Brazil, America and the Realities of Private Equity

The New York Times’ Andrew Ross Sorkin pops up Tuesday, Day 2 in the Times’ Era of the Paywall, in São Paulo, Brazil, where he’s discovered the country’s booming buyout business, which, he tells us over and over again, uses no leverage. I should italicize that: They use no leverage. This he views as not only virtuous, but a kind of rebuke to the American and European private equity industry, which he defines as a band of financial engineering megamaestros who “pursue elephant-sized deals,” ignoring, unlike the Brazilians, smaller, family-owned companies that can be tuned up and provided growth capital to expand and make everyone happy without leverage. Indeed, Sorkin argues that these virtuous Brazilians are more akin to “what the fledgling private equity industry circa the 1970s in the United States pursued.” That is, before they became greedy barbarians in the ’80s.

Now, in fact, Sorkin’s report from Brazil does cast a light on an interesting growth story — and one, as he suggests, that has attracted the acquisitive attention of major U.S. players, like Blackstone Group, which last year took a stake in one of the leading lights in Brazil, Pátria, and J.P. Morgan Chase & Co., which took a majority stake in another, Gávea. But Sorkin is so intent on confirming the cartoon version of private equity, which the Times has had a hand in creating, that he ends up all over the place.

Begin with Brazil, which is growing rapidly and is attracting lots of international flows of capital — enough that the country, which has had an historical tendency to boom and bust, has tried desperately to control. Buyouts in Brazil are quite recent, and the industry, compared to Europe and the U.S., is still immature. For all its recent successes, Brazil is just developing the kind of capital markets that can support larger buyout efforts. As a result it’s the kind of situation financial types just love: very little competition, large numbers of targets, a general lack of transparency, big fat profits. As Sorkin’s own sources explain, lending rates are high, and so they’re forced to use no leverage (or little leverage) and seek out opportunities where they can make a big difference by injecting some capital or providing some expertise. If rates fell, they would rush to use leverage. But by then competition will have increased, and the game will have grown tougher. As Arminio Fraga, the founder of Gávea told Sorkin at the very end of the column, “There will be more leverage for sure. Hopefully, we won’t do anything too stupid when the opportunity becomes real.”

So much for virtue.

If Sorkin overpraises Brazil, he presents a picture of U.S. private equity that’s simply bizarre. Sorkin still seems to be fixated on the 2005 to 2007 era of megabuyouts, when the largest private equity firms grabbed huge corporate assets like Freescale, First Data, TXU, HCA and a dozen others. They used leverage, and that leverage in some cases caused problems when credit froze. Sometimes they banded together in consortiums. In that bubble era of abundant liquidity, leverage was easy, terms loose and financial engineering rife. But there are two points to be made about that era that Sorkin ignores. That era (for now) is over. And simply to characterize U.S. private equity as a bunch of big operators looking to snare “elephant-sized” corporate assets is a distortion of reality.

This is not an apology for U.S. private equity, which, in Fraga’s phrase, will engage in stupid deals when opportunity beckons — perhaps sooner than we wish. But most private equity in the U.S. takes place in the middle market, despite the fact that the Times tries to pretend that only Blackstone, Kohlberg Kravis Roberts & Co. and Carlyle matter. Just last week was the annual “InterGrowth” meeting of the Association for Corporate Growth, an organization of middle-market players including corporates, lenders, advisers and investors. This is no small show: Well over 2,000 blazered dealmakers milled around a fancy hotel in San Diego, networking like mad. A large number of them engage in private equity throughout the middle market. Most of them have personal relations with smaller companies, many of which are family owned — just like those in Brazil. Many middle-market deals also get done with less leverage than, say, a megabuyout. Indeed, the ’70s still lives in middle-market buyouts (truth be told, a lot of the big buyout shops have an awful lot of operational expertise; the charge of financial wizardry is overstated in “normal” markets). But unlike Brazil, there is plenty of competition in the U.S. middle market. Many of these firms are sizable, and the scale is striking. We at The Deal are currently building a national database of these folks called City by City (see here for the first four cities); the infrastructure is both impressively dense and extensive. And arguably what makes it go is the stimulus of private equity.

