Private equity, labour rights and the new corporate debt economy (part 1)

In the first of his two-part blog series, Ben Crawford discusses the current expansion of private equity ownership and what it means for workers.

Commentary icon29 Nov 2021|Comment

Ben Crawford

London School of Economics

This series explores how corporate law, and the private equity model facilitates the extraction and transfer of value from workers to rentier investors and corporate elites.

Part 1 explores how value transfers from workers to shareholders are driven through the takeovers market and the leveraged buyout. Part 2, to be published next week, will explore the debt side of the corporate balance sheet, exploring the legal coding of credit instruments and the shifting function of debt in the corporate economy.

Part 1: Coding the share

Private equity is booming. Long considered a fringe model to UK corporate capitalism, private equity is rapidly becoming the dominant model of corporate ownership. Global private equity net asset value has grown by a factor of nearly 10 since 2000, outstripping growth in public equities by threefold. By 2007, the 10 largest private equity firms were already significantly larger by numbers of people employed within their portfolio companies than the 10 largest corporations in UNCTAD’s top 100 TNC’s list. The period since the 2008 crisis has seen the rise of private equity towards a dominant mode of ownership, with private markets accounting for 50% of new funds raised in 2019. Despite the global coronavirus recession 2020-21 saw a record number of leveraged buyouts, with record prices paid and record levels of debt attached to target companies. Private equity is no longer a fringe model. In many ways it never was, in fact it tells us a lot about how corporations and corporate law work in general. The private equity model shows how the rights structures embedded in the corporation and the forms of intangible property it issues (shares and debt instruments) open a deep disparity in power between workers and investors. These rights structures are selectively ‘coded’ in law by corporate elites, with no input or say for workers whose labour generates the value packaged up as fees, dividends, and interest payments. This imbalance has major implications for the effectiveness of workers’ rights, and the way that value, control, and risk are distributed across the firm.

Private equity is no longer a fringe model. In many ways it never was, in fact it tells us a lot about how corporations and corporate law work in general.

Takeovers as value appropriation

In June of this year private equity firm Clayton Dubilier & Rice (CD&R) joined the ranks of bidders competing to take control of Morrisons. The excitement in the financial press was palpable, with the Sunday Times describing how CD&R’s entrance was “raising hopes of a bidding war” for the retailer, pushing up the price paid for the firm. In the event CD&R sealed the deal at a valuation of £7bn, a premium of 60% on the pre-bid share price. Surely such a high valuation would be a good outcome for Morrisons and its employees, right? Not quite. The £7bn figure does not represent an ‘investment’ in Morrisons, rather the price paid from one group of investors to another to take majority control of Morrisons equity. The financial press had been cheerleading for a big payday for shareholders. When investors compete for control of a listed firm the share price uplift is known as the ‘share premium.’ Finance theory holds that the share premium paid represents incumbent shareholders assessment of the additional value that will accrue to the bidders by taking concentrated control of the firm. Where stock prices are bid-up during a takeover it is the claims upon the future revenues of the firm that are increased. Studies have shown that a significant proportion of this premium is paid by workers through job destruction and wage cuts as the new controlling parties seek to recover the premium paid. One startling paper demonstrated that higher levels of collective bargaining coverage act to incentivise takeovers as the higher wage levels in unionised workplaces represent a rich source of transfers to acquiring shareholders and generate a higher ‘share premium’. As the authors conclude “all else equal, collective bargaining protections generate substantial gains for target shareholders”. Takeover bids need not be successful to trigger value transfers to shareholders. In 2017 3G private equity attempted to use its control of Heinz Kraft as a vehicle to takeover Unilever. The industry impact of 3G’s earlier acquisition at Heinz was described by a Rabobank analyst thus: “Many in the industry have been surprised (scared!) by the size of the savings squeezed out of Heinz, a company that was previously considered well-run and efficient…This has left them sifting through their own business operations for savings knowing that if they do not, they might just find themselves on the menu of private equity”.  The Heinz Kraft bid for Unilever failed but had an immediate impact. Unilever at once announced a “comprehensive review of options available to accelerate delivery of value for the benefit of our shareholders” including potential asset sales and would boost operating profit margins towards the steeper margins of Kraft Heinz. The subsequent review lead to the sale of Unilever’s spreads division to Kohlberg Kravis Roberts in an $8bn LBO, as well as a number of other asset sales and factory closures and job losses across Port Sunlight, Warrington and Norwich in 2019 and 2020. Fortune magazine described the wider ripple effect of 3G’s aggressive approach: “The entire food industry is “3G-ing” itself before Kraft Heinz can do it to the companies”. Such bids play as simple disciplinary function in the share market: a complementary synthesis of private equity and plc. shareholder power.

