The proposed acquisition of Chrysler by a private- equity firm, Cerberus, reflects a growing trend throughout the world. That is, between twenty and twenty-five percent of all mergers and acquisitions over the past year have involved private-equity firms. These companies employ significant leverage to make their purchases. Moreover, in recent years, the private-equity firms have expanded their target horizons; that is, their appetite includes a large variety of firms with diverse cash flow characteristics. Historically, private-equity firms focused on companies generating substantial cash flow, hoping to reduce costs substantially while benefiting from an assured cash infusion from the on-going business.  While private-equity firms are still heavily focused on reducing costs, selling low returning assets, and borrowing extensively, they have substantially widened their investment focus geographically, type of industry, and size of target companies. The combination of private-equity acquisitions, increased scale of mergers and acquisitions by traditional corporations, and the influence of institutional investors have led to increased focus on short-term profit objectives and corresponding decline in corporate-employee loyalty bonds.

 

The purchase of heavily unionized companies in the auto and steel industry reflects an ominous trend. That is, many of these companies have become non-competitive globally because of their heavy pension and health benefit liabilities. Over the past few years, we have seen private-equity firms make substantial fortunes primarily by getting the unions to forego these benefits or alternatively getting the government to take over these liabilities. The bottom line is the Pension Benefit Guarantee Corporation, which was established by the government to provide some level of support for employees who lost their pensions because of the bankruptcy of their employers, is not only seriously under funded but suffers greater financial exposure to the extent that thinly capitalized companies acquire firms that have significant pension liabilities. That is, at a cost ultimately to the tax payer, there has been transference of obligations from the private sector to the government. In essence, the private-equity firms have structured their investments to maximize the percentage upside while laying off the risks either to the lenders, the workers, or the government.

In the case of Chrysler, Daimler, their German owner, is in reality paying Cerberus close to $700 million dollars to off load their $18 billion pension and health liabilities. That is Daimler is absorbing an expected one and half billion dollar negative cash flow over the next eighteen months to provide an added incentive for Cerberus to consummate the transaction. Until recently, the unions recognizing that a private-equity firm does not have the balance sheet to fund the liabilities have opposed a sale to a private-equity firm. However, the realities on the ground were no company with substantial assets was willing to commit resources to acquire Chrysler. In essence, Cerberus will probably acquire Chrysler using in essence a shell company, limiting their downside dramatically. Several years ago, Wilber Ross acquired U.S. Steel using similar financial tactics. That is a combination of government guarantees replacing private obligations plus a reduction in union obligations altered dramatically the financial position of U.S. Steel. In less that twenty-four months Ross then sold a substantial portion of U.S. Steel to a foreign company.

 

Moreover, to run their stable of companies, private-equity firms have aggressively pursued leading government officials and seasoned operating executives. Cerberus, for example, employs the former Chrysler Group operating chief, Wolfgang Bernhard, as well as the former Secretary of the Treasury, Jack Snow. Kohlberg Kravis and Robert paid an estimated $100 million to hire David Calhoun, a former vice chairman of General Electric Company. Aside from substantial pay bonuses, seasoned executives prefer to avoid the intense scrutiny of regulators and investors.

In conclusion, the emergence of private-equity firms as substantial owners of corporate assets reflects several trends. First of all, pressure from the investment community on maximizing shareholder value has forced corporate management to focus on short-term price objectives. Secondly, the widespread availability of cheap debt has encouraged significant leverage and enabled corporate takeovers of almost unlimited size. Thirdly, avoidance of regulatory scrutiny has encouraged privatization. Lastly, the willingness of the government to absorb pension and health liabilities puts added pressure on our social security and Medicare system. That is, private industry will continue to reduce their commitment to providing long-term benefits to their employees.