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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 + asset

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.
  - pstuart 6y ago
    > I think the reason LBOs are so hated It feels like economic strip mining to me. p.s. thank you for the clear explanations
    - topkai22 6y ago
      It isn't always- there are certainly times where a PE company recognizes that a fundamental good company is doing stupid things with its assets. One of the reasons why LBOs and "corporate raiding" was such a cultural meme in the 80s is that there really were a ton of companies that weren't allocating capital well, and sometimes were run for management's benefit to the expense of the shareholders. A totally made up example might be a furniture manufacturer that also happened to own a some water parks and a bunch of real estate, because the CEO liked water parks. A corporate raider/PE firm might do the math and conclude the water park segment was dragging down the rest of company and the real estate would fetch a ton if the company actually sold it. So they take over the company with debt, pay off a chunk of the debt by spinning off the water park segment, sell off a bunch more real estate to people who want to use it, and then the core furniture manufacturer actually ends up with more free cash flow because they aren't supporting the dead weight businesses. That's the idealistic case, and it does happen. But then there are the counter examples we all know...
  - whatok 6y ago
    I think it's more because the examples people are familiar with are cherrypicked "heads I win, tails you lose" examples that have recently been recognizable American brands. Someone linked a list of LBOs elsewhere in here and TXU was at the top of the list. A lot of people lost a lot of money on that deal but you didn't see the kind of press Toys R Us got. I'm guessing a tiny percentage of people here even know what TXU is. Toys was a brand everyone recognized and PE got paid on that even though they went under.
jazzkingrt 6y ago
This was helpful to me. How does the PE company fare in the bankruptcy scenario? Have they put up collateral or are somehow on the hook to the lenders? It's my understanding that the bankruptcy applies only to the purchased subsidiary, so the PE firm only stands to lose the principal they put in at the start. If so, it sounds like the PE firm gets all the upside, but is less exposed to the downside. So they are incentivized to rachet up the risk.
- topkai22 6y ago
  You are at the limits of my understanding- in my simple example, the entity that took the company private is only on the hook for the principal, but these deals can be super complicated- multiple layers of companies transfering or lending money to each, and PE companies can be both a lender and an owner through these arrangements.
- whatok 6y ago
  > This was helpful to me. How does the PE company fare in the bankruptcy scenario? Have they put up collateral or are somehow on the hook to the lenders? All deals are different. You're probably not going to have any collateral put up by the actual PE firm in most cases. > It's my understanding that the bankruptcy applies only to the purchased subsidiary, so the PE firm only stands to lose the principal they put in at the start. In most cases this is true. Depending on how aggressive the firm has been and how long they've been involved, they might have already dividended out their principal. > If so, it sounds like the PE firm gets all the upside, but is less exposed to the downside. So they are incentivized to rachet up the risk. This is a correct but simplified conclusion. They're incentivized but there's usually a set of checks and balances in the form of banks providing financing and investors willing to finance deals. This system of checks and balances typically erodes as the business cycle/bull market rides on. The binding constraint in most of these deals is how much leverage you're able to get away with.

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.
- pstuart 6y ago
  > I think the reason LBOs are so hated It feels like economic strip mining to me. p.s. thank you for the clear explanations
  - topkai22 6y ago
    It isn't always- there are certainly times where a PE company recognizes that a fundamental good company is doing stupid things with its assets. One of the reasons why LBOs and "corporate raiding" was such a cultural meme in the 80s is that there really were a ton of companies that weren't allocating capital well, and sometimes were run for management's benefit to the expense of the shareholders. A totally made up example might be a furniture manufacturer that also happened to own a some water parks and a bunch of real estate, because the CEO liked water parks. A corporate raider/PE firm might do the math and conclude the water park segment was dragging down the rest of company and the real estate would fetch a ton if the company actually sold it. So they take over the company with debt, pay off a chunk of the debt by spinning off the water park segment, sell off a bunch more real estate to people who want to use it, and then the core furniture manufacturer actually ends up with more free cash flow because they aren't supporting the dead weight businesses. That's the idealistic case, and it does happen. But then there are the counter examples we all know...
- whatok 6y ago
  I think it's more because the examples people are familiar with are cherrypicked "heads I win, tails you lose" examples that have recently been recognizable American brands. Someone linked a list of LBOs elsewhere in here and TXU was at the top of the list. A lot of people lost a lot of money on that deal but you didn't see the kind of press Toys R Us got. I'm guessing a tiny percentage of people here even know what TXU is. Toys was a brand everyone recognized and PE got paid on that even though they went under.

jazzkingrt 6y ago

This was helpful to me. How does the PE company fare in the bankruptcy scenario? Have they put up collateral or are somehow on the hook to the lenders? It's my understanding that the bankruptcy applies only to the purchased subsidiary, so the PE firm only stands to lose the principal they put in at the start. If so, it sounds like the PE firm gets all the upside, but is less exposed to the downside. So they are incentivized to rachet up the risk.

topkai22 6y ago
You are at the limits of my understanding- in my simple example, the entity that took the company private is only on the hook for the principal, but these deals can be super complicated- multiple layers of companies transfering or lending money to each, and PE companies can be both a lender and an owner through these arrangements.
whatok 6y ago
> This was helpful to me. How does the PE company fare in the bankruptcy scenario? Have they put up collateral or are somehow on the hook to the lenders? All deals are different. You're probably not going to have any collateral put up by the actual PE firm in most cases. > It's my understanding that the bankruptcy applies only to the purchased subsidiary, so the PE firm only stands to lose the principal they put in at the start. In most cases this is true. Depending on how aggressive the firm has been and how long they've been involved, they might have already dividended out their principal. > If so, it sounds like the PE firm gets all the upside, but is less exposed to the downside. So they are incentivized to rachet up the risk. This is a correct but simplified conclusion. They're incentivized but there's usually a set of checks and balances in the form of banks providing financing and investors willing to finance deals. This system of checks and balances typically erodes as the business cycle/bull market rides on. The binding constraint in most of these deals is how much leverage you're able to get away with.