Private equity has recently started employing ESOPs in their leveraged buyout transactions. It looks like strange bedfellows since they serve opposing interests. It’s touted by private equity and is being hailed by some in the ESOP arena as a great potential expansion of true employee ownership. But is it really?
Private Equity Exploitation of ESOPs
It’s bad enough that private equity kills companies and deprives employees of good jobs. Now the private equity industry wants to use ESOPs to help boost their investor returns by getting employees to work harder and better and be more engaged until the private equity companies get all their money out and dispose of the company.
How is private equity going to give ESOPs a bad reputation? If you listen to news stories about how companies connected to private equity go out of business, private equity is never mentioned. The blame is laid upon market forces, some strategic mishaps, or mismanagement.
What will the private equity and ESOP stories be in the end? “It was an ESOP company and it failed because ESOPs are a bad deal for employees and too risky. ESOPs kill companies.” We heard that in the 1980s when investors bootstrapped their deals with ESOPs because it lowered part of the cost of their LBOs by making the debt deductible. But now, if the private equity has their best scenario, they buy off the employees with a pre-negotiated ESOP sale and terminate or wind it down, while the private equity companies reap their improved disposition value.
For example, Toys R Us was run into the ground by private equity. Private equity killed Geoffrey Giraffe. The autopsy showed that he was strangled to death. But, the media’s published story was that Toys R Us couldn’t compete with online toy sales and other deceptive bits of data, such as they didn’t modernize their systems. Who didn’t? Online sales of toys at the time of Toys R Us’s demise were estimated to be only 20% of the market. We don’t have precise figures as to what was taken out of the company while private equity owned it, however, the employees will testify as to the deteriorating conditions of the stores and how the company was neglected and was not run the way it was prior to the private equity buyout, with a long-term perspective. As a result, many employees lost their career jobs at Toys R Us.
Don’t be fooled. Private equity is telling a good story about providing ESOP forms of employee ownership, but “the spots on the leopard don’t change.” Or if you read the book or saw the movie, “The Life of Pi”, “the tiger will always be a tiger”. They haven’t changed their business plan. They have just juiced it up with a transitory ESOP. Employees will be given their “go away money,” so they can claim the deal was good for everyone, but certainly not true ESOP employee ownership.
You know the comedian Lewis Black? He is one of my favorite comedians because he bluntly speaks his mind. Now, how did I get off on this rant? I recently came across a couple of resources that got me worked up enough to drop this podcast.
The Private Equity Formula
I read a book entitled “Plunder – Private Equity’s Plan to Pillage America” by Brendan Ballou, a federal prosecutor, who served as Special Counsel for Private Equity at the Department of Justice. He knows this market sector.
If you’re not familiar with the private equity formula and how they squeeze value out of companies, pick up the book. It’s a breezy read and it’s great for laying on the beach if you’re a business advisor. If you’re a CEO and are looking to sell your company, it’s an interesting perspective, though, in most cases the money does the talking. I often hear from CEOs and other company officers that think when the company is being bought by a private equity group, the buyer is interested in running the company as one of their “portfolio companies” and they “keep their hands off”. In most cases, those officers are gone in a year and they’ve been bought out of their retention, bonuses, stock benefits, and executive compensation. The company is now on track to suffer the fate of private equity—take money out and offload it per their business plan.
The Real Intentions of Private Equity’s ESOP Strategies
The second and most telling is an interview I stumbled across on YouTube with Peter Stavros, the new co-CEO of Private Capital at KKR, at the Annual Milken Conference. KKR is one of the largest private equity firms in the U.S.
If you listen to the interview closely or read the transcript, the rationale given for the use of an ESOP is that, “Isn’t it great that employees in five years can get an account balance that’s equal to a full one year’s salary?” In the interview, Mr. Stavros explains that they had carefully calculated the size of the ESOP or other stock benefit needed for this employee engagement strategy to work, and it has to be in a certain range for it to pay off for the private equity investors. They know what the employee equity end game is. They know what it costs to get greater productivity out of the, perhaps temporary, workforce. Make no mistake, this is not long-term employee ownership. Peter clearly states, “If you are not showing someone a path to earn 100% of their income, over say, five years, it isn’t enough to move the needle. It’s not enough to capture and keep their attention over our typical investment horizon.”
