The Color of Money

The Credit Strategist - June 2024

During the Great Financial Crisis of 2008-9, institutional investors failed to recognize that they were allocating capital to managers who were working against their interests.  They were funding managers to invest in mortgage securities while simultaneously investing in other managers betting against the same mortgage securities.  For many of the beneficiaries of pension funds and the like, the consequences of this contradictory behavior turned out to be extremely damaging.  The same phenomenon is occurring today with institutions allocating capital to private equity firms while simultaneously financing their leveraged buyouts (directly or indirectly).  Private equity firms use the capital allocated to them by institutions to fund the equity in leveraged buyouts and then borrow the balance of the funds needed to complete these transactions from lenders that are funded by the same institutions.  And when these transactions run into trouble, the private equity firms take steps to prejudice the interests of these lenders by exploiting loopholes in debt instruments or shifting assets out of reach of lenders.  Private equity firms argue that they are fulfilling their fiduciary duties to their partners but that argument rings hollow when those partners are the same parties sitting on the other side of the table as lenders.

            The failure of institutional investors to connect the dots between their roles as private equity investors and lenders is not only a serious intellectual and ethical failure but a serious breach of their fiduciary duties to their beneficiaries. The private equity and credit managers may owe separate duties to their respective partners but when their underlying partners overlap the difference is one of form over substance.  Institutions need to do a much better job policing these conflicts.  For the moment, however, they are increasing their allocations to private credit and with good reason.  Private credit offers better terms than public credit markets.  As I have been saying for several years, public debt markets offer no yield, no covenants and no liquidity while private markets offer attractive yields, strong covenants and no liquidity.  So private markets are more attractive than public markets.  On May 25^th, The Wall Street Journal reported that nearly 61% of limited partners investing in private markets – pension funds, sovereign wealth funds and insurance companies – plan to expand their asset allocations to private credit in 2024 according to a January 2024 survey by S&P  Global Market Intelligence (“Investors To Boost Assets in Private Credit,” May 25-25, 2024).  CALPERS raised its allocation to private credit from 5% to 8% in May, claiming its return on this asset class was 13.3% last year.  But private credit markets primarily serve the private equity industry so lenders are still subject to the abusive practices and tactics of private equity borrowers described below.  Along with better terms comes the risk that private equity borrowers will try to deprive private lenders of the benefit of debt covenants or try to move assets out of their reach.  That is what private equity firms tend to do.

            In recent weeks, two companies filed for bankruptcy after being ravaged by private equity ownership:  Steward Health Care and Red Lobster.  Both companies were victims of the so-called “private equity playbook” which is a term used to describe private equity firms stripping companies of their most valuable assets while cutting costs to maximize their own returns at the expense of employees, customers, communities and creditors of businesses they purchase using large slugs of debt.  The private equity owners of Steward (Cerberus Capital Management) and Red Lobster (Golden Gate Capital) sold the companies’ valuable real estate in sale-leaseback transactions that significantly increased the companies’ debt burdens.  The higher debt burden crippled Steward’s hospitals and endangered patient care while enabling Cerberus to pay itself a dividend and eliminate its risk on the transaction, leaving its lenders holding the bag. Golden Gate Capital did the same thing with Red Lobster (selling $1.5 billion of real estate in a sale-leaseback to recapture most of the $2.1 billion price of the going private transaction), the only difference being that Red Lobster is a restaurant chain and wasn’t endangering people’s lives with its actions (unless it undercooked the lobsters).  If we look deeper, it is likely that at least some of the lenders to these companies were also directly or indirectly limited partners in these private equity firms’ funds (and it is even conceivable that patients in Steward’s hospitals were beneficiaries of institutional investors in Cerberus’s funds), which if true would be further proof of the words that started this newsletter:  everything is connected.  The problem is that while everything is connected, the fiduciaries charged with protecting people’s money aren’t making the connections so they are effectively losing with the left hand the money they think they are making with the right. 

            Steward’s bankruptcy, the largest hospital company bankruptcy in years, is bringing more attention to the damage wrought by some private equity transactions to the healthcare industry.  In a recent “Heard on the Street” column, The Wall Street Journal argued that the consolidation resulting from private equity deals is also raising healthcare costs: “Years of dealmaking have led to sprawling hospital systems, vertically integrated health insurance companies, and highly concentrated private equity-owned practices resulting in diminished competition and even the closure of vital health facilities.”  “High Health Bills? Thank Private Equity,” May 31, 2024)  The Journal described the problems that resulted from Welsh, Carson, Anderson & Stowe’s roll up of anesthesia practices into U.S. Anesthesia Partners, a company that was sued by the Federal Trade Commission last year for anti-competitive behavior (the case is still pending and like many government suits may prove to be unfounded).  Regardless of the merits of that case, there is no doubt that the “private equity playbook” applied to healthcare involves adding more debt and cutting expenses in these businesses, often at the expenses of patients.  As the Journal writes: “During the past decade, private equity has spent hundreds of billions of dollars acquiring healthcare businesses from emergency care to anesthesiology to nursing homes.  Where private equity has gone, studies show, prices have tended to increase.”  Private equity is attracted to healthcare because the government throws nearly one trillion dollars at the sector every year (much of it wasted or stolen).  And one of the reasons America’s healthcare system spends more than other developed countries’ with no better (or worse) patient outcomes is that it is based on profit-seeking behavior that may not necessarily be the best model for this particular industry.  Blind faith in markets is still blind faith with an emphasis on the word “blind.” It’s time we ask whether it is optimal public policy to allow private equity firms to leverage up businesses whose priority is saving lives.  The experience so far has been decidedly mixed.