Inside Job (34 page)

Additionally, private equity firms sometimes force employee retirement plans to purchase stock in the company, or even the whole company. This allows the private equity firm to cash out, even
(perhaps especially) if the company is failing. This occurred, for example, with Simmons Bedding, a company that I discuss in more detail below. If the company later goes bankrupt, the private
equity firm has no liability to pay employee pensions. Either the employees must see their retirement income destroyed, or, if the company is eligible, their pensions are paid not by the private
equity firm but by the Pension Benefit Guaranty Corporation, a US government agency. In 2010 the PBGC paid out $5.6 billion to failed pension plans, and had an accumulated deficit of $23 billion.
It is not known what fraction of the deficit derives from private equity transactions.

Another recent case of gaming government subsidies involves forprofit universities, which are nearly entirely dependent upon federal student-loan programmes for their tuition revenues. In 2006 a
group of private equity firms led by Goldman Sachs bought the Education Management Corporation for $3.4 billion; Goldman owned 41 percent.
¹⁰
This
acquisition coincided with a change in US law that had been championed by the Republican leader of the House of Representatives, John Boehner, and which eliminated the prior requirement that loans
be restricted to schools where the majority of students attended a physical campus. After the change, schools were eligible for government student loans even if they barely existed physically, and
even if the overwhelming majority of their students were online.

Immediately following its private equity acquisition and the legal change, Education Management started extremely aggressive
recruiting efforts, and the number of online
students increased sharply. So did dropout rates. From 2006 to 2011, Education Management’s revenues increased from less than $1.5 billion to $2.8 billion. Recruiting allegedly became
extremely manipulative, even fraudulent; allegedly, for example, students with felony records were told that after obtaining criminal justice degrees, they could work in law enforcement, which is
false. Recruiters were paid bonuses very similar to the yield-spread premiums that were paid to mortgage brokers during the housing bubble. But once students received their loans and paid their
tuition, Education Management had its money whether the students graduated or not. Education Management had no liability for the loans, even when they defaulted in high numbers.

In 2010 the attorneys general of Florida and Kentucky initiated investigations of Education Management. In 2011 a whistle-blower lawsuit was filed. The US Justice Department and four states
joined the suit, and accused Education Management of fraudulent recruiting, and of fraudulently obtaining a total of $11 billion in tuition derived from government student aid. The complaint,
however, is only against Education Management; Goldman Sachs has not been sued or charged.
¹¹
As of early 2012, no one has been criminally
prosecuted.

More frequently, private equity transactions depend heavily on the favourable tax treatment of dividends and of extreme leverage. Companies owned by private equity firms almost never pay
corporate taxes, because they have such huge interest bills. This is because private equity firms force the companies they own to take on enormous levels of debt, often for very nasty reasons
(discussed shortly). Interest rates have been extraordinarily low for many years now, so it has been an ideal environment for private equity–owned companies. Falling rates allowed them to
continually refinance debt, allowing their private equity owners to extract more and more cash with minimal impact on debt service, in a manner very similar to the refinancing boom during the
housing bubble. When a Blackstone-led group bought Freescale Semiconductor in 2005, its debt immediately ballooned elevenfold, from $832 million to $9.4 billion.

Why so much increased debt for the companies they buy? Private equity firms add debt to pay themselves “special dividends”, sometimes to the tune of $1 billion
or more, distributed among the private equity firm partners and their limited partners in the deal. Firm partners typically have little or none of their own capital in their deals. The equity comes
from their limited partner investors, and it is usually completely returned within the first few years from these debt-funded “special dividends”. There is an additional benefit to this
trick. Often, private equity firms give stock to a small number of senior managers of the companies they buy. These managers therefore receive dividends, too, which are taxed at 15 percent rather
than at the far higher rates that apply to “ordinary income”.

Moreover, a significant fraction of private equity firms’ profits come in a very direct way from screwing the employees of the companies they buy. The US has very weak protections for most
workers, and even those protections have been insufficiently enforced. In addition to wage cuts, private equity firms often attack benefits, especially pensions and retirement health care.

