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Private Equity Should Not Exist

• sokoloff 7y ago
  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...
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  • downrightmike 7y ago
    "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.
    • bena 7y ago
      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.
    • viscanti 7y ago
      > 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bet big that they could help Toys R Us make the jump to e-commence as well as revamping stores (they were notoriously outdated compared to the competition at the time of the buyout) and improve operational efficiency.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.
    • icebraining 7y ago
      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.
      • clairity 7y ago
        those loans are made as much on the relationship with, and past performance of, the PE firm, as it is on the fundamentals of the turnaround plan.
      • charlesdm 7y ago
        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.
    • tvladeck 7y ago
      > 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.
      • rileymat2 7y ago
        Is this true if you manage to extract some of the capital leaving the debt?
        • tvladeck 7y ago
          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.
      • yyyk 7y ago
        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.
        • tvladeck 7y ago
          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.
  • gridlockd 7y ago
    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.
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• qrbLPHiKpiux 7y ago
  Further, private equity should not be involved at all in healthcare. I’m in healthcare and they tear it apart.
• kccqzy 7y ago
  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.
• crb002 7y ago
  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.
• lacker 7y ago
  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.
• Havoc 7y ago
  >But that one’s for my book, [...] which you can pre-order here. Well that was an impressively elaborate sales pitch
• ikeboy 7y ago
  The theory is wrong. 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.
  • gridlockd 7y ago
    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”.
    • ikeboy 7y ago
      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.
      • gridlockd 7y ago
        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.
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• lpolovets 7y ago
  (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.
  • bsder 7y ago
    > 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.
    • zaroth 7y ago
      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. [1] - https://corpgov.law.harvard.edu/2017/12/19/analysis-of-delaware-supreme-courts-dell-appraisal-decision/ https://corpgov.law.harvard.edu/2017/12/19/analysis-of-delaw...
• chrisgd 7y ago
  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.
• Jgrubb 7y ago
  A good proofread is arguably not as important in a 5 minute blog read, but in a 20 minute read it really adds up.
• batmenace 7y ago
  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.
  • mcv 7y ago
    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.
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