Coping with corporate bonds.
With memories of 2008-2009 still fresh, some observers have focused on corporate debt as the likely culprit. It’s true that corporate debt has risen rapidly during the expansion, both in absolute terms and in relation to corporate profits. But low interest rates mean that debt service—interest payments on this debt relative to after-tax profit—is about 25 percent, where it usually is during periods of expansion and not a cause for worry. Bank regulators are concerned about the rapid growth of leveraged loans and weaker lender protections. But they appear to be correct in their assessment that leveraged lending, despite a 20 percent growth since last year to almost $1.2 trillion, “isn’t a current threat to the financial system.”
Still, recession or no recession, there will be pain.
A large and growing share of corporate debt is “speculative debt”—either leveraged loans used to acquire target companies and burden them with high debt levels or high risk junk bonds. Many companies with high levels of speculative debt on their books were acquired by private equity in a leveraged buyout, meaning the PE firm used high amounts of debt to buy them. This is debt the target companies, not their private equity owners, are obligated to repay.
Often, these PE-owned companies are required to issue junk bonds and further increase their indebtedness in order to pay dividends to their owners. A 100-day plan imposed on company managers at the time of the buyout lays out the steps that the company will need to take to service this mountain of debt. Reducing labor costs is a big part of these plans, whether by closing less profitable stores and establishments, laying off workers at those it continues to operate, or cutting pay and benefits. After it takes these steps to manage its debt, the company is on a knife-edge.
If all the assumptions made by the private equity firm when it persuaded creditors to lend it boatloads of money hold up, the company will avoid defaulting on its loans and going bankrupt. But if these assumptions are upended—say, by a slowdown in the economy, defaults and bankruptcies will spike. Creditors who have loaned billions of dollars to finance private equity-sponsored leverage buyouts will experience losses. Establishments will be shuttered, some companies will be liquidated, workers will lose their jobs, and communities will lose businesses that have played a key role in the local economy.
In 2013, concerned that loading a company with debt greater than 6 times earnings increased the likelihood of default or bankruptcy, bank regulators—the Office of the Comptroller of the Currency (OCC), the Federal Reserve (Fed) and the Federal Deposit Insurance Corporation (FDIC)—updated lending guidance. Banks were advised to avoid making loans that saddled a company with debt greater than 6 times earnings unless they could show that the company would be able to pay back the loan.
Initially, this put a crimp in private equity’s ability to load up companies with excessive amounts of debt. But private equity firms soon found a way around this limitation. They set up their own lending operations and extended loans to other firms in the industry. Trump administration regulators have chosen to relax enforcement of the guidelines. The result? In the first quarter of 2019, six years after the updated guidance was issued, leverage used in buyouts has risen to an average of 6.96 times earnings, up from 5.80 times in the first quarter or 2013.
We don’t need to look far to understand how this will affect the viability of businesses and the outcome for workers. Bankruptcies of department stores and specialty shop chains are so widespread, they have been dubbed a “retail apocalypse.” Retail is a business that has always faced disruptors—consumer tastes can be fickle, innovations like fast fashion challenge traditional marketing, recessions lead customers to postpone purchases, e-commerce puts pressure on brick and mortar stores. Traditionally, retailers have prepared for this by keeping debt levels low and owning their own real estate—holding costs down so they can weather tough times and make the necessary adaptations in how they do business.
Private equity owners turn this formula for success on its head. The low debt levels of retailers are an invitation to load up the stores they acquired with high amounts of debt. Selling off some of the stores’ real estate in sale-lease back agreements enriches the PE owners who pocket the proceeds of the sale, but leaves the stores to pay rent on facilities they used to own. Stores are stripped of resources they need to modernize and keep up with the competition by owners that put their hands in the till to pay themselves generous dividends. Often the owners collect fees from these companies, even when company profits spiral downward. These measures guarantee that the PE firm will make its bundle. While private equity owners prefer a profitable resale of their companies, that’s really the second bite of the apple. Exiting investments via bankruptcy is increasingly common.
Private equity firms own only a fraction of U.S. retail chains, but they are behind a disproportionate share—financial news service Debtwire calculates 40 percent—of retail bankruptcies: Toys ‘R Us, Payless Shoes, Gymboree, Claire’s Stores, PetSmart, Radio Shack, Staples, Sports Authority, Shopko, The Limited Charlotte Russe, Rue 21, Nine West, Aeropostale. The list goes on.
by Eileen Appelbaum, Economic Policy Institute | Read more:
