This article really overstates the importance of private equity.
private equity, the financial model in commerce which more than any other defines the Western political landscape
That doesn’t seem accurate. Public companies controlled by the stock market, a board of directors, and a CEO are far more important, both politically and overall, than the small number of companies which have been taken over by private equity.
I might well be biased since I do work in an investment bank that caters mainly to private equity clients, and having spent a decent amount working in a PE fund, but this article also conveniently focuses solely on the bad part of the industry. Of course, not all PE is perfect, and not all are the same. There are high leverage funds, debt funds, distressed investment funds, large cap funds investing billions of dollars, small cap funds financing companies worth just about 10m. The fund I worked for, for example, focused on buying only a few companies (3-4 portfolio businesses) and then building these up over 5-10 years to become market leaders, by investing in the companies capabilities both through add-on acquisitions and R&D spending.
Of course, PE can also mean that in order to improve the company, some parts of it have to be restructured or shut down, but the blame for that cannot go only to the fund, but also to the management of that company letting divisions become lethargic.
Not all PE is the same - some funds are bad, focusing on just stripping as much money out of a business as possible and then getting rid of whatever is left. But generally, PE's make most money with businesses that grow beyond their original scale, and innovate more than their rivals. Also, thanks to the investment time frame and relative freedom that investors give the funds, a lot of good can be done with capital, such as investments in emerging economies and local champions.
The point is, the PE landscape is infinitely more complicated than just saying it is good or bad.
Maybe, but there are definitely a number of popular behaviours that are very clearly bad. Buying companies with borrowed money, then offloading that debt to those companies, and driving them into bankruptcy while sucking them dry, does not create value for anyone except the PE company itself. Funds that do that are vultures leeching on otherwise perfectly healthy companies.
(FWIW, I'm in VC, but I know very little about how PE works.) As a general observation, businesses like PE usually don't exist unless somewhere down the line they create some value. So if a PE firm makes a buyout offer to a CEO and the CEO takes it, then presumably that buyout offer was better than the CEO's alternatives (like other offers, or staying private, or etc). The problem here is not the PE firm, but the lack of better alternatives.
One could make similar observations about the payday loan industry: most of the firms are predatory and their offers suck, but 1) because of high default rates, the loan offers will necessarily be poor, and 2) creating more alternatives to payday loans would be great. But banning payday loans would be a net negative, because the choice of "very high interest rate loan or nothing" is better than having "nothing" as the only option.
> The problem here is not the PE firm, but the lack of better alternatives.
Were the alternatives better for the stockholders or the CEO? And, were the alternatives better for which stockholders?
The number of firms that have started public, gone private, and then gone public again seems to indicate that private equity doesn't seem to be adding business value.
In addition, a lot of private equity seems to be about stripping cash from companies in creative ways--effectively the endgame of the "hostile takeover and then partition the company" from the 1980's. Toys R Us, Sears, K-Mart sure didn't seem to benefit from private equity.
If the alternative was better for the stockholders and the Board disregarded it, then the shareholders will sue, and win. There were some recent cases where Delaware courts awarded some pretty significant damages using hypothetical valuation models that were extremely favorable to the shareholders (Dell is a famous recent example [1]).
PE firms, once they own the company, can strip all the cash they want to from the company they own. There’s no law saying a company can’t be harvested for its assets if the shareholders believe that’s the most effective way to extract value from the asset.
The number of firms that have started public, gone private, and then gone public again seems to indicate that private equity doesn't seem to be adding business value
No? It seems like the opposite to me, surely. The company couldn't go public again at a profit if it wasn't improved.
There's a public company. It has some core goodness to it, but the senior management from board on down are useless and damaging it. The shareholders are passive and don't know what to do. PE steps in, buys it, taking it over and thus taking it private. They then reorganise the firm, getting rid of the bad management and potentially, making hard decisions those managers were emotionally incapable of doing, like shutting down treasured but loss-making business units, slaughtering some sacred cows, quite possibly letting people go and so turning the business around.
Having gone in and done the hard stuff, they then take the company public again and profit from turning the firm around, because they don't really want to manage that company in perpetuity, they just wanted to make money by righting the ship and salvaging what was possible.
