6 ms·

Thanks for that. But why is the company now worse off than before? A company can be funded with equity or debt (different terms and obligations, I understand)

Thanks for that. But why is the company now worse off than before? A company can be funded with equity or debt (different terms and obligations, I understand) but if a company converts 100% of its outstanding shares to debt, why does anything change? I assume this is what happens when a company takes itself private to escape the grind of quarterly earning, short-term growth, tyranny of Wall Street analysts, etc. If I could run a company better/extract more value from it, say, by decreasing expense, increasing revenue, and therefore profits, I'd write myself a big check quarterly and continue running the company. Something else extractive and zero-sum (I gain but the company loses) is going on and I don't know what that is.

sfkdjf9j3j 6y ago
The company is now servicing $100m of debt. That cash went to the previous shareholders in the buyout.
whatok 6y ago
> If I could run a company better/extract more value from it, say, by decreasing expense, increasing revenue, and therefore profits, I'd write myself a big check quarterly and continue running the company. If you can. If you can't and your cash flow either stays flat or declines, you now have more debt to service. The more debt you have, the less leeway you have to execute on your plan. That's assuming you don't screw anything up in the business without considering any macroeconomic factors.
- devchix 6y ago
  Right, and in that case I've made a bad decision and now I "own" a company that is not doing well and have more debt to service. The company declares bankruptcy, gets restructured or folds. How does that help me? That is to say, if it ends this way frequently, or fair odds ending this way, why do PEs keep structuring leveraged buy-outs? (This thread makes it sound like it's frequent enough that one person can say, Debts? Lemme guess, PE? Right you are!) There's an incentive to do this and the edge is ... what?
  - whatok 6y ago
    PE is very cyclical and rates have been very low. Massively levered PE transactions are usually tied to the business cycle. When the economy is doing well you're able to get away with larger and more levered transactions than normal. If you add on low rates to this, you can get away with larger transactions. All debt deals have covenants and covenant protection is at an all-time low right now; investors have decided that it is worth giving up this protection for whatever the potential investment happens to be. Covenants on the amount of leverage a company can take on are common but there's no universal formula for calculating leverage. It is not atypical to have multi-page definitions of how a company calculates EBITDA. Some firms are known for being very aggressive with this and are also very aggressive with issuing dividends shortly upon the close of a transaction. Aggressive dividend policies help PE derisk transactions substantially. The more money you are able to take out of the company (and sometimes able to issue debt to do so), the more you derisk your initial investment. I could go on for days about whether any of this is good or bad, blah blah but as far as your observation that this seems to happen with all PE deals, PE is a multi-trillion dollar industry. Just think about how the world would look if that happened with all PE-backed companies.
kshacker 6y ago
Your theory is good, but is it what happens in practice? In the headlines, you will find examples of "corporate raiders" who bought the company to "extract value" which means doing pretty much what a leech does. Also most of these examples showcase that the company would have been better off without the private equity buyers. Could there be good buyers, sure.
- devchix 6y ago
  "extract value" -- what does this mean? Sell off the furniture? Fire 50% of the employees? I have image of Richard Gere saying "I buy companies that are in financial difficulties, I break it up into pieces, and I sell that off." Like stealing cars and selling them for parts, right?
  - Allower 6y ago
    So kind of like white blood cells destroying a cell that has become cancerous or diseased in order to protect the organism overall, I see.
  - topkai22 6y ago
    Yeah, that's pretty much the canonical model. Huge in the 80s for a variety of reasons, still extremely common today. There are other models for PE and going private- sometimes companies don't use nearly so much leverage and are effecitvely bought as part of portfolio, sometimes you see very rich individuals take their companies that they used to own private again, sometimes they do use tons of leverage but buy and run the companies mostly as is, just growing the company in place and paying down debt from cashflow. PE's and LBOs aren't necessarily bad things at all and the economy as a whole is better for having them exist. The problem is that the risk/reward profile tends to exaberate inequality. The PE/LBO firm is already rich individuals who may make our lose millions on a bet on the company. The control their own risk and decide. The workers and communities who also have a stake in the company? They have very limited upside and the downside is that they lose their jobs and anchor institutions in their communities, and they have very little control over whether or not to accept the risk.
  - 6y ago
CPLX 6y ago
It's a bust-out. It's much easier to look at the examples in mob movies, like when they took over the outdoor store in the Sopranos or burned the nightclub in Goodfellas. They take over a business with existing good will and loot it, using that good will to delay the collapse until they've extracted all the money and left others holding the bag, usually creditors (especially tradeline partners like suppliers, or landlords) and employees. Ref: https://www.experian.com/assets/decision-analytics/white-papers/bust-out-fraud-white-paper.pdf https://www.experian.com/assets/decision-analytics/white-pap...
tlb 6y ago
They're required to pay a fixed interest rate on the debt. So during an economic downturn when profits dip, they can become insolvent. By comparison, when the capital came from stock, the dividends could adjust up and down with their profits. Like any form of leverage, it magnifies both the upside and downside risks.
topkai22 6y ago
Becuase the risk of investment is now structured differently with leverage. Let's pretend we live in world where companies are always worth 10x earnings + assets. Our pretend company $100M makes $5M in earnings and has $50M in assets (cash, real estate, etc..) To take the company private, the lenders require an interest of 10% and 10% principal Some PE company (or the CEO, whatever) thinks they can make this work, so they come up with $10M of principal, take the lenders money and buy the company. The first thing they do is sell as many of those underlying assets as they can to pay down the debt. You now have a company that has $5M a year in earnings before debt, $10M in assets (the principal, serviving as the required reserve for the lenders), and $50M in debt, with a debt service of ~$5M a year (so really 0 earnings). If the the PE company does a great job managign the company and the economy is good, so they double earnings to $10M, then the company is now worth $50M ($10M in income x 10 + assets - debt) and the PE company made a 5x return already (FYI- I know I'm abusing my financial math, fake numbers, but its illustrative). Now lets assume they were wrong and a global pandemic breaks out, and the companies start losign money to the tune of $1M a year. If the company had stayed publicly owned, they might have to cut their dividend and burn through reserves, maybe sell off some assets, but other than that all their employees and the majority of their assets are probably fine. The company's market cap is a lot less, but shareholders don't go to zero eithier. The world where the company went private in an LBO? That $10M cushion runs out in less than 2 years. They are bankrupt. They might get a few more chances to restructure debt and such, but eventually the lenders give up and liquidate the company a la Toys R Us. The employees get fired and local landlords lose tenants. Pension funds disappear. It's not fun.
- devchix 6y ago
  Thank you, I understand better now with the numbers worked out. Although in this example, outcome is dependent on circumstance and LBOs are not covers for malfeasance the way they're frequently talked about.
  - topkai22 6y ago
    I think the reason LBOs are so hated is difference in utility between the capitalists and the community. The capitalists (PE, management, and lenders) are putting a boatload of money at risk to make an even larger boatload of money, and are empowered to take that risk. If the bet doesn't work out? They'll lose money (but probably have lots left over) and maybe their jobs if goes bad. The community (workers, local suppliers, and governments) are seeing their jobs, livelihoods, and institutions put at risk, and they likely are seeing no reward for success. They are not empowered to decline the increase in risk, even though they certainly have a stake in the future of the company.

