How Hedge Fund Billionaires Loot Worker Pensions
- Hedge funds use bankruptcy to wash off worker pensions throwing the burden on government pension insurance
- Government pension insurance plans are in crisis because of this tactic
- Meanwhile, many economists of influence praise them because, as they are great for shareholders, we should ignore the harm they do to workers.
- The more workers suffer economically, the more they support populists like Trump, the more he supports leaving the hedge funds unregulated
This is the third article on hedge funds. I explain the various vulture tactics hedge funds use generally under the guise of shareholder activism here. I then show how they were used to loot Sears here.
Are these titanic entities that operate in the shadows of our financial system corporate vultures or Samaritans? Let’s look at what the academic economists say.
Undoubtedly Samaritans, Harvard economists Bebchuk, Brav and Jiang conclude in a 2015 study. The authors tell us that hedge fund actions overall are beneficial as they have a positive effect on shareholder returns and corporate long-term health.
You will easily find the pro hedge fund Bebchuk study by searching about hedge fund effectiveness. The search results listing this report will fill the first two or three pages as it has been reproduced on several academic and business sites — usually with high praise. Yet, there is a serious flaw in their fundamental hypothesis. Recall Socrates’ warning, “Let me ask the question and I will determine the answer.”
A Legal Geek Interlude: Multi-millionaires and billionaires pool their money in organizations that may be called hedge funds or private equity funds. There is no true distinction in their operation. Hedge funds may do equity investing; equity funds may do hedging. They both want to make money by any means possible. For simplification, I will only refer to them as hedge funds.
In 2017, another study pointed out the flaw in the Bebchuk work. This study you are not going to find easily on a search. It hasn’t been reproduced or praised on academic or business sites. If you find it at all, it will be on the third search result page or later. Yes, these economists agree with all of the upticks cited in the Bebchuk study, but — a very big but — as the hedge funds won, somebody lost.
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An Effective Wealth Transfer Mechanism for Inequality
Economists Anup Agrawal and Yuri Lim noticed something their colleagues overlooked: as the hedge fund returns increased, employee pension funding decreased.
Shareholder gains from activism appear to partly come from raiding deferred compensation promised to workers, and from taxpayers via PBGC [Pension Benefit Guarantee Corporation] guarantees.
They exposed a common tactic in the hedge fund playbook:
We find that targeted firms reduce employer contributions to the pension fund, which they justify by increasing the assumed rates of returns on plan investments. They also tilt plan investments toward riskier assets, in a failed effort to boost plan returns.
Additionally, these authors point out that if the government pension fund cannot cover the claim, the taxpayers may have to kick in.
Later, in 2018, a study by Ed deHaan, David Larcker and Charles McClure, Long-Term Economic Consequences of Hedge Fund Activist Interventions, found the supposed benefits in the Bebchuk study were a misleading product of poor methodology. DeHaan, like Bechuk, looked only at returns on investments to shareholders, but overall found, contrary to Bebchuk, no increase compared to non-hedge fund controlled firms. In fact, there was no difference at all between hedge fund controlled and non-controlled companies using shareholder returns as a measure only, i.e., no benefits nor detriments.
Again, you will not easily find this study on an internet search.
In a note for the Harvard Law School Forum, corporate lawyer Martin Lipton says the deHaan research:
“basically refutes the “empirical evidence” cited by some academics as support for their approval and encouragement of attacks by activist hedge funds. In addition, it provides support for approval and implementation of defenses against such attacks.” [Emphasis added]
Only the Aggarwal and Lim study looks at the effect on worker pensions. That’s a glaring oversight in those studies that support hedge fund activism according to Joshua Gotbaum, a former head of Pension Benefit Guaranty Corporation (PBGC). According to a 2013 review by Gotbaum, companies controlled by hedge funds and private-equity firms have used bankruptcy to avoid more than $650 million of pension obligations. That leaves the government’s pension insurer or employees—then eventually taxpayers—to pick up the tab.
Hyena Capitalism at Play
The above-cited studies by economists look only at big data. I examined how a hedge fund shed the Sears’ workers’ pension fund here. Let’s look at another example where journalists have investigated how hedge funds put a corporation they controlled into bankruptcy for their profit at worker pension expense.
