Private equity, labour rights and the new corporate debt economy (part 2)

Part 2: Coding the corporate debt

In part 1 of this blog, I argued that the current private equity boom has major implications for workers, and that these can only be understood through the prism of corporate law and the property relations mediated through the corporation and the equity and debt instruments tied to it. In Part 2, I explore the shifting role of debt in contemporary capitalism – exemplified by the private equity model – through the prism of the debt/equity distinction, and the economies of value extraction and risk shifting enabled by innovative uses of law. I show how law is used by corporate elites to ‘code’ the capital of the firm in ways which maximise extraction of value for investors in ways which break with basic norms of industrial relations and labour rights.

The shifting role of debt in contemporary capitalism

Debt is integral to capitalism. In the transition from feudalism to capitalism land and labour and material goods became commodities. Bringing these commodities together in production required credit: an advance on the future profits that would be made. The genius of the capitalist economy as it expanded in the 18^th and 19^th Century was this very ability to pull value forward in time to bring these factors of production into coordinated activity. Economic activity in capitalist societies therefore entails a bet on the future. The legal rules through which firms are constructed set the terms of that bet and shape how the gains, risks and losses will fall. The capitalist bet on the future is manifest through a series of claims on that future, rooted in the intangible property forms of the corporation. The global financial crisis in 2008-09 was the culmination of a long build-up of debt in the advanced capitalist economies. This was in part traceable to changes in the labour relationship. The share of income going to labour had declined significantly in both developed and developing countries since the 1980’s, whilst the link between productivity gains and wages had been broken. In consumer driven economies such as the UK this relative decline in the buying power of workers combined with an expansion of consumer credit to produce a debt driven model of growth. At the same time, the proportional increase in wealth gains at the top as the labour share was transferred upwards generated large volumes of capital seeking returns. The flawed logic of this was fatally demonstrated in the US sub-prime housing market. People too poor to afford housing were sold mortgages at terms impossible to fulfil to meet the investment needs of people with surplus capital, chasing returns in a stagnating real economy.

In the corporate sector the shift in the value distribution away from workers was driven by extractive models under the rubric of ‘shareholder value,’ which included expansive use of debt to drive shareholder returns. Increasing dividend and interest payments are linked to the declining share of wages in national income across developed economies between 1986 and 2007. In the run-up to 2008 private equity funds had been spending big, with a major round of LBOs in 2006-07 leaving huge numbers highly indebted firms exposed to the crisis and raising concerns of large numbers of insolvencies amongst PE owned firms. The expected reckoning never came. The new era of near zero interest rates spurred by the crisis allowed steady refinancing of the huge leverage carried by PE controlled companies. Instead the combination of low interest rates and the promise of ‘outsize returns’ by PE firms pushed many pension funds (themselves facing huge liability gaps arising from the GFC) towards private equity and high yield lending, ensuring a ready influx of investment capital. The financial crisis also intensified the shift of private equity companies towards capital market financing as the regulatory constraints and leverage restrictions placed upon the banking sector pushed PE borrowers towards debt capital markets to access the required levels of leverage. Central banks had effectively bailed out the private equity business model, private equity had “won the crisis”. The period since 2008 has seen the new corporate debt economy shift into overdrive. The historical role of debt in capitalism – to pull value forwards to finance productive investment – has given way to the pulling forward of value to distribute as shareholder returns. Total UK listed corporate debt soared to all-time highs in the period 2015-2018 as Low overall profitability combined with pressure to pay dividends led to £263bn in dividends accompanied with £122bn in debt. The collapse of Carillion in 2018 with over £6bn in liabilities and only £400m in cash, very nearly followed by fellow outsourcing giant Interserve later that year, underscored the extreme lengths corporate elites would go to in order keep the dividend tap running. The UK corporate sector entered the covid crisis in poor financial health, with many balance sheets hollowed out through years of debt financed returns. Only the unprecedented scale of financial stimulus and government backed loans prevented a much wider collapse. Multiple firms either previously or currently owned under private equity models went bust or shed huge numbers of jobs including Debenham’s, Boots and numerous ‘casual dining’ restaurant chains such as Pizza Express, Zizzi and Byron, prompting industry experts to label as a ‘car crash’ private equity’s involvement in the casual dining sector.