Sometimes maybe the business can't be saved. Maybe it's been cobbled together out of acquisitions that made no sense. Maybe it over-extended into new product lines where it had no real advantage over its competitors. In these cases breaking the firm up actually makes most sense from a macroeconomic perspective: the capacity the uncompetitive product departments had may be better utilised by more capable competitors, maybe the acquired firms make more sense to be separated.
The article is written from a leftist perspective that PE is bad and uses lots of perjorative and biased language as a consequence, e.g. "A private equity fund is a large unregulated pool of money run by financiers". What makes this pool of money "unregulated" vs any businesses pool of money? The question is left unanswered. The author knows that "unregulated" is a dog-whistle to certain types of reader and is blowing it as hard as he can.
Other things it says that just aren't true:
private equity is not business
Yes it is.
PE is a political movement
No it isn't.
I've read quite a few critiques of private equity over the years, and worked at a firm that received a major investment by one, albeit not a controlling stake due to the complex nature of that firm's privatisation from government. True to form one of the first things the PE guys did was come in and review every employee, firing a lot of them. "Dead wood", one of them apparently said. But they were right and the company has grown significantly through the privatisation and their involvement. Even the critiques I've read (like this one) usually admit there's positive outcomes to the work PE does.
The challenge I have is that I'm not really sure what "value" is right now; if you give the Bain Cap guys another couple hundred million / billions in compensation, it's not like they're going to go out and invest it in incredibly high returning things that really drive our economy forward.
It'll just sit there, along with the other huge pools of capital that can't seem to find great investment opportunities.
I think (?) that Toys-R-Us provides more value to the _country_, if nothing else in terms of employment for a few thousand people, than a few $b sitting in a bank somewhere.
If we were really effective at putting that $b to work, that might be the better option. Infrastructure somewhere might be worth more than TRU to society.
Toys R Us, Sears, Radio Shack, Montgomery Ward, and dozens others failed because they didn't sufficiently adapt to the business climate and competition.
It's not like "but for Private Equity firms, these would be vibrant, competitive, going concerns". At most, PE was a specific acceleration of their demise, but it seems overwhelmingly likely that the reaper was coming for them anyway...
"Toys R Us, Sears, Radio Shack, Montgomery Ward, and dozens others failed because they didn't adapt to the business climate and competition."
Not really, they could have survived and had run way to make changes if PE didn't burden them by taking out loans against the company's assets and taking that out of the company in the form of management fees. Leaches.
> They could have survived and had run way to make changes if PE didn't burden them by taking out loans against the company's assets and taking that out of the company in the form of management fees.
Sure. This downplays how poorly things were going for Toys R Us before the leveraged buyout. They significantly underperformed expectations the holiday season before the leveraged buyout. Private Equity bet big that they could help Toys R Us make the jump to e-commence as well as revamping stores (they were notoriously outdated compared to the competition at the time of the buyout) and improve operational efficiency. The added debt did make things worse, but Toys R Us was failing on multiple fronts before the buyout (which is why they became a buyout target). Given their underperformance in several strategic areas, it's unlikely that Toys R Us was going to magically turn things around if Private Equity never got involved.
I'm not arguing that Bain and KKR (the Private Equity companies involved) added any value. Both bet and lost $1.3B each on the idea that they could legitimately turn things around at Toys R Us. The rapid rise of e-commerce along with the economic downturn in 2010 meant that Toys R Us was likely doomed regardless of who tried to lead their turnaround. There are legitimate reasons to be critical of Private Equity, but it's not as simple as saying Toys R Us died only because of it.
Yes, Toys R Us was making money every year. There was never a year where it lost money. After the buyout, they could not keep up with the interest payments made in its name to buy itself back.
But who is making these loans to companies that will be obviously unable to meet their payments? I never saw that part in the PE-sinks-companies story properly explained.
Who? Easy: banks. Bank debt generally has first call in the event of a liquidation, so if everything goes to hell the assets will be liquidated and banks will be the first to be paid back. They likely don't end up losing a lot, if anything at all.
The article makes it seem super obvious that these deals won't work out. But that is actually not the case. Many / most PE deals actually do work out, and end up making the sponsors a lot of money.
And why would banks allow this? Because private equity are huge profit drivers. They use lots of debt. They also acquire many companies, so there is an ongoing relationship.
> if PE didn't burden them by taking out loans against the company's assets
if this were the true problem, i.e. if there were a profitable business that just wasn't making enough income to service its debt, then the enterprise would continue to exist after restructuring the cap table.
adding debt to the company just changes the cap table, it doesn't change the profitability of the underlying company.
