Ethical Issues in International Sourcing of Capital by Private Equity Companies

Table of Contents

1. Introduction

2. Proposed Research Topic

3. Scope

4. Research Objective

5. Initial Research Questions

6. Research methods

7. Literature Review

8. Conceptual framework

9. Conclusion

KEY WORDS

REFERENCES

ANNOTATED BIBLIOGRAPHY

1. Introduction

“After buying out companies, they load them with debt, take out the cash, and then sell the emaciated carcass a few years later” (Schiller in Bendell and Cohen, 2007:8). In the context of global sourcing and ethical issues, this quotation could be easily associated with the well known problem of the exploitation of developing countries by western corporations, here however, these words refer to Private Equity (PE) companies acting in the developed countries. Franz Müntefering, the head of German Social Democrat Party, called PE companies "locusts", who “don’t waste any thoughts on the people whose jobs they destroy” (Spiegel-Online, 2006). The image of locusts highlights the negative image of PE and implies its destructive effect on employment and thus the economy of a country. This paper intends to explore how a single multinational PE company can influence the labour market of a country by buying out the shares of local companies.

David Rubenstein, the co-founder and managing director of The Carlyle Group, one of the world’s largest private equity firms, indicated an end to the golden era of PE and the beginning of a new era, to which PE needs to adapt. He put the PE industry’s image problems at the top of the challenges list which the industry has to deal with. The less-than-favourable public image is followed by threats of higher taxes and other legislative and regulatory constraints, protectionism in countries where investments are targeted and finally declining investment returns (McConnell, 2007).

This view of public image seems to be increasingly important for PE companies, who have been severely criticised for their opaque business practices (Grote, 2007). Therefore the purpose of this paper is to describe and analyse the manner in which a multinational PE company deals with the arising criticism concerning their methods of sourcing capital in order to improve their public image.

2. Proposed Research Topic

Which ethical risks should the American-based investment bank Goldman Sachs consider as threats to their reputation and business activities when deliberating financial involvement in a Western European country, such as Germany, through PE and how or whether they should change their investment in order to conform to the code of conduct? This code has been defined as "principals, values, standards, or rules of behaviour that guide the decisions, procedures and systems of an organization in a way that contributes to the welfare of its key stakeholders, and respects the rights of all constituents affected by its operations" (IFAC, 2007:6).

3. Scope

The scope given for both the scoping paper and the main paper requested a topic related to ethical issues or concerns in international sourcing and its impact on the host country, community or society.

The paper will address the sourcing of capital by the American-based Goldman Sachs Private Equity Group (GS PEG) into and out of Germany and is thus related to international sourcing. The relationship is spelled out as follows: the sourcing of capital includes an investment - an inflow of capital into the host country - in order to finance a project and disinvestment – a backflow of capital – which ideally consists of the invested capital plus a profit.

This process involves a clash of interests, which results in ethical tensions between the participants of the process. The areas of ethical tensions will be identified later in the Literature Review and Conceptual Framework. This issue, which the company faces while sourcing from a European country will be analysed and thus clearly address the journal theme “Ethical issues or concerns in international sourcing”.

4. Research Objective

In particular I will examine the example of GS PEG, a part of the American-based investment bank Goldman Sachs. GS PEG is one of the biggest PE names on the list of companies, who “buy up companies, suck them dry, and spit them out again” (Spiegel-Online, 2006). The Group was accused of exploiting German companies as well as threatening employment and the economy.

The aim of the paper is to explore which ethical issues GS PEG has had in the past and still face while sourcing capital from and into Germany and how they deal with the problem of negative public image.

While previous papers have concentrated on either the effects of PE on employment or Corporate Social Responsibility (CSR), this study will combine those two topics in order to analyse how capital sourcing can affect the image of a PE company, which implications it can have on its business and what particular methods could be used to improve a company’s image in the light of CSR. The addressed ethical tension lies between PE’s pursuit of profit maximisation on the one side and employees’ of PE-owned companies demand for CSR on the other side.

