
Background
Cerberus Capital, a private equity firm, began buying several hospitals in Massachusetts in 2010. In 2015, Cerberus sold most of its hospitals’ property to other investors for $1.25 billion. This suddenly added significant lease (rent) costs to the hospitals’ budgets. Other cost-cutting practices were applied. The hospitals then provided worse patient care, more falls, hospital-acquired infections, and patient readmissions. In May 2024, the entire nationwide Steward Healthcare system of hospitals declared bankruptcy. The state of Massachusetts spent a reported $700 million dollars of public money on keeping the Massachusetts hospital system afloat.1
What Is Private Equity? – from production to extraction
Private Equity (PE) funds are, at the moment, the pinnacle of financialization. PE firms work on an entirely extractive business model. They are only interested in extracting as much money as possible in the shortest time. And they do this with other people’s money, borrowed money. “These facts of short-term, high-risk, and low-consequence ownership explain why private equity firms’ efforts to make companies profitable so often prove disastrous for everyone except the private equity firms themselves.”2
Brendan Ballou lists the strategies employed by PE firms:
- Acquire a company and take it private.3
- Debt – load up the acquired company with debt that it must pay back out of operating funds.
- Leasebacks involve selling assets and leasing them back to the acquired company. PE firms gain the value of the assets, while the acquired firm is further burdened with lease payments.
- Dividend Recaps – Use part of the borrowed money to pay a dividend to the owner, the PE For example, using borrowed money, Blackstone extracted $200 million from Apria Health in 2020.
- Operational changes – Layoffs, Price Hikes, and Quality Cuts
- Strategic Bankruptcies
- Tax Avoidance
- Legal structures designed to shield PE from liabilities and responsibilities.
- Perverse incentives for managers of acquired companies
PE serves the needs of the rich and other institutional investors (e.g., pension funds, university endowments, etc.). PE is a rebranding of the 1980s’ Leveraged Buy Out (LBOs) operations.
Here is a brief description of the PE model in action. A fund of money is raised from private investors, pension funds, endowments, wealthy individuals, sovereign wealth funds, etc. Companies are targeted for acquisition, most often with large amounts of borrowed money to meet the acquisition price. Once acquired, additional debt can be added with a rigorous cost-cutting regime to drive down operating costs. Reductions in staffing and benefits (including pensions) are typical. This supports the significantly increased costs of paying back the debt. It is not uncommon that fixed assets of the acquired company are sold off. This is a favorite strategy for retail companies. In these cases, the PE firm retains the money from selling the retail store’s real estate while further burdening the retail operation with the costs of leasing the space back from the new owner. Acquired companies are typically sold off within five years.
PE funds also earn money through what is usually referred to as the 2 + 20 fee structure. Each year, the PE firm charges investors 2% of their invested capital and receives 20% of the gains in the transactions. The PE firm managers also receive very favorable Federal income tax breaks through the carried interest deduction.4
A study of 484 companies acquired by PE firms showed that they suffered a 20% bankruptcy rate compared to a 2% rate for a control sample.5 The PE strategy is entirely focused on immediate, short-term financial results for the PE firm, not for the acquired company, its employees, and customers.
Beyond financial strategies, the legal system can be used to shield private equity firms from legal responsibility or even visibility. Unlike public corporations, privately held companies are exempt from most of the regulations and requirements for public disclosure. PE then adds a further layer of obfuscation by breaking firms up into small pieces that are then held by innumerable shell corporations, making it difficult, if not impossible, to determine who is doing what. This also facilitates the shifting of legal responsibility back to the acquired companies shielding the PE firm from legal responsibilities.
As with other sectors of the economy where market concentration creates problems for competitors, workers, choice, and innovation, PE has surged in size over the past two decades. “In 2000, private-equity firms managed about 4 percent of total U.S. corporate equity. By 2021, that number was closer to 20 percent. In other words, private equity has been growing nearly five times faster than the U.S. economy as a whole.”6 “In 1996, about 8,000 firms were listed in the U.S. stock market. Since then, the national economy has grown by nearly $20 trillion. The population has increased by 70 million people. And yet, today, the number of American public companies stands at fewer than 4,000.” PE is making large parts of the economy invisible to public scrutiny.
A Side Note about Real Estate Asset Sales
In the case of Steward Healthcare, the PE firm employed a favorite strategy – sell off the buildings and require the company to become a tenant and pay rent. This is referred to in the PE industry as the Sale-leaseback strategy. This produces a huge windfall of cash that the PE firm can use to pay itself dividends. This has been applied on a massive scale in PE acquisitions of retail establishments. For example, here are some PE-owned restaurant chains: Domino’s, Wendy’s, Pizza Hut, Taco Bell, Tony Roma’sBoston Market, Auntie Anne’s, Arby’s, and more.
What Does the Massachusetts Law Do?
House Bill 5159 provides for the following oversight in the healthcare industry in Massachusetts:
- Expanded notification requirements for mergers, acquisitions, or affiliations for hospitals and the formation of new entities.
- Notification of transactions involving equity investors that change control or ownership, sale-leaseback deals, conversion from non-profit to for-profit status, and mergers and acquisitions that would give an organization a dominant market share in a service or region.
- Cost and Market Impact Review process to evaluate deals
- Investors may be called as witnesses at public hearings
- Annual financial reporting requirements and penalties for failure to comply
- Expanded authority for the Attorney General
- Expanded liabilities for owners and investors for violations of the Massachusetts False Claims Act
What’s Missing?
This new law provides greater transparency and establishes penalties and enforcement for notifications. However, it does not address the fundamental problem with PE (and many other forms of financial manipulation): the sole purpose of these ventures is to extract as much money as quickly as possible from the victim. There is no notion that investment should be designed to produce new or better products and services. The only purpose of PE is to extract money. This business strategy explicitly allows for and encourages the destruction of productive organizations in pursuit of maximum fast money.
Footnotes
- https://www.wgbh.org/news/local/2024-08-27/cloaked-in-secrecy-steward-health-care-drama-will-extend-into-september
- Brendan Ballou, Plunder: Private Equity’s Plan to Pillage America (New York: PublicAffairs, 2023). Chapter 1 Part 1.
- Going “private” means that the company is not traded publicly and thus is not subject to public disclosure of its performance.
- Under the carried interest deduction, the profits received by the investment managers are treated as long-term capital gains rather than ordinary income. Long-term capital gains are generally taxed at a lower rate than ordinary income.
- Ayash, Brian, and Mahdi Rastad. “Leveraged Buyouts and Financial Distress.” SSRN Scholarly Paper. Rochester, NY, July 20, 2019. https://doi.org/10.2139/ssrn.3423290
- Rogé Karma, “The Secretive Industry Devouring the U.S. Economy – The Atlantic,” The Atlantic, October 30, 2023, https://www.theatlantic.com/ideas/archive/2023/10/private-equity-publicly-traded-companies/675788/.