In late 2009 the
New York
Times published a remarkable series of articles on the looting of the Simmons Bedding Company by its private equity owners and the management they
installed.
¹²
After the private equity firm THL (for Thomas H. Lee, its founder) bought Simmons from another private equity firm (Simmons had already
been flipped several times by
other
private equity firms), THL ordered the Simmons company to borrow over $1 billion. Simmons then paid huge amounts of this borrowed cash—$375
million—to THL in the form of “special dividends”, as well as paying additional, large transaction fees for THL and to the investment banks that arranged the financings.
Employees’ wages and benefits, including their retirement plans, were cut severely, even for blue-collar workers with over twenty years’ seniority. Indeed, the employees’
retirement fund had already been victimized by the actions of an earlier private equity owner, William Simon (who was Treasury secretary in the Nixon administration). Simon had forced the
employees’ retirement plan to purchase Simmons stock from him at an
inflated price. When the stock price declined, Simmons was purchased by another private equity firm
at a far lower price, devastating the employees’ retirement savings.

During much of the time that Simmons Bedding was owned by THL, the company’s CEO (approved and installed by THL) was a man named Charlie Eitel, who ran Simmons remotely from his homes in
Jackson Hole, Wyoming, and Naples, Florida, as well as from his yacht,
Eitel Time
. He also forced Simmons to hire his son. Eitel made more than $40 million, keeping it all even when Simmons
was forced into bankruptcy, which caused its employees and bondholders to lose enormous sums. The company laid off a thousand people, over 25 percent of its workforce, including employees with more
than twenty years’ seniority, giving them little severance pay or retirement benefits. THL was not harmed by the bankruptcy and in fact made a large profit on Simmons, because it had paid
itself in cash long before, as well as taking large special dividends and transaction fees from the proceeds of the debt financings that bankrupted the company.

Was this all legal? It is hard to know which answer would be worse—that it was illegal but nothing was done, or that this was all, in fact, perfectly legal in America. As it is also,
apparently, perfectly legal to construct and sell a security with the intent of betting on its failure.

There are other ways in which private equity firms may depend upon dubious behaviour for their profits. In 2006 the SEC investigated the industry with regard to alleged “club deals”,
whereby supposedly competing private equity firms would secretly collude in order to reduce the prices they needed to pay for companies. The SEC closed the investigation without filing charges, but
several investors filed a major private antitrust suit, which was still proceeding as of 2012. In early 2012 the SEC opened another investigation centred on the possibility that private equity
firms inflated the value of their assets when trying to attract new investors.
¹³

And without question, private equity firms are superb at avoiding taxes. Mitt Romney’s ability to pay a 14 percent tax rate on income of over $20 million per year, much of it coming from
Bain Capital
a decade
after he left the firm
, is no accident; nor is it unusual. So whatever limited economic contribution might be made by private equity firms, it is
outweighed by their practice of redirecting managers’ attention to skimming off the maximum financial rewards for themselves.

IT IS EASY TO
multiply such examples, and data on the growth of financial transactions volume fills in the rest of the picture. Over recent decades,
securitized transactions have increased from nearly zero to trillions of dollars annually. Foreign exchange trading has grown thirty times faster than global GDP. Daily oil futures trading, which
used to run at about the same value as the underlying physical supply, is now ten times the underlying supply, while market volatility seems to have increased.
¹⁴

In other words, we seem to have reached an unhappy position in which a substantial fraction of our most intelligent and articulate citizens either sit at Bloomberg trading terminals or jet
around the world in very expensive tailor-made suits “doing deals” that, judging by the recent record, have no purpose except to put more money in their own pockets, and that on a net
basis are economically detrimental to the rest of the population.

The drain on America’s talents is substantial. In 2008, exclusive Harvard University reported that 28 percent of its “gainfully employed” new graduates chose jobs in finance;
for equally prestigious Yale, it was 26 percent. Even in 2011, the percentages remained strikingly high—17 percent for Harvard, 14 percent for Yale. Across all of the elite Ivy League,
Princeton University had the highest percentage in the Ivy League—40 percent. Whatever cynical thoughts one might have about the value (and ethics) produced by an Ivy League education, there
is no doubt that finance has diverted enormous human capacity away from more productive work.