Hedge fund managers usually target well-established businesses to unlock value — which means stripping out the net wealth as much as possible as soon as possible for their members return on investment and their own commissions. Their ideal quarry has at least two of the following: cash in its bank account, assets such as divisions that can be sold immediately for cash, or real estate that can be sold and leased back producing immediate cash while putting off these new rental expenses for the future.
As all the possible cash is cleared out by dividends to the shareholders (the hedge funds), exorbitant management fees (to the hedge funds) and lease payments to the new landlords, there is little left for the long-term needs of the business such as innovation to changing business models, renovations or reserves to ride out the inevitable downturns in the business cycle. The business must borrow to meet the minimum for these needs.
Once the businesses are hobbled by these financial albatrosses, takeover artists can claim that the business failure was due to competitive factors and clean off the businesses debts through bankruptcy—a big debt is worker pensions. (I explained how to make money by bankruptcy in a prior article here—but it won’t work for you. It’s only for the wealthy; it takes a pile of money to do it.)
How Sun Capital Does It
Sun Capital acquired the ailing Marsh Supermarkets, once one of Indiana’s top companies, with 15,000 employees and more than 100 stores. It is an example of how sophisticated shadow bankers can extract value for themselves from a weak business before it fails. The Washington Post reported one of the first moves it made at Marsh was a sale-leaseback: It sold off its real estate portfolio for about $260 million and then leased the stores back from the new owners.
Next, according to the WaPo article, Sun Capital began selling off Marsh assets, such as Village Pantry convenience stores. At that time, about $80 million was owed to workers’ severance and pensions— but the entire proceeds of the sale went to Sun Capital as a major shareholder instead. Of, course, this cannibal capitalism technique of taking out all available cash as it came into a troubled business meant that business was doomed. It went bankrupt on May 11, 2017.
The Pension Benefit Guaranty Corporation made up the shortfall in the general worker pension plans.
Additionally, Peter Whoriskey, of WaPo reports Marsh’s warehouse workers had a claim on a separate pension fund that was part of a Teamsters-affiliated fund known as Central States. Even before the Marsh bankruptcy, Central States was running out of money, partly because so many trucking companies have filed for bankruptcy. Whoriskey comments:
“However, more than $1.5 billion of the Central States pension shortfall can be traced to bankruptcy by companies owned by hedge funds, according to the pension fund. It is expected to be insolvent within seven years.”
Sun Capital told Whoriskey it has many investments and should not be judged by this one. To the contrary, even if Sun Capital had engineered a profit only once at worker pension expense, that would be indefensible.
However, Whoriskey tells us that, for Sun Capital, this process of buying companies, extracting profits and leaving pensions unpaid is a familiar one.
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Over the past 10 years, it has taken five companies into bankruptcy while leaving behind debts of about $280 million owed to employee pensions.
How Worker Pension Fund Managers Help Hedge Funds Harm Workers
The Toys ‘R’ Us bankruptcy should be a warning to union members that the money managers of their pension funds, for their own commissions, invest in hedge funds that cannibalize businesses leaving employees without severance pay or pensions.
According to Wolf Richter of Wolf Street, three private equity firms (I call both hedge funds and private equity funds, hedge funds in my articles for simplification): “Kohlberg Kravis Roberts (KKR), Vornado Realty Trust, and Bain Capital Partners acquired the publicly traded shares of Toys ‘R’ Us via a $6.6 billion LBO [leveraged buy out] in 2005. They funded the acquisition in large part by loading up the acquired company with debt — hence ‘leveraged buyout.’ In other words, the PE firm had little skin in the game, and over the years extracted $400 million in fees even as the retailer died.”
A leveraged buyout has two malign aspects: the share purchase price goes to the shareholders, who are usually wealthy investors, but not to the corporation; and the borrowed debt is transferred to the corporation that is now saddled with this added financial obligation — while the hedge fund does the usual: charge extravagant management fees, sell off assets for cash and such, then extract all profits by dividends to itself — then blame market conditions when the business fails.