The debt/equity distinction        

The controversies generated by the private equity model suggest that social understandings of the distinction between profit and debt have a distinct moral character. The differences in law however have been eroded over time. The historical development of company law sheds some light on these distinctions. Under the law of partnership – the dominant legal form of the firm until the late 19^th Century – partners were held jointly and severally liable for the company’s debts. The distinction between a partner and a creditor was therefore of crucial importance. Broadly speaking, a contributor of funds to a company was understood to be a partner if the returns accruing to them were variable and unfixed, therefore sharing the risk of the enterprise and having the appearance of ‘profits.’ Taking a role in defining that risk through a modicum of control was an important but secondary criterion. Creditors were understood to take no part in defining or sharing the risk of the enterprise. With the emergence and proliferation of the corporate legal form the liability question fell away. A residual normative understanding of the difference has however persisted. This is reflected in tax law, which understands interest payments as a business cost and as such non-taxable, and dividends as payment of profits and so subject to tax. This cost/profit distinction disappears in contemporary corporate finance. The multiple debt instruments utilised in LBO capital structures embed a spectrum of overlapping control rights, priority claims and options, from ‘equity-like’ debt to ‘debt-like’ equity, blurring any sharp distinction between shareholders and creditors rights. For example, debt is often used to transfer profits in a tax efficient way. Prior to the Kraft takeover Cadbury’s deployed a corporate structure under which Cadbury’s was loaded with debt in order to transfer profits as interest payments rather than dividends – to virtually eradicate its UK tax liability. Conversely apparent ‘equity’ holdings can be structured like debt. In the buyout of Heinz by 3G Capital and Berkshire Hathaway Capital Partners the nominal amount of debt was low for an LBO, with only 42% debt ($12bn out of $28bn paid). But the deal included $8bn preferred stock for Berkshire Hathaway paying 9% plus share options. The preferred stock represented a fixed (debt-like) claim, with the (equity-like) option to also capture future increases in value.

This blending of rights makes it clear that creditors also significantly shape and benefit from the risk of the enterprise. Moreover, it demonstrates that frequently, debt is not a ‘business cost’ but a pure mechanism for transferring wealth to investors. Understanding debt as a business cost generates a particular social framing of the relationship between the corporate entity, its private equity owners, and its creditors which confers legitimacy upon creditors’ claims, even as workers claims are obliterated. When Toys ‘R’ Us went into administration, at a cost of 33,000 US and UK jobs, the $400m annually which went to interest payments arising from an LBO was naturalised in media reportage as the outcome of a company “struggling under the burden of its debt”. One might consider that, had the $5.3bn in new debt arising from the takeover instead been in the form of equity, which had paid out $400m a year over ten years totalling (at least) $4bn investor returns from a company in rapidly declining financial health, significantly as a result of the amounts of cash being withdrawn to pay investors, then the legitimacy of these actors would be a feature of the public debate following the firms collapse. Yet the press coverage entailed no discernible critique of those senior secured creditors, who would collect on liquidation whilst US workers faced $75m in losses, and UK workers claims were reduced to statutory minimum payments from the insolvency service.

