Tags: profitability | quality | focus | company

Does the Focus on Profitability Kill Quality?

Does the Focus on Profitability Kill Quality?

(AP/Zhang Chunlei)

By    |   Tuesday, 18 October 2016 07:29 AM




Has the obsessive focus on company performance caused a decline in the quality of products in the United States?

I walked into my local upscale specialty grocery market and after perusing the aisles noticed something seemed different. I couldn’t put my finger on it right away. I had entered the store with the purpose of gathering the list of ingredients needed for a homemade chicken soup recipe.

While selecting my vegetables, I noticed it became difficult to find the pristine ultra-green fennel, leeks, parsley or other greens as before. Could it be a poor time of the year for crops? Not likely, as when I began to prepare my chicken, I also noticed that in addition to odd color, it also had an unfamiliar odor.

I pondered this unusual experience and whether it was an isolated event of a popular chain once heralded as the highest in quality for produce and protein, and outstanding service. Coincidentally, several days after this shopping trip, I came across a business news article disclosing the sale of the large grocery chain to Apollo Global Management, a private equity conglomerate. The name may sound familiar, as it had been in the news recently for some troubles – having just paid a $53 million settlement, $12.5 million of it in fines, to the Securities and Exchange Commission.

This had me wondering what happens before, during, and after the buyout of companies by private equity firms and what is the impact on quality throughout the stages? Does the focus on profit margin cause a decline in quality or is it merely a correlation?

Coincidence? And since correlation doesn’t imply causation, I began to dig in and do some research, which resulted in very few commentary on the “increase of quality” after a private equity buyout. However, there is quite a bit of empirical data supporting the decline, which eliminated “coincidence.”

Slashing expenses and raising prices has become part of a good business model not just in preparation for an acquisition or sale. For many post-transaction private equity deals, the ultimate target is to generate an annual investor return of 25 percent per year for the first three years, then 12 percent for subsequent years.

The longer the acquirer it holds the investment, the returns are less but closer to the 12 percent, until it quickly drops after a five-year holding period. In private equity, the lure of the sometimes double-digit non-correlated market return has a tendency to obfuscate the true process by which it’s obtained.

In general, private equity firms typically target profitable, slow-growth market leaders.

They currently own companies employing one of every ten U.S. workers, or 10 million people. Once the buyout is complete and one of their own executives is placed in charge, they begin the process of aggressively cutting costs wherever they can by laying off workers and cutting capital expenditures. This boosts operating profit in the short-term; however in the long run, the “austerity” measures make it difficult for companies to stay competitive, or maintain their original standard of quality, leading to the potential degradation of the brand. Without having the capital to reinvest in their products and services or growth, it makes it almost impossible to sustain the same consistent level of product excellence.

According to the author of “The Buyout of America,” it takes several years before the impacts (loss of market share, decline in revenues) of this predatory activity become fully apparent, resulting in significant reduction in customer service, and inferior products. By that time, the private equity firm has generally resold the business at a profit and moved on.

Listed below are some startling statistics on most companies bought by private equity firms:

  • Of the 25 companies that private equity firms bought in the 1980s that borrowed more than $1 billion in junk bonds, more than half went bankrupt.
  • Of the 10 biggest buyouts of the 1990’s, six, including Saks Department Stores, performed worse than they likely would have had they not been acquired in leveraged buyouts.
  • Private equity-owned companies reduce jobs over their first two years of ownership by 3.6 percent more than their competitors. Historically, on average, the worst job cuts come in the third year after a buyout, according to a study by the World Economic Forum.

The priority of profitability and stock price performance can be quite addictive, and cause companies, not just private equity deals, to lose sight of core values. So much so, that many brand images have suffered.

For example, Mylan pharmaceuticals currently in the headlines over the EpiPen controversy for charging over $600 (a 400% price increase from acquisition date at $57) for a dual pen pack. All the media attention led the Justice Department to deepen its investigation and find that Mylan also misclassified its drug, resulting in Mylan having to pay a $465 million settlement.


So how then, could this be positive for any U.S. consumers, including those behind and involved in the deals? Sure it puts lots of dollars in the pockets of some, but its pernicious effects are widespread.

Much of the data on private equity firms using leveraged buyouts points to suffering businesses, workers, and the economy – but they also avoid paying their fair share of taxes. Because they are structured as private partnerships, a giant loophole in the tax code gives them tax and regulatory advantages over public companies, enabling them to deduct loan interest from taxes, a part of the tax code originally intended to encourage borrowing to build new factories, not for leveraged buyouts.

Most private equity firms buy only to sell. Their management is lean and focused, and avoids the waste of time and money that “bog-down” corporate conglomerate’s shareholder profitability. In many scenarios, this is good business as long as the focus ultimately remains on product excellence.


 

Kathleen A. Grace, CFP®, CIMA® is a Managing Director at United Capital and Amazon Best-Selling Author of "Prince Not So Charming," a financial planning novel.

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Has the obsessive focus on company performance caused a decline in the quality of products in the United States?
profitability, quality, focus, company
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2016-29-18
Tuesday, 18 October 2016 07:29 AM
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