5. Initial Research Questions

- What are the ethical issues of sourcing capital from and to developed countries?
- What is the impact of PE on employment?
- What public image problems did GS PEG have in the past?
- How did PE’s negative public image impact the business outcome of GS PEG?
- What attempts has GS PEG undertaken to improve its image?
- How far can an improvement of CSR by PE companies influence German employment?

6. Research methods

The paper will be based on secondary research. Gathering and analysis of primary data on the chosen topic is not possible due to time restrictions. Using secondary data to answer the research questions, I will have to deal with different kinds of information sources, both academic and none. My research will be mainly based on reliable academic articles. However in order to generate objectivity I will also consider opinions of all parties involved in the topic, which means considering information from homepages of popular magazines, PE companies, PE associations, labour unions and global organisations committed to protect public interest. In order to find relevant and qualified information, all sources will be screened for the author’s impartiality and possible biases. The main sources of reliable information are books, academic articles and publications of independent public organisations, which are available in the NTU Boots Library and in online databases like Emerald and Business Source Premier. Since the research questions concern Germany, I will use German as well as English sources in order to include the points of view of local authors, who mainly write in German. Incorporating many different perceptions of the problem can help in finding objective answers.

7. Literature Review

Research on ethical issues requires a clear theoretical background in order to ensure understanding of the theory and proper use of terms. “Ethics can be defined as a mode of human behaviour ... in dealing with others” (Prindl and Prodhan, 1994:3), whereas ethical business means operating “according to moral values that permeate all its activities and guide and give support to all the people who work in it” (Wyburd, 1998:2). However dealing with the sourcing of capital requires a more specific definition of ethics. The most appropriate one is the ethics of investment. “Ethical investors care not only about the size of their prospective financial return and the risk attached to it, but also its source – the nature of the company’s goods or services, the location of the business or the manner in which it conducts its affairs” (Prindl and Prodhan, 1994:215).

Moving towards the ethical issues of capital sourcing we need to understand the background and logic of PE companies’ behaviour. A pragmatic point of view on the business of PE companies shows that “finance theorists invest in ‘opportunities’ and not in goods, services or people” (Prindl and Prodhan, 1994:4). In order to survive and prosper in the free market, PE companies have to deal with high levels of competition. Ethical tensions within competition can be summed up in one sentence: “competition generates energy, rewards winners and punishes losers” (Handy in Wyburd, 1998:1). The origins of free market and competition theories lie by Adam Smith and Milton Friedman, who were also strong supporters of laisser fair principles. The first mover in the opposite direction was Keynes, who abandoned the laisser fair for the reason that “the conditions for its success have disappeared” (Keynes, 1924 in Wyburd, 1998:6). Moreover he was the first to draw intention to the corporate social and environmental responsibility and thus shown a way to the further development of CSR theories.

Most ethical issues of this paper are derivates of “the moral problems in the modern-day capitalism”, which are also about the “short-term interests of politicians and special interest groups, (...) the non-complementarity of economic and ethical principles, and in an imbalance in the solidarity principle” (Karsten, 1997:664). The issue of short term interests is also a point of discussion and criticism by Prindl and Prodhan (1994).

Dealing with the ethical issues around the PE’s impact on the German labour market requires knowledge of relevant cultural background. The basis of the current German socio-economic policy is Social Market Economy (SME). According to this policy German prosperity has been built on the “national social consensus”, which is “rooted in a process of consultation between government, employers and unions” (Smith, 1994:35). From the SME policy point of view, capital sourcing by PE companies threatens the ‘national social consensus’. This arises from the ethical tensions between employers and unions and the intermediate government. On the one hand, Smith (1994) supports the state intervention in order to stop the trend of free market moving toward monopolisation, whereas on the other hand he emphasises that competition is the best way to achieve prosperity. Harding and Peterson (2000:38) go further by stating that German SME and the concept of “social consensus” weaken Germany’s position in the global economy.