Liquid markets and arbitrary magnitudes

As described in Part 1, the legal conceptualization of the share as both transferable property and interpersonal rights was enabled by the corporate legal form, giving rise to deep liquid markets for shares and dynamics of rentier appropriation of value. The creative use of law to construct new forms of tradeable financial property continues to this day. The contemporary boom in private equity has been rooted in the explosion of markets for ‘covenant-lite’ leveraged loans. So-called because they lack the standard loan covenants which provide early warning to creditors of a firms declining financial health, and enable creditors to trigger insolvency proceedings, cov-lite loans boomed on US markets in the years prior to the 2008 crisis. The push to reduce contractual covenants was driven by a demand from investors for high yield debt. Complex contracts became a barrier to a rapidly trading liquid market. Market players wanted transferability and were prepared to sacrifice some protections in order to get it. Reflecting developments in the sub-prime mortgage market the increased risk for lenders was mitigated by the packaging up of loans through ‘Collateralised Loan Obligations’ enabling diversification of risk for the lenders. Private equity firms pay a premium for covenant-lite loans because they retain increased control and flexibility during periods of financial distress and avoid the need to enter into debt restructurings that may target the equity investment, or the imposition by lenders of other costly controls. In enabling PE owners to hold off insolvency the risk of ultimate liquidation is increased. The higher default risk is passed onto employees and small trade creditors. Once viewed as symptoms of pre-crisis excesses in the credit market, covenant-lite loans are now a major feature of the UK buyouts market. The majority of funds generated through issuance of leveraged loans were used for the purposes of corporate control. In 2018 approximately 60% of leveraged lending was used to finance M&A including LBO’s, 9% to finance buybacks or dividends, and 30% used for refinancing, 1% went to productive investment.  As the Bank of England Financial Stability Report 2018 noted, “most of these proceeds have been used to engineer changes in the liability structure of the corporate sector to optimise returns, rather than to fund new investment’. The boom in high yield debt enabled the Issa brothers and EG group to acquire ASDA – at a value of £6.8bn – with only £800m of their own funds. The demand for high yielding debt instruments driven by the era of low interest rates, and for credit by PE firms eager to snap up ever more targets has led to an explosion of valuations in the buyout market. Despite the dire economic context, the 2020 LBO boom saw record valuations of target firms, with valuation multiples reaching 13.5 x earnings as private equity firms – flush with easy credit – competed for takeovers. Such valuations do not reflect the rationality of capital market participants, rather a frenzy for rentier control. Many investors in high yield debt such as cov-lite loans will still be ranked above workers in insolvency: empowered by the legal coding of their capital as both transferable property and priority rights. As private equity has been shown to be highly cyclical it is workers that will suffer when credit markets turn. The cov.-lite and LBO boom may or may not lead to another systemic collapse anytime soon, but it will continue to extract value, increase inequality, and undermine job security.

Contesting value

The paradoxical qualities of the share; as entailing both hierarchical rights within the firm and the right to freely transfer these rights through the share market, are reflected in the proliferation of new high-yield debt instruments. Social ideas of the legitimate distribution of value are quietly eroded through legal innovations in the service of investor interests. The example of private equity and the corporate debt economy demonstrates that corporate legal structures develop not according to the direct needs of production or the imperatives of efficiency, but to generate rentier returns. This takes place through processes by which elites selectively ‘code’ productive and financial assets in law, in ways which transfer control, value and risk in particular ways. The lesson of 2008 was that if the way in which value relations are structured is left to financial and corporate elites then they will chase returns right over the cliff, and the rest of us with them. Yet this lesson has not been learned. The private equity boom and the forms of increasingly risky debt upon which it is being built are proceeding with minimal intervention by the people most effected: working people and their organizations. Trade unions need to get serious about intervening in the property relations of the corporation. Reforms to takeover regulation, and the way that TUPE functions could significantly enhance the power of unions during takeovers. The absence of TUPE protections when a change in ownership takes place via a share transfer leaves workers unprotected following an LBO. Extending TUPE to share acquisitions would limit the scope for the ‘share premium’ paid to be borne by workers; effectively re-establishing a legal relationship between the share as property and the conditions of workers. It would prevent bids seeking to transfer wealth in the short term and give workers and unions time to organize in relation to proposed changes. The right to make ETO changes would still leave wide facility for post-acquisition restructuring, which is especially problematic given the role of debt and the ‘leverage ratio’ in forcing through restructures. This could be minimised through a right for employees to a vote on takeover bids. Takeover regulation already establishes the principle through the right to express an opinion on bids, but this is a hollow right. Why not a say instead? This could be achieved in line with proposals for worker votes set out in the Rolling out the Manifesto for Labour Law. Workers could be recognised as company members with the right to vote equivalent to a proportion of 20% of the outstanding shares. Under current rules where bidders are seeking 100% control, they require approval of 90% of shareholders in order to squeeze out minority holders. Worker approval would therefore be an important factor for bidders seeking total control. Bids with aggressive uses of debt and asset stripping could be rejected by workers acting in the long-term interests of the company: something that cannot be said of shareholders looking to trade out at the highest possible price. The impacts of speculative bubbles and extractive activities on equity and debt markets upon workers are ultimately the outcomes of law and regulation, not economic forces. These rules currently empower corporate and financial elites to ‘code’ their claims over the firm with relative autonomy. Intervention in these processes must become a central aim of trade unions to protect pay, conditions, and job security in an era of financialised capitalism.