Financial Capitalism, Breach of Trust, and Collateral Damag - PowerPoint Presentation

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Financial Capitalism, Breach of Trust, and Collateral Damage: Four Cases

Eileen

Appelbaum

, CEPR

Rosemary

Batt

, Cornell University

Ian Clark, University of

Birmingham

BJIR Conference: Across Boundaries

London School of Economics

December 12-13, 2011Slide2

This session’s agenda

New Financial Intermediaries

Actively manage claims on wealth creation, distribution

Private equity business modelBreach of TrustAgency theory and profitsDefault on implicit contracts and stakeholder claimsFour cases – will focus on twoChallenges to Employment Relations Research

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New Financial Intermediaries

Private equity sponsors (investment firms)

Raise PE funds that invest in operating (portfolio) companies

Actively insert themselves into management and operationsPrivate equity business modelInvestment firm (general partner) raises capital from pension funds, endowments, individuals (limited partners)Uses PE fund to acquire portfolio of operating companies

Expectation is fund will make profitable exit in a few years

‘Two and twenty model’ – management fees, carried interest

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Agency Theory

(Jensen &

Meckling

1976, Jensen 1986)Provides rationale for LBOs, PE intervention in managementSeparation of ownership, control = managerial opportunismLBO takes company private, ownership is concentratedDebt good ?

Retained earnings used to service debt

Have to borrow to invest – subjects these decisions to market test

Leads to more efficient allocation of capital

LBO boom in 1980s ended in bankruptcies, scandal

Buyout firms came back at end of 1990s, as private equity

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Breach of Trust

Distinguish value creating/value redistributing effects of LBOs

Agency theory view of commitments to employees, suppliers

Defaulting on implicit obligations can benefit shareholdersCan be a virtue – shift resources to more productive uses

Can be a vice – improve financial performance in short-run, undermine competitiveness, viability of firm in long-run

PE can seek rents rather than create wealth and profits

Change structure and financing to reduce taxes

Co-opt management via out-sized financial incentives

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Four Cases of Collateral Damage

Collateral damage

Outcomes that are unintended or incidental to intended outcomes

May result from privileging interests of shareholders over those of other stakeholdersOften due to breach of implicit contracts with other stakeholdersFour cases of LBOs where costs to other stakeholders outweigh gains to shareholdersUS: Mervyn’s, Stuyvesant Town/Peter Cooper VillageUK: EMI, Cadbury

Focus in presentation on two:

Mervyn’s

and EMI

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Mervyn’s

Mid-tier retailer, profitable but needed sprucing up

30,000 employees; 257 stores, 155 company owned

Bought by PE – included Sun Capital in 2004$1.2 B - $400 M equity, $800 M debt against real estateOp Co/Prop Co modelPE prospered via sale of Prop Co, dividend recaps ‘05, ’06Stores saddled with high rentsPromised Investment for turnaround not forthcomingOp Co went through 4 CEOs in 4 years

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Mervyn’s

Breach of implicit contracts w/vendors led to downfall

Trust is critical in dept. store operations

Orders to manufacturers paid after delivery of goods‘Factors’ finance production, need to believe retailer will paySun Capital refused to give assurances of paymentFactors cut off financing for back-to-schoolDeclared bankruptcy July 29, 2008High rents made it impossible to sell chain – liquidated

Vendors owed > $102 M, Levi-Strauss owed $12 M

PE did fine – profits from Prop Co > losses on Op Co

Vendors now suing PE for ‘fraudulent conveyance’

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EMI

Divisions – music publishing, new recording releases

Bought by Terra Firma in August 2007

£4.2 B, £2.5B loan from CitiBank – high debt burden Unlike Odeon cinema deal, no RE assets Difficult to issue bonds against rights to publish songsPublishing profitable, new music division losing moneyFailure to turn EMI around due in part to global crisis, falling music salesMore fundamental: breach of trust w/established artists

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EMI

Breach of trust with established artists

Music industry requires a form of ‘patient capital’

Established artists w/back catalogue subsidize new artist pipeline Loss leader approach – rests on trust between artists/ managersPE tried to increase shareholder returns Pruned roster of established artists, reduced new artist pipelineBroke implicit contract between artists/repertoire & line managersAlienated EMI’s managers: PE as ‘plantation management’Artists/managers saw management discretion as source of success

PE saw it as opportunism and waste

Led to voluntary departure of valuable

talent

Managers/artists (Rolling Stones, Radiohead, Paul McCartney)

Declared insolvent and seized by Citibank in Feb. 2011

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Challenges to Employment Relations Research

Organizational context for labor has changed

Workers, unions, researchers still think in terms of

managerial capitalismPE ownership changes goals and governance of firmsTrust relations devalued - implicit contracts breached

PE use of debt to drive cost efficiencies is at odds with competitiveness based on knowledge and innovation

Long-run competitiveness of firm takes back seat to maximizing financial returns over 3 to 7 year time horizon

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Mechanisms for value extraction have changed

Finance capital dominates economic and financial activity beyond financial markets – e.g., PE portfolio companies

Financial actors actively assert and manage claims on production and wealth creation

Do this as owners, not as managers – accounting value, not economic value via production, dominates decisionsRent seeking not wealth creationDefault on implicit commitments Increased debt not sustainableBankruptcy as strategy to reduce pension liabilities

Challenges to Employment Relations Research

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May challenge Varieties of Capitalism approach

PE operates across borders => to what extent is acquired firm’s behavior constrained by interlocking national institutions ?

PE ownership alters governance of firms – moves firms away from embeddedness in national business system

What does country of origin tell us about operation of firms Can we still speak of the “Britishness” of EMI, Cadbury?

Challenges to Employment Relations Research

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Conclusion: Challenges for Researchers

Realization of value, not creation of wealth, dominates decision making by PE-owned firms

May need to examine assumptions – e.g., importance of productivity agenda, influence of country of origin

Firms governed by PE less able to keep bargainsBreach of trust may realize value for owners, but at expense of workers, vendors, other stakeholdersDivergence of interests of owners, managers and workers intensified by PE ownership

Who should unions bargain with in PE-owned firms, who should researchers interview and study?

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