Questions concerning the PE industry and its problems with negative image require research on how this image was caused and whether there is real evidence of PE’s negative impact on German companies. The main reason for the negative public image is that, while PE companies concentrated on their profitability in order to convince a few private shareholders, they neglected to pay attention to the opinion of the growing number of stakeholders, who play the major role in the shaping of public image (Grote, 2007; Gilligan and Wright, 2008). Another useful insight in the problematic PE image is provided by Haarmeyer (2008), who compares the image of PE with Venture Capital (VC). Although basically similar business activities, VC enjoys a much better public image. According to Schumpert’s theory of “creative destruction” the reason for this difference lies in the public perception of capitalism, namely “the problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them” (Haarmeyer, 2008:245).

8. Conceptual framework

illustration not visible in this excerpt

The Illustration above shows a draft of my conceptual framework for this study. It shows the interactions between the parties of the researched topic in order to visualise the areas where the ethical tensions appear.

The action starts when a PE company sources capital to the German market in order to buy out a German company. After a certain period of time, the PE company starts to pull the invested capital back. At the end of the process, the German company will be sold. This research paper is primarily concerned with what happens to the employees of the German company during and after the process. The public image of PE companies suffers under accusations that whilst pursuing profit maximisation, it often destroys employment as a side effect. Possible consequences are regulatory constraints from German government, which is under public pressure to protect employment. In order to avoid this threat PE companies try to improve their corporate image by publishing a code of conduct or CSR schemes.

9. Conclusion

The first results of the research have shown a large amount of relevant information which requires further screening and analysis before it could be used in the main paper. However, whereas the issues of PE’s impact on employment and CSR were found to be widely covered in the literature, issues around the public image of PE companies and its influence on the business outcome were only thinly covered. Especially difficult was to find independent and reliable information concerning GS PEG. This deficit of data could be an indicator that the PE’s attempt to improve the firm’s public image through disclosure of the business activities remains limited.

KEY WORDS

Key words used in the secondary research:

Private Equity, Corporate Social Responsibility, International Sourcing, Capital, Ethics, Profit Maximisation, Free Market, Globalisation, Reputation, Corporate Image, Stakeholder, Germany, Social Marker Economy, Goldman Sachs, Carlyle, Code of Conduct, Venture Capital, Business Ethics, Laisser Fair, Employment.

REFERENCES

- Bendell, J., and Cohen, J., 2007. World Review. The Journal of Corporate Citizenship Issue 27, pp. 6-17.
- Gilligan, J., Wright M., 2008. Private equity demystified. An explanatory guide. [Available at www.icaew.com/corpfinfac] (Accessed on 24.11.2008)
- Grote, M., H., 2007. Private Equity im Mittelstand – Mythos und Realität. Working paper series: finance & accounting, N 183.
- Haarmeyer, D., 2008. Private Equity. Capitalism’s Misunderstood Entrepreneurs and Catalysts for Value Creation. The Independent Review, v. 13, n. 2, pp. 245–288.
- Harding, R., and Peterson W., I., 2000. The future of the German economy. Oxford: Manchester University Press.
- International Federation of Accountants, 2007. International Good Practice Guidance. Defining and Developing an Effective Code of Conduct for Organizations. [Available at www.ifacnet.com] (Accessed on 07.02.2009)
- Karsten, S., G., 1997. A perspective on US and German socioeconomic policies. International Journal of Social Economics v.24, n.6, pp. 652-665. [Available at EBSCOhost] (Accessed on 13.11.2008)
- McConnell, B., 2007. Rubenstein warns PE world. [Available at www.thedeal.com] (Accessed on 10.02.2009)
- Prindl and Prodhan, 1994. Act guide to ethical conflicts in finance. Oxford: Blackwell Publishers.
- Smith E., O., 1994. The German economy. London: Routledge.
- Spiegel-Online, 2006. Private Equity Firms Strip Mine German Firms. [Available at http://www.spiegel.de/international/] (Accessed on 11.02.2009)
- Wyburd, G., 1998. Competitive and ethical? How business can strike a balance. London: Kogan Page.

