Wednesday, October 8, 2008

What GAO Missed Regarding PEU's

Private equity employs the same management sins that led to America's financial implosion. They include loads of leverage, risky financial strategies, off balance sheet items, high profit growth expectations and executive incentive compensation which causes CEO's to swing for the fences. Yet, a GAO report highlighted the somewhat positive role private equity underwriters (PEUs) play in the economy. Consider the following:

1. Carlyle Capital Corporation invested in mortgage backed securities. The fund was highly leveraged, 39 to 1. The Carlyle Group used massive amounts of debt to finance risky securities. The firm imploded, but could be rolled up at better rates under Treasury's Wall Street bailout.

2. SemGroup, a Carlyle affiliate in the oil and gas pipeline distribution business, declared bankruptcy due to hedging. This activity wasn't listed as a primary function of the company, but $2.4 billion in hedging losses took down the firm. It's unclear if SemGroup's bad forward looking contracts will be purchased by the federal government.

3. KKR, Bain Capital and Merrill Lynch Private Equity own much of giant, for-profit hospital company HCA. HCA's professional liability insurance subsidiary owns $1.6 billion in level 2 or 3 investments, $652 million of which are untradeable auction rate securities. Private equity, with all their billions, could show up at Treasury's window for even more.

4. Carlyle's LifeCare Hospitals failed 24 patients after Hurricane Katrina. They blamed rogue clinicians when LifeCare is responsible for credentialing staff, for ensuring continuity of care in disaster situations. When that strategy failed, Carlyle's attorneys shifted blame to the federal government. They cited how patients became "wards of the government" as soon as FEMA evacuation teams set up in New Orleans. After failing patients in one of twenty one long term acute care hospitals, the feds allowed Carlyle to purchase ManorCare, with its 500 nursing homes.

5. Carlyle's Dunkin Donuts got lawsuit happy with franchisees. After acquiring Dunkin' Brands in March 2006, Carlyle Group attorneys went on a suing spree, bringing cases against 154 of its two thousand franchises. Other large franchises kept their lawyers sheathed. McDonald's sued only five times during the same period and Subway twelve. Dunkin' Franchisee Cindy Gluck wrote of her trials under Carlyle's thumb in a New York Daily News op ed.

6. Private equity's preferred taxation on carried interest seems more egregious in light of the financial meltdown. Calls for capital gains tax cuts, if implemented, would magnify this inequity.

7. Increased interest expense (on huge debts associated with recapitalization) cuts income taxes paid to the federal government. HCA cut their income taxes from $730 million to $316 million after private equity purchase.

8. PEU purchase of health care companies adds billions in interest expense and management fees. These are passed on to patients. Not one new provider, no new technology, no new facilities are added, just billions in new costs. The purchase of HCA by KKR and company added $1.5 billion in interest expenses and $440 million in management fees.