productive employment and Decent Work for All.

Imbalances in financial markets are related to wider disequilibria in society and in the process of globalization. Averting the risk of a major global slowdown and ensuring recovery to a sustainable global development path thus requires coherent policy action within and between countries across several policy fields, including finance and investment, trade, employment and social affairs and environment.

Responding to the current financial turmoil is also an opportunity to develop a new agenda for sustainable development fit for the era of globalization. We need to find a better balance between the democratic voice of society, the productive dynamic of the market and the regulatory function of the state.

Fiscal and monetary counter-cyclical measures will need to both reflect the specific situation of individual countries and also the potential for increasing the impact of policy initiatives through coordination. In principle, joint action should be a more efficient way of counteracting the deflationary effects of the credit squeeze than isolated national reactions. It is however vital that underlying challenges of a longer term character are also addressed through an enhanced effort of multilateral cooperation.

I see four priorities for international discussions at the Spring 2008 Meetings of the IMF and World Bank and more widely within the multilateral system:

§ Fiscal Policies for Social and Economic Stability

§ International Regulation of Financial Markets

§ Sustainable Enterprise Development

§ The Employment Dimension of Policies to Address Climate Change

Fiscal Policies for Social and Economic Stability

In considering fiscal policy options, I believe governments will wish to take into account the growing evidence of a widening of income gaps over the last two decades. These social imbalances, as well as creating tension and division, have contributed to financial and economic imbalances. The other side of the sub-prime mortgage crisis is a long period of stagnation in the real wages of middle class America and the consequent increase in borrowing to pay for housing.

Governments can shape the distribution of disposable incomes through the tax and transfer systems. In tandem, progressive taxation and social security systems can reduce the inequality of disposable incomes to a level that is often much lower than that of market incomes. Possible trade-offs between equity and efficiency furthermore need not be steep. Indeed equity and efficiency can often go hand in hand; over the past two decades countries with low inequality – such as the Netherlands – did equally well in terms of growth as those with limited redistribution and higher inequality.

This evidence is particularly important in the current economic conjuncture as countries consider the fiscal policy options recommended by Managing Director Strauss-Kahn. In industrialized countries, as the World Economic Outlook argues, so-called “automatic stabilizers” consisting in a large measure of progressively financed social security systems are more fully developed in European countries than in the USA and reduce the risk of economic deceleration as well as inequality. Fiscal responses to slowdown should therefore seek to strengthen the redistributive quality of tax and benefits systems both to ensure the maximum impact on consumption and also to counteract the trend towards increased inequality of market incomes.

Some developing countries have started to build automatic social and economic stabilizers. However such systems often reach only a small layer of society leaving most workers and their families, mainly in the informal economy, vulnerable to risks such as ill-health, injury or job-loss and the country as a whole vulnerable to external and domestic crises. The lessons for developing countries of previous financial crises are that informal employment tends to rise more than outright unemployment, driving up the incidence of poverty and that recovery is long and slow for the most vulnerable workers.

Many developing countries need to address widening economic and social gaps that hinder a balanced expansion of consumption, savings and productivity growth. This is given added urgency by the likelihood that exports to industrial countries may not be sufficient to drive growth and development over the next two to three years. As the World Economic Outlook argues, accelerating public investment plans and advancing the pace of reforms to strengthen social safety nets, healthcare and education is an appropriate response to a more negative external environment for developing countries with the policy room. And as President Zoellick stressed in a recent speech the poorest are hit hardest by rocketing food prices and need cash or food assistance to supplement their incomes.

A basic social security floor, adapted to meet specific countries needs and possibilities, is a feasible goal within a reasonable time frame for most developing countries. Such a social security floor could consist of:

• Access to basic health benefits;

• Income security for all children through family/child benefits aimed to facilitate access to basic social services: education, health, housing;

• Access for the poor and unemployed in active age groups to basic self targeting social assistance, for example through employment guarantee schemes;

• Income security for people in old age, invalidity and survivors through basic pensions.

Brazil, Chile, Mexico, India, Namibia and South Africa are successfully implementing elements of a basic social floor. ILO research shows that the combination of a modest cash benefit for children and a modest pension, which could be an entry level benefit package for the least developed countries, could reduce the poverty head count by about 40 per cent costing about 4 per cent of their GDP. 10

The distributional impact as well the size of fiscal policy injections influence the effectiveness of policy packages. The composition of such policy packages should therefore figure in international discussions on joint efforts to meet the global challenges of underlying social and economic imbalances.