sfkdjf9j3j 6y ago

The company is now servicing $100m of debt. That cash went to the previous shareholders in the buyout.

whatok 6y ago

> If I could run a company better/extract more value from it, say, by decreasing expense, increasing revenue, and therefore profits, I'd write myself a big check quarterly and continue running the company. If you can. If you can't and your cash flow either stays flat or declines, you now have more debt to service. The more debt you have, the less leeway you have to execute on your plan. That's assuming you don't screw anything up in the business without considering any macroeconomic factors.

devchix 6y ago
Right, and in that case I've made a bad decision and now I "own" a company that is not doing well and have more debt to service. The company declares bankruptcy, gets restructured or folds. How does that help me? That is to say, if it ends this way frequently, or fair odds ending this way, why do PEs keep structuring leveraged buy-outs? (This thread makes it sound like it's frequent enough that one person can say, Debts? Lemme guess, PE? Right you are!) There's an incentive to do this and the edge is ... what?
- whatok 6y ago
  PE is very cyclical and rates have been very low. Massively levered PE transactions are usually tied to the business cycle. When the economy is doing well you're able to get away with larger and more levered transactions than normal. If you add on low rates to this, you can get away with larger transactions. All debt deals have covenants and covenant protection is at an all-time low right now; investors have decided that it is worth giving up this protection for whatever the potential investment happens to be. Covenants on the amount of leverage a company can take on are common but there's no universal formula for calculating leverage. It is not atypical to have multi-page definitions of how a company calculates EBITDA. Some firms are known for being very aggressive with this and are also very aggressive with issuing dividends shortly upon the close of a transaction. Aggressive dividend policies help PE derisk transactions substantially. The more money you are able to take out of the company (and sometimes able to issue debt to do so), the more you derisk your initial investment. I could go on for days about whether any of this is good or bad, blah blah but as far as your observation that this seems to happen with all PE deals, PE is a multi-trillion dollar industry. Just think about how the world would look if that happened with all PE-backed companies.