But it can make internal investment impossible and make the entire company act in cost-cutting mode, which isn't necessarily helpful to maximize profit. Eventually, the profitable business would stop being profitable.
it doesn't make internal investment impossible. it just changes the pockets it comes out of. well, actually it doesn't even do that, because either way it would be coming out of the cash owned by the PE shops, whether it sits on the books of the company or has been paid out to its owners. they can always decide to invest more into initiatives that show a promising return. the issue here is not the structure, it's rather that the owners of these shops made mistakes, which will happen. but the incentives are not misaligned.
Maybe internal investment being 'impossible' is too strong a word, but practically it's very unlikely after the company has been taken over and is piling debt.
"either way it would be coming out of the cash owned by the PE shops". They don't have to invest you know. After all, the company is now unprofitable. Obviously it's just inefficient. Why give money to an inefficient company from your core profitable business, when you can break the company up and use the profit from looting it in your core profitable business which you're good at?
It makes much more sense for PE finance to siphon funds for use in a field they have expertise in (more finance) than try to manage companies in various fields (like retail) they're so not expert on, especially when the companies are in the debt.
yes, in the sense that everything that's on the cap table (including special dividends, etc.) won't affect the P&L, except for the interest payments. but investors in the company treat interest payments separately, because it's just part of apportioning who on the cap table gets what. that's why investors often look at EBIT (earnings before interest and tax) and enterprise value as opposed to market cap, as enterprise value includes the value of the debt.
If 97% of your profits go to servicing debt that you would not have if it wasn’t for the LBO that was forced on you externally, perhaps the business climate is not the real issue.
Perhaps you can do it for pension funds, although most pensions are government backed anyway.
But investors are taking a known risk. These are all sophisticated adults. If a bank wants to sign a contract that they will lose money if the company goes under, who is Warren to say they shouldn't? They're getting well paid for that risk, they know it's a risk.
If you ban debt-funded PE, you'll just have banks in-house the PE firms or any number of other structures that have the same result - people buying companies with other people's money and only sharing in the upside. Because that's a structure that benefits both sides (the banks and the PE companies) and they both want it to work.
Nice theory, but in practice many banks do not actually carry risk, because they are “too big to fail”. LBOs fall in the same category as credit default swaps - useful in theory, huge moral hazard in our version of a “free market”.
If you think the risk of debt is too high, then require banks to be capitalized higher against that kind of debt. Don't ban them from funding certain kinds of debt.
There are no banks that failed due to defaults from LBOs.
Besides, the plan goes well beyond banks. If a private investor wants to lend money for an LBO, this still prevents it.
I am not arguing for a ban, nor am I saying that LBOs cannot work. I am saying your bank risk argument in favor only works in theory and therefore we will have for more LBOs that cannot work.
Of course LBOs are not significant enough to single-handedly cause a bank to fail. However, they can still cause companies to go bankrupt that would have otherwise survived.
In any event, in a system where banks are not allowed to fail, I cannot see how they should be allowed to finance LBOs.
>However, they can still cause companies to go bankrupt that would have otherwise survived.
If a company's operations aren't profitable, it wouldn't have "otherwise survived". If it is profitable, then bankruptcy will wipe out debt and permit it to continue operations, hence it will continue to survive. It's the difference between Chapter 7 and Chapter 11.
>In any event, in a system where banks are not allowed to fail, I cannot see how they should be allowed to finance LBOs.
What work is LBO doing in this sentence? Financing LBOs carry some risk of loss, as does everything except Treasuries. Why would LBOs be special as something banks shouldn't be allowed to finance? Why are banks uniquely bad at risk analysis of LBO debt as opposed to, say, regular corporate debt, or junk bonds, etc?
> If a company's operations aren't profitable, it wouldn't have "otherwise survived". If it is profitable, then bankruptcy will wipe out debt and permit it to continue operations, hence it will continue to survive. It's the difference between Chapter 7 and Chapter 11.
Debt is wiped out after liquidation. Most companies do not survive this. Debt service can make the difference between profitability or unprofitability. Remember, this is debt that was forced on the company externally.
> Why are banks uniquely bad at risk analysis of LBO debt as opposed to, say, regular corporate debt, or junk bonds, etc?
