Business forum: Take a harder look at predatory investing

The nurturing and encouragement of private equity is part of the American DNA, and most politicians are loath to tamper with it.

However, private-equity and hedge-fund activities have increased to such an extent that we should now take inventory of where we are. What are the benefits, exposures, risks and ramifications of the increasing tendency to put much of industrial America in the hands of people seeking a quick buck?

The volume of private-equity and hedge-fund activity is enormous and growing precipitously. In 2005, it was estimated that such funds were then managing around $500 billion, with positions in about 4,000 companies. Two years later the activity is much larger, but details on these private investments are hard to find and harder to analyze.

Meanwhile, many of America's stellar companies have been affected. Chrysler, Allison Transmission, Rexnord, TRW, RJR Nabisco, Houghton Mifflin, Hertz and several other major firms already have been taken over. Alcoa, Dow Chemical and several other prominent companies are rumored to be candidates.

The sheer magnitude of recent private equity investments is mind-boggling: Among them have been a $48.5 billion offer for a Canadian telecom group, a potential $22 billion bid for a British cable television company, and the $26 billion purchase of Hilton Hotels. The research group Private Equity Intelligence suggests that $240 billion of private equity money was raised in the first half of 2007, well beyond the 2006 record of $459 billion.

The Blackstone Group by itself reportedly has $98 billion worth of assets under management. KKR has $86 billion. About $600 billion in buyouts were announced in the first half of 2007.

Yet there are honest questions regarding the role of what is often predatory investing.

Private equity managers have sketchy histories of bringing prosperity to companies where they invest. Often, they have no practical experience in managing the affairs of industrial companies. And the effects, such as with the disastrous 1989 leveraged buyout of Northwest Airlines, can be calamitous.

Frequently, the heavy debt needed to consummate takeovers or acquisitions weighs so heavily on the acquired firm that its competitive advantages erode.

Tax collections are invariably reduced because company profits are almost always diminished or eliminated by the heavy (and tax-deductible) interest payments associated with huge debts necessary to finance the transactions. Vendors, common targets for cost and cash savings, often suffer with dictated lower prices and delayed payments.

The cost to society

There is often a large societal cost because employees, communities, creditors and customers often find their own security has been severely compromised as a result of takeover transactions.

Concern about the potential downside of rampant private equity fund activity has surfaced at the Securities and Exchange Commission, the Federal Reserve and Congress. Greater regulation has been recommended on several fronts, but these initiatives are meeting strong resistance from the special interest groups directly and indirectly involved in these activities.

My concern is for the country's more robust and competitive manufacturers, utilities and transportation companies. These companies are especially appealing candidates for predatory investments because they often have something other companies do not: collateral that can be borrowed against.

As we look at the list of companies targeted, or rumored to be targeted, by leveraged buyout firms, it is not surprising that some of America's most prestigious and long-established manufacturers are among them.

Think of how much collateral Alcoa must have, or Dow, or the Allison Transmission unit of General Motors -- collateral that, in some cases, took more than a century to accumulate. What will become of these important companies if they fall into the hands of this inexperienced cadre of predatory investors?

Dividend recapitalization

One of the techniques employed to make sure the private equity funds look good and recoup their investments is through what is termed "dividend recapitalization."

It is not a complicated transaction: The acquired firm, now under the management of the private fund, borrows as much as it can against all available assets to declare a huge dividend to the acquiring fund -- often sufficient for the firm to recover its initial investment.

The fund shows profits, but the acquired firm is impoverished.

There is some evidence that the bloom might be off the rose on predatory investment activities. Blackstone Group stock has been hovering at around $19 per share -- about 45 percent below its June high of $35 per share the day after its June 21 initial public offering.

Shares of Fortress Investment Group, another New York-based private equity firm, is off about 57 percent from its 52-week high.

Although many of us might rejoice at the sudden reversal of fortunes for the predatory investors, we may find that the bulk of this misfortune will fall upon others, rather than to the managers of the private investment funds. The two founders of Blackstone, for instance, sold $2.6 billion of stock during that company's initial public offering in June.

It always surprises me that elected public officials do not show more concern about the critical need to retain effective and high-quality businesses in the United States. Predatory investing needs review from the perspective of trade balances, tax collections, the orderly working of markets and employment.

Perhaps we should ask our public officials what they are doing -- besides raising money for their own campaigns.