Keep their attention over our investment horizon? I don’t even know how to describe the real intentions here. They are absolutely geared to maximizing private equity returns by buying off employees with a five year account balance. It’s all about keeping them focused so that private equity can get their maximum investment. What is happening in the meantime? Read Brendan Ballou’s book, “Plunder – Private Equity’s Plan to Pillage America.”
This is simply an equity flip for the employees. This isn’t absolutely bad financially for the employees at the company for those five years, but do they know that they are (just) private equity investors now? What happens five years down the road? How many ultimately lose their jobs and what is happening in the meantime?
When asked by the interviewer, “What is this? Is this long-term employee ownership or is this an equity grant?” He deftly states that a mere grant of a small equity interest “would be dilutive to our shareholders and investors…it wouldn’t meet the higher productivity, corporate and better corporate outcomes, so as fiduciaries of capital,…so yes, we want to do good, but we have to be good stewards of capital.” First things first. He is absolutely across the table on this one, even as he describes the ESOP contribution as “a free benefit.”
Enough said about that. The game plan is the same. I wonder what the internal memos in the private equity firms say versus what the employees understand? What are their investors told about this strategy for enhancing their return on flipping the target company? On the other side, does the average worker know the private equity model?
The True Impact on ESOP Companies
In all fairness, let’s consider the example cited in the interview by Mr. Stavros this way: “Let’s take an example of a company we purchased, CHI Overhead Doors…over eight years…investors made a huge gain…” What was the end of CHI? Was it milked and killed by private equity? No, it was bought by NUCOR, a publicly traded seemingly strategic buyer for 13 times earnings. Compared to ESOP multiples, that’s high, perhaps doubling their money over eight years assuming the first sellers got a good price themselves or if private equity got a good deal on the front end, tripling their money.
It may be that whoever was working there at the time got a good deal on the equity play, but it wasn’t long-term employee ownership and it was merely an employee ownership blip on the radar screen.
On the other hand, the employees could have arguably done this themselves and netted all of the return. A 100% ESOP can be a tax-free company. It can use the 33% cash flow savings as working capital. Employ these same economic engagement techniques that KKR uses and keeps proprietary behind their Ownership Works non-profit, and make a killing themselves with no investor taking out their fees and profits in the meantime. Then again, they could stay employee-owned.
Personally, my first introduction to private equity and what it did to ESOP companies at the back end was in the sale of a regional chain of men’s stores in 1988. Private equity acquired the company from the original family ownership. It already had a 30% ESOP in place and the employees wanted to buy the rest of it and give the sellers a tax deferred sale. Private equity claimed that they were going to modernize it, improve inventory systems, etc. What they were actually doing, even though we didn’t know about this, was they were acquiring other chains like Aaron Brothers Art Mart, if you are old enough to remember them, “rolling them up” with the aim of doing something with them. Ultimately, what happened to both of those store chains? The death of our client’s store was attributed to bad management and the inability of the stores to improve the inventory mix and install inventory controls and barcoding systems for managing sales and cash flow. Well, who failed to do that? It wasn’t the old management.
Read the chapter in the Plunder book about how private equity has decimated the retail sector of our economy.
Will all of the private equity ESOP flips be as seemingly successful as CHI? Pete Stavros, KKR, and their non-profit affiliate Ownership Works are not the only ones in on this action.
There are many more articles on this subject that have been published. Here are just a few.
- Private Equity Is Gutting America and Getting Away with It
- Employee Ownership Programmers: How do they affect returns for LPs?
- Private Equity Firms Want to Give Workers Ownership Stakes
- Is Private Equity’s Employee Ownership the Real Deal?
In an upcoming podcast, we’ll talk about where the legal flaws are in this strategy, so far as we are aware of their structures. There are some fundamental issues in how they’re using the ESOP and economic engagement strategies to achieve their goals.