ANNOTATED BIBLIOGRAPHY

- Bendell, J., and Cohen, J., 2007. World Review. The Journal of Corporate Citizenship Issue 27, pp. 6-17.

- Reports about the current state of the conflict between PE firms and Labour Unions. Supported by numbers of recent job cuts in PE-owned companies.
- Academic article; provides references.

- Gilligan, J., Wright M., 2008. Private equity demystified. An explanatory guide. [Available at www.icaew.com/corpfinfac] (Accessed on 24.11.2008)

- This explanatory guide sheds light on the motivations of the main participants in private equity transactions and on their risks and rewards.
- Academic report which includes a summary of academic studies and references

- Grote, M., H., 2007. Private Equity im Mittelstand – Mythos und Realität. Working paper series: finance & accounting, N 183.

- This working paper discusses and examines myths around the PE.
- Academic paper published by Goethe University Frankfurt

- Haarmeyer, D., 2008. Private Equity. Capitalism’s Misunderstood Entrepreneurs and Catalysts for Value Creation. The Independent Review, v. 13, n. 2, pp. 245–288.

- This comprehensive report on PE is supported by strong theoretical framework and referencing.
- “David Haarmeyer is a director at PowerAdvocate, an energy supply chain company. He also writes independently, as in this article, on markets and active investors”
- The source has a good academic reputation, hence article could be seen as academic.

- Harding, R., and Peterson W., I., 2000. The future of the German economy. Oxford: Manchester University Press.

- The book gives a deep insight in German socio-political system and its historical and theoretical background.
- Academic resource

- International Federation of Accountants, 2007. International Good Practice Guidance. Defining and Developing an Effective Code of Conduct for Organizations. [Available at www.ifacnet.com] (Accessed on 07.02.2009)

- The paper provides a comprehensive set of information about development and implementation of code of conduct
- IFAC is an NGO which serves public interest

- Karsten, S., G., 1997. A perspective on US and German socioeconomic policies. International Journal of Social Economics v.24, n.6, pp. 652-665.

[Available at EBSCOhost] (Accessed on 13.11.2008)

- This article analyses critically the differences between German and US socioeconomic. Supported with a strong theoretical framework.
- Academic article

- McConnell, B., 2007. Rubenstein warns PE world.

[Available at www.thedeal.com] (Accessed on 10.02.2009)

- This article tells about the opinion of the chairman of the biggest PE company on the future development of PE sector
- Non-academic source.

- Prindl and Prodhan, 1994. Act guide to ethical conflicts in finance. Oxford: Blackwell Publishers.

- The book draws together a comprehensive set of definitions as well as a review of main authors and theories in the ethical conflicts in finance area.
- Based on both academic research and the views of professionals

- Smith E., O., 1994. The German economy. London: Routledge.

- The book shows the various aspects of German economy and Growth.
- Academic source, Smith is senior lecturer in Economics at Loughborough University.

- Spiegel-Online, 2006. Private Equity Firms Strip Mine German Firms.

[Available at http://www.spiegel.de/international/] (Accessed on 11.02.2009)

- World Economic Forum, 2008. The global Economic Impact of Private Equity

Report 2008. Globalisation of Alternative Investments, Working Papers Vol.1.

[Available at http://www.weforum.org/] (Accessed on 13.11.2008)

- These Working Papers represent a first step to providing a comprehensive fact-base related to the global economic impact of private equity to enable a rich series of further discussions and analyses.
- Very useful for my research is the included case study on buyout of the Messer Griesheim Company by Goldman Sachs and Allianz Capital Partners.
- The report and case study are written by academicians for WEF, which is an independent organisation with good reputation.

- Wyburd, G., 1998. Competitive and ethical? How business can strike a balance. London: Kogan Page.

- The book provides the main economic and competition theories examining them from the ethical point of view. Author provides also advices how companies can increase their competitiveness by being ethical with stake holders.
- Wyburd has been a member of the executive of the Institute of Business Ethics, thus assumed as academic source.