kshacker 6y ago

Your theory is good, but is it what happens in practice? In the headlines, you will find examples of "corporate raiders" who bought the company to "extract value" which means doing pretty much what a leech does. Also most of these examples showcase that the company would have been better off without the private equity buyers. Could there be good buyers, sure.

devchix 6y ago
"extract value" -- what does this mean? Sell off the furniture? Fire 50% of the employees? I have image of Richard Gere saying "I buy companies that are in financial difficulties, I break it up into pieces, and I sell that off." Like stealing cars and selling them for parts, right?
- Allower 6y ago
  So kind of like white blood cells destroying a cell that has become cancerous or diseased in order to protect the organism overall, I see.
- topkai22 6y ago
  Yeah, that's pretty much the canonical model. Huge in the 80s for a variety of reasons, still extremely common today. There are other models for PE and going private- sometimes companies don't use nearly so much leverage and are effecitvely bought as part of portfolio, sometimes you see very rich individuals take their companies that they used to own private again, sometimes they do use tons of leverage but buy and run the companies mostly as is, just growing the company in place and paying down debt from cashflow. PE's and LBOs aren't necessarily bad things at all and the economy as a whole is better for having them exist. The problem is that the risk/reward profile tends to exaberate inequality. The PE/LBO firm is already rich individuals who may make our lose millions on a bet on the company. The control their own risk and decide. The workers and communities who also have a stake in the company? They have very limited upside and the downside is that they lose their jobs and anchor institutions in their communities, and they have very little control over whether or not to accept the risk.
- 6y ago

CPLX 6y ago

It's a bust-out. It's much easier to look at the examples in mob movies, like when they took over the outdoor store in the Sopranos or burned the nightclub in Goodfellas. They take over a business with existing good will and loot it, using that good will to delay the collapse until they've extracted all the money and left others holding the bag, usually creditors (especially tradeline partners like suppliers, or landlords) and employees. Ref: https://www.experian.com/assets/decision-analytics/white-papers/bust-out-fraud-white-paper.pdf https://www.experian.com/assets/decision-analytics/white-pap...

tlb 6y ago

They're required to pay a fixed interest rate on the debt. So during an economic downturn when profits dip, they can become insolvent. By comparison, when the capital came from stock, the dividends could adjust up and down with their profits. Like any form of leverage, it magnifies both the upside and downside risks.

topkai22 6y ago

Becuase the risk of investment is now structured differently with leverage. Let's pretend we live in world where companies are always worth 10x earnings + assets. Our pretend company $100M makes $5M in earnings and has $50M in assets (cash, real estate, etc..) To take the company private, the lenders require an interest of 10% and 10% principal Some PE company (or the CEO, whatever) thinks they can make this work, so they come up with $10M of principal, take the lenders money and buy the company. The first thing they do is sell as many of those underlying assets as they can to pay down the debt. You now have a company that has $5M a year in earnings before debt, $10M in assets (the principal, serviving as the required reserve for the lenders), and $50M in debt, with a debt service of ~$5M a year (so really 0 earnings). If the the PE company does a great job managign the company and the economy is good, so they double earnings to $10M, then the company is now worth $50M ($10M in income x 10 + assets - debt) and the PE company made a 5x return already (FYI- I know I'm abusing my financial math, fake numbers, but its illustrative). Now lets assume they were wrong and a global pandemic breaks out, and the companies start losign money to the tune of $1M a year. If the company had stayed publicly owned, they might have to cut their dividend and burn through reserves, maybe sell off some assets, but other than that all their employees and the majority of their assets are probably fine. The company's market cap is a lot less, but shareholders don't go to zero eithier. The world where the company went private in an LBO? That $10M cushion runs out in less than 2 years. They are bankrupt. They might get a few more chances to restructure debt and such, but eventually the lenders give up and liquidate the company a la Toys R Us. The employees get fired and local landlords lose tenants. Pension funds disappear. It's not fun.

devchix 6y ago
Thank you, I understand better now with the numbers worked out. Although in this example, outcome is dependent on circumstance and LBOs are not covers for malfeasance the way they're frequently talked about.
- topkai22 6y ago
  I think the reason LBOs are so hated is difference in utility between the capitalists and the community. The capitalists (PE, management, and lenders) are putting a boatload of money at risk to make an even larger boatload of money, and are empowered to take that risk. If the bet doesn't work out? They'll lose money (but probably have lots left over) and maybe their jobs if goes bad. The community (workers, local suppliers, and governments) are seeing their jobs, livelihoods, and institutions put at risk, and they likely are seeing no reward for success. They are not empowered to decline the increase in risk, even though they certainly have a stake in the future of the company.