Reflection and self-questioning, however, are not the financial sector’s greatest strength. Self-reform is accordingly unlikely. In his
January 2011 speech at the
World Economic Forum in Davos, Jamie Dimon complained of “this constant refrain [of] ‘bankers, bankers, bankers’—it’s just a really unproductive and unfair way of
treating people.”
¹⁵
Lloyd Blankfein told a different audience that he was doing God’s work.

Can we turn Mr Hyde back into Dr Jekyll,
shrink
the financial sector, restore safe banking, and rid the world of the winner-take-all casino controlled by the likes of Goldman Sachs and
THL? The truthful answer is that maybe we can’t yet; the industry’s power is greater than ever, despite the crisis. So it may take another crisis before enough people get angry enough;
we consider that question in the final chapter.

Next, however, we examine another important sector of society, one that has long been considered immune to the corrupting influence of corporate money and “revolving door” hiring.
Academia, along with the media, has generally been regarded as an important bastion of independent, and if necessary critical, analysis of economic and political behaviour. Unfortunately, this is
less and less true. As with politicians, the financial sector and other wealthy interest groups have figured out that professors make an excellent investment. They have proven stunningly easy to
buy; for very small sums, considering the stakes involved, the financial sector has hired the best propagandists in the world.

CHAPTER 8

M
ANY PEOPLE WHO SAW
my documentary
Inside Job
found that the most surprising, and disturbing, portion of the film
was its revelation of widespread conflicts of interest in universities, at think tanks, and among prominent academic experts on finance, economics, business, and government regulation. Viewers who
watched my interviews with eminent professors were stunned at what came out of their mouths. It was indeed very disturbing, and sometimes I was stunned myself.

And yet, we should not be entirely surprised. Over the past couple of decades medical professionals, professors very much included, have amply demonstrated the influence that money can have in a
supposedly objective, scientific field.

Randomized clinical trials of pharmaceuticals, including those conducted in academic centres, are, according to one large study, 3.6 times as likely to produce a favourable result if they are
financed by a
pharmaceutical company. Doctors who own interests in diagnostic imaging centres are four and a half times more likely to refer patients for such services. A
recent US Senate investigation showed how the pharmaceutical manufacturer Sanofi enlisted medical groups and individuals it had financed to help block generic equivalents to one of its drugs. In
the course of just a few years in the 2000s, the US Justice Department won settlements of more than $1.5 billion against three pharmaceutical companies for paying kickbacks to doctors or otherwise
engaging in illegal marketing of their drugs. It became a common practice even at top medical schools for doctor-professors to sign their names to papers drafted by drug company staff. Indeed,
Stanford University Medical School banned this practice in 2006; but not all medical schools have done so. In general, medical schools and leading medical journals are responding fairly well to the
rise of this problem, with many of them adopting stringent disclosure requirements and even, in some cases such as Stanford, absolute limits on outside compensation from sources that could pose a
conflict of interest.
¹

But the economics discipline, business schools, law schools, and political science and public policy schools have reacted very differently. Over the last thirty years, in parallel with
deregulation and the rising power of money in American politics, significant portions of American academia have deteriorated into “pay to play” activities. These days, if you see a
famous economics professor testify in Congress, appear on television news, testify in an antitrust case or regulatory proceeding, give a speech, or write an opinion article in the
New York
Times
(or the
Financial Times,
the
Wall Street Journal,
or anywhere else), there is a high probability that he or she is being paid by someone with a big stake in what’s
being debated. Most of the time, these professors do not disclose these conflicts of interest in their public or media appearances, and most of the time their universities look the other way.
Increasingly, professors are also paid to testify for defendants in financial fraud trials, both civil and criminal. The pay is high—sometimes a quarter of a million dollars for an hour of
congressional testimony. But for banks
and other highly regulated industries, it’s a trivial expense, a billion or two a year that they barely notice; and just as with
politicians, it’s a very good investment, with very high benefits.