Coding the share

Since the mid 1990’s a critique of aggressive ‘shareholder value maximisation’ techniques was put forward by ‘stakeholder’ theorists such as Will Hutton, arguing that shifts in the legal duties of Directors, alongside stakeholder representation through mechanisms such as workers on company boards, could re-orientate the firm towards the needs of its multiple constituencies. Such proposals have achieved varying levels of political support, with Theresa May promising to ‘put workers on boards’ as recently as 2017 (and shortly scrapped). Contemporarily large corporations have responded to the covid pandemic, social justice movements such as Black Lives Matter and the climate crisis, with the promise that the pursuit of ‘shareholder value’ will be guided by the ‘purpose’ of the ‘responsible corporate citizen’. In practice corporate governance reforms have consistently entrenched shareholder primacy and corporate power. More importantly, neither the stakeholder critique, nor the promises of corporate social responsibility engage with the basic dynamics of the corporation and the share market as the drivers of the ‘shareholder value’ firm.

The emergence of the corporation as the dominant legal model of the firm in the late 19th Century was reliant upon the emergence of the share as a form of alienable property.

The ‘shareholder value’ model is underpinned by the peculiar legal characteristics of the share and the corporate employer. The emergence of the corporation as the dominant legal model of the firm in the late 19th Century was reliant upon the emergence of the share as a form of alienable property. Originally the rights structure of the share was a barrier to its transferability as property, reflecting as it did contractual interpersonal rights between members of the firm. As the law shifted towards full recognition of corporate legal personality and reconceptualized the share as a form of transferable intangible property in its own right the share market expanded rapidly: legal reconceptualization enabled the development of liquid markets. In conceptualizing the share as an autonomous form of property the relationship between workers and shareholders was obscured. This gave rise to ideas that shareholders had been ‘externalised’ from the corporation opening a space for the corporation as a social institution free from hierarchical property relations between labour and capital: a pre-cursor to contemporary ideas of ‘stake-holding’ and CSR. The vast expansion of capital markets since the 1980’s and the era of ‘shareholder value’ demonstrate that property relations had not been transcended by the corporation but rather intensified by it.

These paradoxical features of the share – as both interpersonal rights and transferable property – generate a deep disparity of power between workers and shareholders. As employee contracts are with the corporate employer, a change of equity ownership has no effect upon workers from the point of view of employment and labour law; workers have no legal relationship to shareholders. This basic feature of corporate law enables the wholesale transfer of employee contracts to the new controlling parties via the transfer of share ownership, with no consent by the employees: a drastic exception to basic norms of contract law. This is so because the corporate entity bisects the relationship; yet it is controlled by managers who are installed by shareholders. In private equity takeovers it is typical for executives from the acquiring firm (the new shareholders) to be installed in the target company board. Protective employment law mechanisms such as TUPE are not triggered as ‘the employer’ has not changed: only the identities of the owners of the corporation’s securities who may, nevertheless, enact sweeping changes. This wholesale transferability has beneficial effects in terms of continuity of business, but at the same time exposes workers to expropriation of value by shareholders through takeovers and the share market. The price paid, the intentions of the new equity owners, and the financial structure of the bid have major implications for pay, terms and conditions, and job security.

