STEVE INSKEEP, Host:
Some other news, now. Two media companies - Clear Channel Communications and Reader's Digest - agreed this week to be acquired by private buyers. The deals are part of something big happening in financial markets. Investors are pouring billions of dollars into private equity funds. The funds specialize in buying businesses and then often borrow heavily against them.
These funds are earning strong returns, but it's unclear whether the surge in buyouts will prove to be healthy or the next Wall Street fiasco. NPR's Chris Arnold reports.
CHRIS ARNOLD: Veracious private equity firms are gobbling up lots of companies - Eddie Bauer, Burger King, Hertz, Domino's Pizza, AMC Entertainment and many more. The private equity firms often look for troubled businesses that they can buy for a good price, then they try to cut costs, streamline them, and sell them for a profit after improving the bottom line.
But some Wall Street watchdogs say many private equity firms siphon a lot of money out of companies before doing much to improve them.
ANDY KESSLER: You know, the way private equity firms work is one of the dirty little secrets of Wall Street.
ARNOLD: Andy Kessler is a former hedge fund manager. Kessler says private equity firms borrow in order to buy a company, and then often keep borrowing. He says they can borrow money in the company's name but then take it for themselves and their investors.
For example, say a private equity group bought a newspaper company:
KESSLER: So in other words, you borrow money, but this operating entity called the newspaper is the one that has the debt. In fact, you can borrow money to pay yourself a dividend to get your initial investment out. So once you get your initial investment out, you sort of own the thing for free. Now the thing that you own is a company with cash flow but a huge amount of debt.
ARNOLD: Kessler says in some cases, there's so much debt that just about all the money the company brings in the door goes to pay those loans.
KESSLER: So sometimes the business changes and the cash flow decreases and these things go belly up, they go bankrupt.
ARNOLD: That's what happened after Bain Capital bought KB Toys for $250 million. Bain only put 20 million down and just 15 months later, Bain and some other investors and executives pulled $121 million out of the company, and that pushed the company into bankruptcy, according to a lawsuit filed by a group of KB Toys' creditors.
The lawsuit says it was fraudulent for the investors to pull so much money out of KB Toys at a time that the company's core sales were declining. The lawsuit called the case, quote, a tale of greed and self-dealing that rivals the most appalling corporate scandals of recent years.
Bain had no comments, but in court documents Bain argued it was market forces that doomed KB Toys.
PERRY STEINER: I think the days of the corporate raiders are behind us.
ARNOLD: Perry Steiner is a partner with the private equity firm Arlington Capital Partners. He says most firms, such as his, are looking to increase the value of the companies that they acquire so they can make more money when they sell them. He says there really is not a slash-and-burn mentality in the business right now.
STEINER: If firms weren't thinking for the long term, and really building companies for the long term, it just - they'd be shooting themselves in the foot. So the firms tend to be fairly rational in how they operate.
ARNOLD: And Andy Kessler says too, often the cost cutting done by private equity funds is necessary and it helps the overall business. Still, private equity groups are pulling a lot of money out of the companies that they buy. Sometimes quickly paying themselves hundreds of millions of dollars while laying off workers and cutting health benefits.
So is all that reasonable, or will some of these buyouts become the next big Wall Street scandals?
JOSH LERNER: Well, it's a great question, and it's probably one which doesn't have an easy answer.
ARNOLD: Josh Lerner is a Harvard Business School professor. He says when these companies that have been bought up go on to hold public stock offerings, the stocks actually perform pretty well. The buyouts don't appear to have hurt the businesses, but most companies bought by private equity firms don't go public so Lerner can't track what happens to them.
LERNER: Getting access tot that information is pretty challenging. This is, I mean after all, they call it private equity for a reason.
ARNOLD: There's a lot less transparency in regulatory oversight of privately held companies. Some experts are concerned that if the economy sours or interest rates rise sharply, a growing number of companies could be in trouble. If private equity firms have loaded them up with debt, they could be forced to cut jobs just to pay their bills, and some could go bankrupt.
Chris Arnold, NPR News, Boston.
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