Private Equity: A Growing Danger

“Private Equity” is a buzz phrase meaning a business corporation with so few shareholders that it is not considered “public.” In the United States and Canada, public corporations are legally required to file a prospectus when they want to sell shares to the public. This has to contain all the information a prospective shareholder needs in order to evaluate the benefits and risks of buying the shares being offered. But that is only the beginning. Each year all the shareholders are entitled to a detailed report on the prior year’s activities, including the salaries and benefits of the president and other officers of the corporation. In some jurisdictions, there is a further requirement to publish an interim report on the business in each quarter year except for the one in which the annual report is issued.

Admittedly, all the reporting is costly and burdensome, and in addition is freely available to the public. However, the requirements of disclosure are part of a remarkably orderly system of security markets in the two countries, with the American one being greatly more significant than the Canadian one. What is wrong with entrepreneurs keeping their information to themselves? In general, nothing at all. For example, family businesses and other proprietorships should not be required to inform the public as to what and how well they are doing. Yet if a large and successful former family business is sold to a new group of owners which does not wish to issue any shares to the public, it will not be part of the security markets and is free to make no reports except confidential ones to the tax authorities. The large private business corporations that have been around for a long time have caused little concern.

What then is new, and what is the danger?
There is now an accelerating trend for small groups of very wealthy individuals “to take private” large public corporations. These formerly public corporations then disappear from the stock exchanges and the former shareholders receive a substantial premium over what their stock was worth only a month or two previously.

Examples of these are Chrysler Corporation and the Hilton Hotel Chain in the U.S., and the Hudson’s Bay Company and the Van Houtte chain of coffee shops in Canada. The new owners then can proceed any way they wish as long as they do not break the law. For example, since they generally re-sell the enterprise within five years, they will do as little training of employees and not much research as possible. Nevertheless, a few enterprises in tough shape, possibly even on on the verge of bankruptcy, have been saved by some new capital and surgery administered by private owners. Equally, the private equity owners have been accused of asset stripping and slashing employment.

During the last few months, The Economist, a highly regarded British business weekly has been warning of the debts of private corporations which arise from the premiums that have been paid to former shareholders as mentioned above. Public corporations obtain the money from banks and also from the issuing of new shares. Private corporations clearly cannot issue new shares. They get some money from banks, but more importantly, use debt instruments that are not secured by assets. As the takeovers become larger and more numerous, these debt instruments cover staggering sums. The Economist may well be right that the trend could lead to bankruptcies and shocks to the entire credit system, but I think there are worse dangers.

To illustrate, let me create a few fictional characters both personal and corporate:

Scenario One
• Professor Helen Trueheart, Chairperson of the Department of Particle Physics at MIT and a shareholder activist.
• Aluminmax a large Canadian-based, integrated aluminum company with 10,000 shareholders in the U.S. and Canada.

As a result of a quarterly shareholder report and a newspaper article, it becomes known that Aluminmax’s management is considering building a smelter in the Sudan, an investment of several billion when completed. Professor Trueheart alerts the presidents or chairpersons of a number of non-profit organizations that the planned smelter will play into the hands of a genocidal government in Khartoum. Not surprisingly, she receives a number of e-mails advising her of this from many quarters before she has even a chance to complete her own alert. A storm breaks loose from shareholders all over the world. The protest is directed to the Aluminmax CEO, all of its officers and all of its directors. The project is abandoned with a corporate statement that Aluminmax is continually looking for sites for its smelters and that the quality or lack thereof of the government of a host country is only one element in the equation.

Scenario Two
• Foxsure, a private equity company with six shareholders and assets worth$ U. S.11 billion with offices in Austin, Texas, and The United Arab Emirates.

An international real estate weekly features one of the shareholders of Foxsure in Rangoon in conversation with a high-ranking member of Myanmar’s military junta. The subject is the construction of a vast shopping centre on the periphery of the capital. Again the problem is the apparent support for the country’s dictators. This time it is not easy to ascertain the identity of all the six shareholders. They are found by consulting a register in Dover, Delaware, where Foxsure is incorporated. Foxsure has a public relations officer who acknowledges all letters with the statement that the matter of apparent support for the dictatorship will be one of the factors in the final decision in regard to the shopping centre, but makes no other promises. In fact, the plans for the shopping center continue, with the opening ceremonies scheduled for February 1, 2009.

North American societies show an increasing gap between their rich and poor members and the fragility of their middle classes. They need a new group of very rich persons who wield great economic power exercised in virtual secrecy, like poison! International treaties already limit the scope of authority of democratically elected governments, and the vast influence of the private equity firms will make these governments even less relevant, and lead to a sense of powerlessness on the part of the informed public. Will the new private corporations become active politically, singly or in concert? No one knows. But one thing is sure, a decision in this regard can be made by each corporation's shareholders/directors sitting around a table.

July 2007