Asset stripping as standard practice         

As the example of the share demonstrates, the types of legal claims investors have vis a vis the corporation matter for the way that value is distributed. In a leveraged buyout, the private equity bidders are taking control of the company’s equity using only a fraction of the payment price, with the rest funded through debt. The acquiring shareholders fund their acquisition of the equity by selling off rights to the future earnings of the firm. The new equity holders get concentrated control, and the creditors get a fixed claim upon future revenues in the form of interest and principal payments. Paradoxically, the corporation pays for the acquisition of its own shares through the granting of security over its own assets. When the success of the CD&R bid for Morrisons was confirmed a number of MP’s claimed that they would be “keeping an eye” on the new equity holders to make sure the company was not asset stripped. Private equity is strongly associated with such practices. When the billionaire Issa brothers, and private equity firm TDR Capital took control of ASDA in 2020 the company’s distribution centres were sold off to raise revenues to pay for the acquisition as part of the familiar ‘OpCo-PropCo’ structures used to spin-off real estate assets into a separate company and require the target firm to rent the use of them back. Yet the question of whether or not tangible assets have been sold off rather misses the core point of the LBO: in selling off enforceable rights to the future revenues of the firm it already has been asset stripped. Future revenues which would rightly be subject to bargaining between workers and shareholders are sold off as fixed claims. In doing so certain trajectories are locked in. The greater the leverage ratio of a bid (the amount of debt to equity used), the greater the cash flow diverted to cover interest and debt repayments and the greater the operational restructuring required to meet target payments. Higher share premiums will result in a higher purchase price and therefore higher leverage, which translates into a greater squeeze on future value. When Bain Capital and Kohlberg Kravis Roberts took over Toys ’R’ Us in 2007 the interest payments on the new $5.3bn debt already outstripped existing profits. The subsequent rounds of cost cutting and attacks on staffing, pay and benefits failed to make up the difference, to the extent that by the time Toys R Us went into insolvency in 2017 (with the loss of over 33,000 US and UK jobs) interest payments were taking up 97% of operating profit.

Given the way in which such trajectories can be locked-in through the financial structure of acquisitions, a voice for workers during the process is critical, yet existing mechanisms are weak.

Regulating for ‘shareholder value’

Given the way in which such trajectories can be locked-in through the financial structure of acquisitions, a voice for workers during the process is critical, yet existing mechanisms are weak. The impact of takeovers on workers came to widespread public attention following the Kraft acquisition of Cadbury’s in 2010. Cadbury’s reputation as a good employer and long history of production in the UK prompted fears that Kraft would unravel Cadbury’s ‘stakeholder’ orientation. The takeover was highly leveraged, with Kraft paying £11.4bn for Cadbury using £7bn of debt and promising to make £450m savings a year by 2012, raising concerns about job and pay cuts. Kraft assuaged concerns by promising in its bid to protect jobs at Cadbury’s Somerdale plant. Once the bid was complete Kraft announced the plant would go, to widespread media outrage and condemnation from MPs across the house. The case influenced subsequent reforms of takeover regulation. The 2011 review of the Takeover Code recommended changes “to take more account of the positions of persons who are affected by takeovers in addition to offeree shareholders”. The language used by the Code Committee seemed to conspicuously rule out the possibility that the interests of shareholders and employees may conflict during a takeover. The resulting reforms targeted the quality of bid disclosures and sought to enhance employee’s rights to information and to express an opinion during the process. These reforms reflected a basic tendency of UK corporate governance: uphold the shareholder interest whilst paying lip-service to the interests of workers, or what we might call ‘triangulated shareholder primacy.’ The City Code on Takeovers and Mergers is explicit that its purpose is to uphold the interests of shareholders, ensure they are treated fairly, and retain the ultimate decisional authority on a bid. Given that the ultimate criteria for any shareholder will be price, the attempted triangulation of the interests of workers and shareholders falls apart in the basic logic of the share market.

The private equity model is a model of pure ‘shareholder value’ of which the sole aim is extraction of maximum returns for investors.

The private equity model is a model of pure ‘shareholder value’ of which the sole aim is extraction of maximum returns for investors. This aim relies upon the ability of investors to legally structure the claims upon the corporation and its assets in certain ways. Recent trajectories in critical legal scholarship have demonstrated that understanding how power works in contemporary political economy requires an engagement with how elites deploy basic private law rules to ‘code’ assets in ways which benefit the asset owners, frequently at the expense of others. As I have described, the emergence of the share is one such process which shows why the development of new forms of property matters for workers. Part 2 of this blog will describe how these processes continue to this day, with the ‘coding’ of new forms of equity and debt designed to maximise wealth transfers to investors. I argue, the pursuit of equitable economic outcomes for workers requires interventions at the level of corporate property and the processes through which value claims are coded through law.

Ben Crawford

Grantham Research Institute on Climate Change at the London School of Economics