There’s a larger point here in how blithely Sorkin sweeps the middle market away. Politicians talk continually about how “small business,” which really means the middle market, leads the way to job creation in America (usually as a prelude to a tax-cut argument). But like the Times, political attention on the national level is nearly always focused on the largest corporations and, particularly when the economy sours, the transgressions of the largest buyout shops. Generally, the middle market is ignored. For that reason, our own Matt Miller attempted in the March 14 issue of The Deal magazine to try to get a sense of its scale. The cartoon that results thus emphasizes the largest firms at their darkest moments and ignores the rest. Brazil, in terms of private equity, may be just beginning its takeoff. Firms like Gávea and Pátria may be the KKRs and Blackstones of that country, if the country can stay aloft. But as these firms grow, as the market matures, more competitors will fill in behind them, reaching further into the Brazilian commercial establishment. Competition will increase, but financing will ease. They will use leverage. They will lose their virtue. It’s just the way things are.

Blame the Brits. In 1942, in the midst of world conflagration, the Brits went squishy. Sir William Beveridge, a member of Churchill’s wartime government (he actually worked for Labour Minister Ernest Bevin, who wanted to get rid of him because he thought he was conceited), published a long, turgid report with revolutionary implications: “Social Insurance and Allied Services.” This wasn’t the first social welfare scheme proposed — Bismarck tried one in Germany in the 1880s — but it kicked off a broad move toward what’s derided by conservatives as socialism. In 1945, the newly elected Labour Party took Beveridge’s plan and launched National Health and other social welfare schemes. America was close behind. The New Deal had passed Social Security in 1935. After debate in which business groups declared it “utterly alien to America and her institutions,” Congress passed the Employment Act of 1946 (dropping “Full” in a compromise), which made the federal government responsible for generating jobs and monetary stability. If Beveridge was a conceited Brit who designed social welfare aspects of this state expansion, John Maynard Keynes, genius, provided the theoretical underpinnings. This was social welfare enabled by cutting-edge economics.

Both plans represented a remarkable admission, new to history. A primary function of the state was to improve the lot of its people. What provoked this? Many linked the Great Depression to Nazism and economists were predicting the slump’s return. The war required mass mobilization; now those masses demanded recompense. Meanwhile, a vanguard of economists believed Keynes had found a way to regulate economic perturbations, though it’s doubtful, for all his self-regard, that the great man himself would have been so certain. This policy of “compensatory finance” attracted bipartisan support for decades; Republicans like Dwight Eisenhower and that Keynesian Richard Nixon were fully onboard. In 1965, Congress passed Medicare and Medicaid; in 1976, a bill combining “Full” and “Employment” finally passed. All this made the Greatest Generation the most “socialist” in American history. Why not? The economy boomed in the ’50s and ’60s, with little overseas competition. And demography helped. The population was young — baby boomers were mastering credit cards — industrial jobs, many unionized, were rife, income inequality was low, tax rates high. Taxes were not yet considered theft.

Then we lost it. The erosion of faith in government had many sources, particularly in a nation with a tradition of Jeffersonian do-your-own-thingism. Besides, the rest of the world, first Europe and Japan, then Brazil, India, China and South Korea, woke up. The industrial age became post-industrial. Globalization advanced. We aged. Shadows fell upon our sunny self-regard. After its first successes, Keynesian management got rocked by ’70s stagflation. The full-employment mission persisted (it’s still rhetorically sacred), but faith in markets replaced confidence in government. This proved to be a rickety faith. In 1974 Congress passed the Employment Retirement Income Security Act to regulate private pensions, mostly defined-benefit plans. Less than a decade later, the situation began to change, based on a loophole in Erisa: Companies replaced DB plans with defined-contribution plans, like 401(k)s, dumping investing on workers. This occurred quietly, privately, without legislation or debate, then mushroomed. There were many rationales for this, including giving employees ownership, but the real motive was more prosaic: DB plans were expensive for corporations increasingly defined by share price. True, hiring money managers wasn’t cheap. But more significantly, companies found investing, well, difficult. Recessions. Meltdowns. Wars. When they missed targets, they had to top up plans, often when they could least afford it. So they palmed it off on workers, most of whom had no investing skills to speak of, and insisted breezily that long-term, equity markets generally rose. Note the “generally.” This was widely accepted as plausible until 2001. Then came 2008.

The last big holdout of DB plans are underfunded public pensions, which are now poised to make the same forced march to 401(k)s, among more draconian givebacks, like killing collective bargaining. The arguments for this move are a) familiar (too expensive) and b) novel (everybody else is screwed, no exceptions for you). Indeed, after a decade of stocks treading water, the equities-always-rise argument has been battered, particularly for retiring baby boomers. What all this shows is that the market as foolproof social welfare tool is no more reliable than Keynesian-style economic wizardry. This produces a queasy realization 65 years after the Employment Act: As confidence in our ability to ensure long-term prosperity wavers — perhaps needlessly; we are prone to hysteria — the belief that a function of government is to broadly improve lives for everyone deflates. What’s next? Malthus?