I never said they are bad at risk analysis, I am saying they do not truly carry the risk in the first place. The difference is in the outcome. An LBO that should never have happened is worse than a corporate loan that should not exist.
> I get the feeling you don't know the difference between chapter 7 and chapter 11?
Same here.
Chapter 11 doesn't "wipe out debt", that's what Chapter 7 does. Chapter 7 implies liquidation.
Chapter 11 may reduce debt obligations, entail partial liquidation, and so on. It doesn't just wipe out the debt.
> Why?
Because of the moral hazard. If I can just get a loan for an LBO to buy a company and squeeze it out like lemon, that's highly destructive. Unlike when issuing a junk bond, I have no real interest in the companies long-term survival. I guess you can make an argument that debt-financed stock buybacks have similar issues, but that's a topic for another day.
In the short term, even a bad LBO looks good for both the bank and the PE firm. Meanwhile, the company has a debt burden that paid for nothing but the privilege of having been bought out, likely requiring them to charge higher prices, which is a strong competitive disadvantage. This leads the whole argument of "restructuring companies to be more efficient" ad absurdum.
Feel free to look for contradictory numbers yourself, if you have reason to believe that Chapter 11 outcomes have somehow radically changed in the past years.
What hasn't changed is the fact that Chapter 11 doesn't discharge debt. The prospect of having the creditors repaid at least in part is a prerequisite to Chapter 11.
"Still open" means the case is ongoing, so those numbers are irrelevant.
"Conversion" means going from Chapter 11 to Chapter 7 right away.
"Dismissal" doesn't mean success or failure, it means the case is dismissed.
"Confirmed" means that the case will proceed as Chapter 11 instead of being converted or dismissed outright. That can still lead to Chapter 7 later on if the restructuring fails.
Dismissal and Confirmed mean the company continues to exist, and add up to a majority.
Sure, any company, including those that successfully emerged from Chapter 11, may file for Chapter 7 later. But generally once it's confirmed it's considered a success.
> Dismissal and Confirmed mean the company continues to exist, and add up to a majority.
Of course confirmation implies that the company continues to exist in order to for the restructuring to actually take place, it doesn't imply that it will exist afterwards. Dismissal doesn't imply that the company will continue to exist for much longer either, it's simply the alternative to going straight to Chapter 7. In any event, dismissal is not a success. You are also ignoring all the cases that go straight to Chapter 7 for your hamfisted construction of a "majority".
No matter how you twist and turn it, the majority of companies that file for bankruptcy do not survive, and the companies that do succeed in Chapter 11 still have to repay debt. That's my whole point.
1) Confirmation rates are actually higher than commonly believed (= roughly one third)
2) If we carefully select for companies that are likely to succeed with confirmation, success rates are higher. Well, duh.
There's a valid argument there, saying that the value of Chapter 11 should not be measured in terms of confirmation rates, because hopeless cases are hopeless no matter how good the law is.
Yet, this doesn't support your view that most companies that file for bankruptcy will survive. If anything, it shows the opposite.
Maybe, but LBOs also offer a way for shareholders to exit. Unless you can sell to a strategic acquirer (which could also be PE, but usually not) there are not a lot of exit options. And who is going to acquire a business just with equity?
People don't want to run businesses for ever. Private equity allows them to, in some cases. An unmotivated entrepreneur who is only doing a half assed job after a while will also cause a company to go bankrupt. Better to sell then.
Banks generally have sufficient collateral (i.e. from the acquired business) to cover the outstanding principal in the event of a bankruptcy.
Kudos to Elizabeth Warren for trying to tackle this problem. But the entire financial services sector would lobby against her in many ways legal and illegal just so that she wouldn't become President.
The banks who agreed to lend so much debt that they were barely able to make payments get off relatively free in these cases. There are plenty of instances where PE levers up and the companies do well but we don’t discuss those. Plus PE makes way more growth oriented investments then LBO type investments because there are more smaller companies than larger ones.
Markets with imperfect information exist. As in the Pentagon example they need to put in contracts that the Petntagon may outsource parts to prevent gouging as long as an IP fee goes to the owner of the original design.
private equity, the financial model in commerce which more than any other defines the Western political landscape
That doesn’t seem accurate. Public companies controlled by the stock market, a board of directors, and a CEO are far more important, both politically and overall, than the small number of companies which have been taken over by private equity.