The Exchanges

Q Brendan, curious what you've seen as you've looked across the industry. What's your sense of whether private equity firms are improving the businesses that they own?

A I really appreciate Sachin's model here, and I think that is sometimes what private equity is, and what I hope through proper regulation, it can be even more. My concern is it goes back to the initial problems that we were talking about. The duration of focus, reliance on leverage and fees, and insulation from liability means that oftentimes private equity managers' incentives are different from those of the portfolio companies and leads to bad results. We can go through some of the anecdotes, That also is borne out at least in some of the sort of quantitative studies, suggesting, for instance, that private equity-owned portfolio companies are 10 times as likely to go bankrupt as non-private equity-owned peers. In the best circumstances where firms are thinking for the long-term, taking responsibility, bringing that focus that they need to bring, it can lead to positive outcomes. The example that I keep coming back to is when a firm bought a timber mill in Arkansas. Invested for a decade or longer, used very little, if any, debt, continued to maintain investment even after it sold its majority stake and kept two board seats. Ultimately, they helped revive this plant and helped to revive a whole town. I think where things are going wrong is when people are applying their expertise, not necessarily to building better companies, but to using and growing the legal loopholes that we…

AI assessment note: “private equity managers' incentives are different from those of the portfolio companies and leads to bad results”

Q Now, Brendan, before we start putting the layers on the layer cake, any thoughts on that?

A No, I think that's exactly right. And I think it's important to talk not just areas where we may have differences, but areas where we agree. I think all of us really believe in a capitalist market. It's not an issue that I really think about that much as a lawyer, but in the course of this project, I think I became much more enamored of a working capitalist system and also a working financial system. As long as you want To build a new factory or hire new people, you need investment, you need people who are willing to take the risk and try to make those things happen. I agree that the problem of time horizons is not unique to private equity. I do think that there are certain things that we did in the law that empowered this, whether it's changes to ERISA in 1979 that revised the prudent man standard, or to go back to our earlier point about Insulation from liability and piercing the corporate veil. When you have a situation where it's typically very hard to hold the investor responsible for the actions of the company that invests in, which often makes sense, but may not in a situation where somebody has a majority stake in the company, that insulation encourages a slightly shorter term thinking, because if things go well, the investor is going to be rewarded. If things don't go well, they can typically walk away without anything beyond the money that they stake. So I think if we…

AI assessment note: “No, I think that's exactly right. And I think it's important to talk”

Q Well, let's start pulling apart some of that and maybe go right to that first big word incentives. Brendan, when you say the incentives aren't working as they might, as they should because of legal constructs, what do you mean?

A I often say that there are three basic problems with the typical private equity business model, and this is not to say that every private equity deal is a disaster. You both know, and every listener knows that that's not the case, but they're incentives that shift behaviors so that the chance of bad outcomes for companies, for workers, for employees increases relative to non-leveraged buyouts, and those three problems are this. One is that Private equity firms typically invest for a few short years, three, five, seven years at a time, and that changes their perspective about how long to invest in a given company and how to think about that company's future. The second is that companies that are bought by private equity firms often are levered up with a lot of debt, and the private equity firms are often able to extract meaningful fees from them. And then the third, and this is the part that interests me the most as a lawyer, is that private equity firms Typically are able to insulate themselves from liability. So if something goes wrong at a portfolio company, the private equity firm is rarely held legally responsible for that. And so those three issues shift the incentives to my mind of private equity firms away from long-term investment, away from investments that might help customers and employees and towards a shorter term perspective. Now I'm a lawyer, so I always have to …

AI assessment note: “those three issues shift the incentives to my mind of private equity firms”

Q talk about today of sustainability. In theory, Carlisle wanted to sell this asset to somebody else over a period of time. And to do that, you couldn't just turn all these facilities into something that was worthless and no one wanted to buy. So as you looked at it, What's your assessment of the cause and effect in that particular example of why it played out the way it did?

A Carlisle raises interesting arguments when you read the reporting on this. Look, ManorCare ultimately went bankrupt, not because of anything that we did, but because of changes in calculations on how Medicare disbursements happened. So this really was not our fault. I'm not in a position to argue otherwise, because I'm not in the weeds on Medicare disbursements. In theory, the interest of the portfolio company And the private equity firm should be aligned. The challenge that we've got is because we've got these dual problems, corporate fail piercing, so sort of an insulation from liability, and that ultimately, typically, the debt to finance the acquisition is held by the portfolio company and not by the private equity firm. And the private equity firm typically puts up a relatively small amount of the acquisition price. It means that it changes the incentive calculus so that things go extremely well for the private equity firm if things go well. But it's not to say that there's no loss, but there is comparatively less loss if things go poorly. It's not a equal upside and downside. And so that, I think, people just acting rationally encourages some riskier behavior than might otherwise exist.