And so. when the already weakened Toys ‘R’ Us saw its demise in 2018, about 30,000 employees lost their jobs and entitlement to about $75 million in severance. The hedge fund trio offered a $20 million trust fund. Journalists heralded this as a magnanimous gesture without considering how much value had been extracted and the shortfall of about $55 million to the employees. That went to the hedge fund law firm that got $56 million in fees for pulling off a profitable bankruptcy for the hedge funds. As severance is an estimate of how long it will take workers on average to find similar employment, now there will be gaps of several months with no paychecks.
In his article, Richter points out it is not only union pensions that invest heavily in hedge funds. In this case, the Washington State Investment Board (WSIB), invested $1.5 billion in the KKR fund that financed the Toys ‘R’ Us share acquisition. After meeting with a KKR rep, the money managers of the WSIB decided to continue to invest in KKR. No doubt KKR made money on the venture so the managers, in turn, got a good result for themselves too— no worry about the carnage.
Warren Buffett has provided the ammunition that union members and voters need to stop their pension fund managers from investing in vulture funds that harm workers. He issued a challenge that no money manager could beat the results of an index fund over a ten-year period. Only one fund Protégé dared accept the challenge. It picked 5 hedge funds to follow — the names were never disclosed.
Legal Geek Interlude: In an active fund, a money manager picks individual stocks and responds to market changes attempting to buy high and sell low. An index fund is a passive investment. The manager selects a sample of all stocks listed on an index, say the S&P 500, and stays with those. There is no need to read financial statements to pick individual stocks nor to follow the market to buy and sell as individual stock prices fluctuate. Generally, the index fund stocks value, as a whole, increase over time. The gains offset the losses. So, while there is no big kill, there is a gentle positive increase. The great savings is in eliminating the high management fees. [end]
After nine years, CNBC reported, hedge fund portfolios were up just 22 percent on average, compared to 85.4 percent for Warren Buffett’s Vanguard Admiral Shares S&P 500 Index Fund pick.
Even better, the ultra-safe U.S. treasury bonds outperformed both the hedge fund portfolios and the index fund. Buffet and Protégé bet a million bucks (to be donated to charity) on the outcome. They funded the bet by putting $640,000 into no coupon (meaning the interest stays in to accumulate) treasury bonds expecting that would turn into $1 million in 10 years. But at the end of nine years, the amount was already $1.8 million — which outperformed both the hedge funds and the index fund.
Bottom line: union members and voters should stop their organizations from paying these high fees to money managers and insist on passive investing strategies — and not only because managers are acting unethically in hurting workers — but the extravagant fees they charge are worthless and their investment choices are damaging pension plans.
Some Good Corporate Doctors
Definitely, there are corporate turnarounds without pension pilfering. Take the case of Starboard Value LP that revived The 800 restaurant chain Olive Garden. The question we now face is of the baby and bathwater type. How to curb the excesses but not the successes.
End The Pension Plundering
The hedge funds seem invulnerable to any restraints, buoyed by an ethic of capitalism today which has transformed from survival of the fittest to survival of the richest. There have been attempts to rein in hedge fund excesses in the past. All have failed. This year, Elizabeth Warren again introduced legislation, the Stop Wall Street Looting Act, aimed at many of the vulture tactics. She wrote a good explanation of it in a Medium post.
All her proposals are justified, but are complex and require a good understanding of how hedge funds do the damage they do — something entirely absent from the public awareness. The hedge fund industry lobby’s public relations firms sow confusion amidst the complexity with articles from prominent economists on its payroll and politicians nestled deep in its pocket.
Warren, and other politicians, have to reach the working class who have little background in these matters. Pension looting is a straightforward issue the public can understand and the hedge fund lobby will have difficulty confounding it.
There may even be support for pension protection among the most committed supporters of the most callous forms of capitalism: business owners whose companies will be picking up the tab in increased premiums. Their taxes will also be funding a likely bailout of the government pension insurance purse when it soon empties.
There’s a simple way to ensure worker pensions are fully funded:
If they are not, dividends, management fees and any payments of any sort or kind paid to the controlling shareholders (the hedge fund), can be clawed back 5 years and traced to the ultimate recipients.
Bottom line: Pensions can be protected!
For more on the financial system’s role in inequality follow Jan at https://medium.com/@JanWeir1 and on Twitter @JanWeirLaw
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