Financial Capitalism, Breach of Trust,
and Collateral Damage: Four Cases
Eileen Appelbaum, CEPR
Rosemary Batt, Cornell University
Ian Clark, University of Birmingham
BJIR Conference: Across Boundaries
London School of Economics
December 12-13, 2011
This session’s agenda

New Financial Intermediaries



Breach of Trust




Actively manage claims on wealth creation, distribution
Private equity business model
Agency theory and profits
Default on implicit contracts and stakeholder claims
Four cases – will focus on two
Challenges to Employment Relations Research
2
New Financial Intermediaries

Private equity sponsors (investment firms)



Raise PE funds that invest in operating (portfolio) companies
Actively insert themselves into management and operations
Private equity business model

Investment firm (general partner) raises capital from pension
funds, endowments, individuals (limited partners)

Uses PE fund to acquire portfolio of operating companies

Expectation is fund will make profitable exit in a few years

‘Two and twenty model’ – management fees, carried interest
3
Agency Theory (Jensen & Meckling 1976, Jensen 1986)

Provides rationale for LBOs, PE intervention in management

Separation of ownership, control = managerial opportunism

LBO takes company private, ownership is concentrated

Debt good ?



Retained earnings used to service debt
Have to borrow to invest – subjects these decisions to market test
Leads to more efficient allocation of capital

LBO boom in 1980s ended in bankruptcies, scandal

Buyout firms came back at end of 1990s, as private equity
4
Breach of Trust

Distinguish value creating/value redistributing effects of LBOs

Agency theory view of commitments to employees, suppliers

Defaulting on implicit obligations can benefit shareholders



Can be a virtue – shift resources to more productive uses
Can be a vice – improve financial performance in short-run, undermine
competitiveness, viability of firm in long-run
PE can seek rents rather than create wealth and profits


Change structure and financing to reduce taxes
Co-opt management via out-sized financial incentives
5
Four Cases of Collateral Damage

Collateral damage




Outcomes that are unintended or incidental to intended outcomes
May result from privileging interests of shareholders over those of
other stakeholders
Often due to breach of implicit contracts with other stakeholders
Four cases of LBOs where costs to other stakeholders
outweigh gains to shareholders



US: Mervyn’s, Stuyvesant Town/Peter Cooper Village
UK: EMI, Cadbury
Focus in presentation on two: Mervyn’s and EMI
6
Mervyn’s

Mid-tier retailer, profitable but needed sprucing up


Bought by PE – included Sun Capital in 2004


30,000 employees; 257 stores, 155 company owned
$1.2 B - $400 M equity, $800 M debt against real estate
Op Co/Prop Co model



PE prospered via sale of Prop Co, dividend recaps ‘05, ’06
Stores saddled with high rents
Promised Investment for turnaround not forthcoming

Op Co went through 4 CEOs in 4 years
7
Mervyn’s
Breach of implicit contracts w/vendors led to downfall

Trust is critical in dept. store operations


Orders to manufacturers paid after delivery of goods
‘Factors’ finance production, need to believe retailer will pay

Sun Capital refused to give assurances of payment

Factors cut off financing for back-to-school

Declared bankruptcy July 29, 2008

High rents made it impossible to sell chain – liquidated

Vendors owed > $102 M, Levi-Strauss owed $12 M

PE did fine – profits from Prop Co > losses on Op Co

Vendors now suing PE for ‘fraudulent conveyance’
8
EMI


Divisions – music publishing, new recording releases
Bought by Terra Firma in August 2007


£4.2 B, £2.5B loan from CitiBank – high debt burden
Unlike Odeon cinema deal, no RE assets


Difficult to issue bonds against rights to publish songs
Publishing profitable, new music division losing money

Failure to turn EMI around due in part to global crisis,
falling music sales

More fundamental: breach of trust w/established artists
9
EMI
Breach of trust with established artists

Music industry requires a form of ‘patient capital’



PE tried to increase shareholder returns




Artists/managers saw management discretion as source of success
PE saw it as opportunism and waste
Led to voluntary departure of valuable talent


Pruned roster of established artists, reduced new artist pipeline
Broke implicit contract between artists/repertoire & line managers
Alienated EMI’s managers: PE as ‘plantation management’


Established artists w/back catalogue subsidize new artist pipeline
Loss leader approach – rests on trust between artists/ managers
Managers/artists (Rolling Stones, Radiohead, Paul McCartney)
Declared insolvent and seized by Citibank in Feb. 2011
10
Challenges to Employment Relations Research
Organizational context for labor has changed

Workers, unions, researchers still think in terms of
managerial capitalism

PE ownership changes goals and governance of firms

Trust relations devalued - implicit contracts breached

PE use of debt to drive cost efficiencies is at odds with
competitiveness based on knowledge and innovation

Long-run competitiveness of firm takes back seat to
maximizing financial returns over 3 to 7 year time horizon
11
Challenges to Employment Relations Research
Mechanisms for value extraction have changed

Finance capital dominates economic and financial activity
beyond financial markets – e.g., PE portfolio companies

Financial actors actively assert and manage claims on
production and wealth creation

Do this as owners, not as managers – accounting value, not
economic value via production, dominates decisions




Rent seeking not wealth creation
Default on implicit commitments
Increased debt not sustainable
Bankruptcy as strategy to reduce pension liabilities
12
Challenges to Employment Relations Research
May challenge Varieties of Capitalism approach

PE operates across borders => to what extent is acquired
firm’s behavior constrained by interlocking national
institutions ?

PE ownership alters governance of firms – moves firms
away from embeddedness in national business system

What does country of origin tell us about operation of firms

Can we still speak of the “Britishness” of EMI, Cadbury?
13
Conclusion: Challenges for Researchers

Realization of value, not creation of wealth, dominates
decision making by PE-owned firms
May need to examine assumptions – e.g., importance of productivity
agenda, influence of country of origin

Firms governed by PE less able to keep bargains
Breach of trust may realize value for owners, but at expense of workers,
vendors, other stakeholders

Divergence of interests of owners, managers and workers
intensified by PE ownership

Who should unions bargain with in PE-owned firms, who
should researchers interview and study?
14