A new business book calls into question the business model of private equity and argues the strategy won’t generate the same returns as in prior decades.

Since the 1970s and 1980s, firms such as Apollo Global Management, Blackstone, Carlyle Group and KKR & Co., among others, made money in leveraged buyouts, more recently dubbed private equity, in which the firms buy up companies using investor assets, leverage them and aim for more efficiencies and higher profits.

Institutional investors have come to expect returns in the high teens or much higher from private equity. Between 2009 and 2021, private equity garnered such returns until 2022, when the asset class lost 1.2%, according to PitchBook’s data.

But with rising interest rates, the world has changed, according to Gretchen Morgenson, a Pulitzer Prize-winning business reporter who believes those historical returns are no longer possible. Morgenson has co-authored a new book with Josh Rosner, managing director at research consultancy Graham Fisher & Co., titled “These are the Plunderers: How Private Equity Runs – and Wrecks – America.”

LBOs became a “big deal in the 1980s with the RJR Nabisco transaction. They took advantage of the fact that the market for public companies — the stock market — was in the doldrums. So there was a vast difference between what the public companies were selling at and what they were worth,” she said.

Initially, “it was a very shrewd arbitrage between the intrinsic value and the market value, which was lower. And these firms used debt — a lot of debt. It increases your gains if prices go up and risk if prices go down.”

At the time, Drexel Burnham Lambert was funding a lot of companies, which otherwise would never have gotten financing, the era of junk bonds, she said.

Leveraged buyout titans such as Leon Black, the co-founder of Apollo Global, were “peddling deals such as insurer Executive Life. And everything was great until we hit the recession of the early 1990s. Drexel failed. It was the ax, the player, the market maker in the junk bond market. The whole market went kaflooey.”

Buying up the junk bond portfolio of Executive Life put Leon Black “on the map. He had done all the leveraging by selling junk bonds to these companies. Executive Life was the talisman because it had all the earmarks of the future transactions that these folks do. Leon Black made $3 billion. But almost all the policyholders were left holding the bag.”

Morgenson adds that particular deal “had a lot of the same characteristics of ‘I, me, mine’ capitalism. You don’t care about the other people – at all.”

In the 2000s and more recently, LBO/private equity firms began investing in retailers and health care. Roughly 40% of all emergency rooms in America are now run by private equity firms, and 11% of nursing homes, she noted, adding “they’re not owned by private equity, they run them through staffing companies. They manage them and force doctors to do things they wouldn’t otherwise do,” she said.

Today, private equity — the more genteel name for LBOs — is “very mainstream, but the alpha is going away. They did generate alpha for a long time in spite of high fees. But they don’t anymore,” Morgenson alleged.

What’s different now?

“There was an arbitrage between what a company was valued at and its intrinsic value. It made the idea of an LBO more attractive, compelling and obvious. But now, these companies have been flipped so many times. What efficiencies are left? They aren’t generating alpha the way they were. They’re creating bankrupt companies.”

She points to the recent failure of Envision Healthcare, which employed roughly 20,000 doctors, under KKR. The company filed for bankruptcy in May, citing unsustainable high debt due to rising interest rates, high labor costs and payment disputes with health insurers.

Inflation and higher borrowing rates today represent new pressure points on the private equity business model, she said.

“Interest rates makes their costs much higher. We’re seeing more bankruptcies in and among these companies.”

In June, Blackstone-owned CARD, the Center for Autism and Related Disorders, also filed for bankruptcy. It was one of the largest U.S. providers of services for children with autism.

Morgenson said she’s waiting to be proven wrong on whether private equity is positive for the labor force.

“Blackstone told me their companies create jobs, 200,000 net new jobs over the past 15 years. But they declined and never gave me the underlying data.”

Blackstone sent P&I the statement included in the book: “Over our more than 35-year history, our flagship private equity and real estate funds have had net returns annually of 15-17% –— approximately double their public benchmarks. At the same time, we seek to help strengthen companies, putting them in a better position to hire and grow for the long-term. Over the last 15 plus years, our portfolio companies have added nearly 200,000 net jobs. During that same period, we have had a bankruptcy rate of just 0.2% out of nearly 1,000 control investments.”

It’s up for debate as to whether private equity’s alpha will continue to outpace public markets, as recent data show.

On the fundraising side, pension funds “are the oxygen that PE needs to exist. As the alpha diminishes, I don’t understand the point of investing. Pension funds such as CalPERS say they need to meet obligations and PE will help do that. Now that it’s no longer generating that alpha, what’s the argument? It’s highly illiquid, very opaque, the fees are enormous. The outcomes for people involved are negative. When the companies go bankrupt — far more frequently than non-leveraged companies — there’s a bad impact on towns and tax rolls, schools and parks. The circle of pain is big. The beneficiaries are small.”