International Regulation of Financial Markets

Housing finance has become an international market. Easy lending pushing up property prices which are then used as collateral for further lending is a practice which should be controlled in view of the serious and widespread damage caused by the eventual inevitable bursting of the asset price bubble and collapse of credit pyramids. Experience suggests that a strong direct or regulatory public presence in housing finance markets is needed to dampen volatility and the consequent negative effects on macroeconomic stability. Ensuring that working families are able to afford decent housing should be the guiding principle in the design of systems of housing finance.

Over the past years of financial market boom, many viable companies have been bought out using highly leveraged borrowing that will saddle productive businesses and their employees with onerous repayments for years to come. It seems likely that many will not survive. As Bob Lutz Vice Chairman of General Motors said recently, “Real economic growth is created by value-added production. You cannot create real economic growth by trading pieces of paper. We have to relearn that lesson over and over again.” Alongside action to stave off systemic risks to the international financial system governments need to put in place new rules to prevent the imprudent behaviour that fuelled the current turmoil in housing markets and damaged the foundations of the productive economy.

I look forward to the results of the international discussions now underway on reforms to financial regulations and urge that consideration be given to building in incentives for investment in productive and sustainable enterprises and disincentives for the financing of high risk borrowing against inadequate collateral.

Sustainable Enterprise Development

The three pillars of sustainable development – environmental, economic and social – provide a conducive policy framework for enterprise development and an alternative to a narrow short term share holder value framework for business.

At its June 2007 Conference the ILO’s tripartite constituency of employers’ and workers’ organizations and governments agreed on a comprehensive set of conclusions on the promotion of sustainable enterprises which provide a sound platform for coherent policies within the multilateral system. Promoting sustainable enterprises is about strengthening the rule of law, the institutions and governance systems which nurture enterprises, and encouraging them to operate in a sustainable manner. Central to this is an enabling environment which encourages investment, entrepreneurship, workers’ rights and the creation, growth and maintenance of sustainable enterprises. Policy frameworks must balance the interests and need to turn a profit of enterprises with the aspiration of society for a path of development that respects the values and principles of decent work, human dignity and environmental sustainability.

A narrow perspective which fails to take into account the benefits as well as the costs of regulations concerning business is unlikely to be sustainable. Respect for human rights and international labour standards, especially freedom of association and collective bargaining, the abolition of child labour, forced labour and all forms of discrimination, is a distinctive feature of societies that have successfully integrated sustainability and decent work. Poorly designed regulations and unnecessary bureaucratic burdens on businesses limit enterprise start-ups and the ongoing operations of existing companies, and lead to informality, corruption and efficiency costs.

Well-designed transparent, accountable and well-communicated rules, including those that uphold labour and environmental standards, are good for markets and society. They facilitate formalization and boost systemic competitiveness. Reform of laws and the removal of business constraints should not undermine such standards. International support to private sector development, including rules for finance markets, should build on the comprehensive sustainable enterprise approach.

The Employment Dimension of Policies to Address Climate Change

Measures to slow and contain climate change as well as adapt to its now unavoidable consequences require investment in a new reduced carbon emissions economic infrastructure. This will alter the structure of employment, creating new jobs, making some jobs redundant and changing the content of virtually all forms of work. This entails a long term transition in how enterprises organize work and what they make. Social dialogue between management and union representatives is an essential mechanism for developing strategies for such transitions that are both efficient and equitable. The sooner major efforts are started to conserve energy use, shift to renewable sources and adapt production, consumption and employment patterns the better both from the perspective of ecological damage control and also the need to manage significant structural change.

There are likely to be significant opportunities to create green jobs that contribute to sustainable development and redress shortfalls in decent work as a result of economic slowdown. Major examples that are relatively labour-intensive include building insulation, which can yield significant reductions in energy consumption, coast and river flood protection barriers, and the upgrading of public transportation systems. The ILO is working with UNEP, the international trade union movement and others on a Green Jobs Initiative to promote dialogue and action on the employment adjustment challenges posed by adaptation to and mitigation of climate change.

Investing in the adjustment of our production and employment structures for sustainable development should form part of recovery programmes.

Conclusions

The ILO Governing Body was pleased to welcome President Zoellick to its March 2008 meeting and much appreciated the wide-ranging discussions his presentation stimulated. They look forward to deepening collaboration on a range of issues between the Bank and the ILO particularly at national and regional level. They also look forward to welcoming Managing Director Strauss-Kahn in the near future. The ILO’s tried and tested mechanisms of social dialogue and tripartite discussions are particularly vital in building consensus around policies to avert a steep slowdown and move out of recession. I believe they are an undervalued asset upon which the multilateral system should draw in shaping policies for a sustainable recovery.