AI assessment note: “changes the incentive calculus so that things go extremely well for the private equity firm”

Q Brendan, I know there are some other pieces that have come out of such and mentioned that are trying to say private equity is bad. Are there other arguments that have resonated with you, either in your work or others, that you think pose challenges for private equity?

A I do think that there is some evidence to say that private equity investments are riskier or have higher bankruptcy rates than non-private equity investments, but I think the broader point is well taken. In terms of Other issues to be concerned about, I think it's a more meta, almost political concern in that I think private equity firms have been uniquely successful in lobbying and not just using the rules of the game, but shaping them. Every industry lobbies. It's certainly not a crime or anything like that, but I think that there is something about both the amount of money spent and the people private equity has managed to attract to work on its behalf that has made it Much more effective than some other industries. For instance, and it's well known, the lobbying stories around the carried interest loophole since back when Barack Obama was a senator, was campaigning around this. He worked on it when he was president, failed. President Trump was opposed to the carried interest loophole, was unsuccessful in changing it. President Biden was as well. I think that story is well known, but there's also a thousand smaller stories, for instance, lobbying around surprise medical billing, which was really crucial to some of the business models of the few private equity portfolio companies. They were successful installing legislation for a number of years, and then when it was passed, …

AI assessment note: “I think it's a more meta, almost political concern in that I think private equity”

Q Brennan, I want to push on that. With your knowledge of the legal system, what's practical? In theory, we could say there are all these things that all the states and municipalities and the federal government could, should do to make this better. What can we actually do?

A This is, I think, a very fair rejoinder, which is, at some level, is this a insoluble challenge? Or it's existed for all of time. Can we ever change it? My rejoinder, again, it's a bit of a straw ban argument, not necessarily what you said, is that this is a legal issue that is a relatively recent creation. And if we created, we can solve it. And I would say that it's really interesting. People that are passionate about these issues in specific industries have actually been enormously successful. So we were talking earlier about the case of nursing homes. Activists have been enormously successful, for instance, in pushing rulemaking to establish minimum staffing criteria. In nursing homes, and rulemaking is going on at HHS right now on that. When we're talking about prison services, which is an area where private equity is particularly active, I'm really astounded. A handful of passionate people were able to pass legislation starting in a few cities, then in the states. So Connecticut, I think, was the first state to pass legislation establishing cap fees for prison phone calls. And just last year, there was national legislation that was passed on the issue. I think a certain amount of pessimism is completely understandable. I think it would be irrational to think that the legal challenges that we've got can be solved in a moment, but I think we have demonstrable instances in o…

AI assessment note: “Activists have been enormously successful, for instance, in pushing rulemaking to establish minimum staffing criteria”

Q So Brendan, in an industry, as Sachin said, that's 12 trillion dollars. How do you get your arms around the significance of this problem? There's always going to be good actors and bad actors in any industry. The anecdotes don't sound good, that's for sure. What's your sense of how pervasive this is?

A As Sachin said, it's an enormous industry, and it's growing in the sense that the quote-unquote private equity firms do so much more than private equity, whether it's Credit, infrastructure, hedge funds, insurance, and so forth. And in some sense, they have, in my observation, sort of supplanted in importance the investment banks of a generation or two ago. We lawyers have this incredible ability to invent a flawed business model every 20 years. Right now, I would argue that it's in large part private equity. 20 years ago, it would have been subprime lenders. 40 years ago, it would have been SNLs. 60 years ago, it would have been conglomerates. A hundred years ago, it would have been trust. Oftentimes, unfortunately, as a result of a crisis, but sometimes not, you know, in the case of conglomerates. We have managed to improve our laws to hold firms more responsible for their actions and align the incentives of the various parts of our economy. So I think that there are actions that our national legislature, Congress, could obviously do. There are things that federal regulators, the SEC, Treasury, Federal Reserve, and so forth, could take on. There are also things that states and localities could do. Famously, our laboratories of democracy to say, okay, if a firm, a Requires a company in our jurisdiction, we're going to place some reasonable limerence on the amount of leverage, …

AI assessment note: “Right now, I would argue that it's in large part private equity.”