How private equity firms operate


I have written before about the terrible role that some private equity companies play in the economy, taking over businesses, loading them with debt they cannot pay, and then leaving them bankrupt while they walk away with a hefty profit. Emily Stewart has come out with a great explainer about how these private equity firms operate and the destruction they leave in their wake. You really should read the full article but here are some key excerpts.

The term private equity can encompass a lot of different types of firms, including venture capital firms and hedge funds. But for the purposes of this story, and what you’re often hearing about in high-profile cases, we’re talking mainly about leveraged buyouts, where private equity firms buy companies basically by loading them up with debt.

To explain leveraged buyouts in easier-to-understand terms, let’s say you buy a house. Under normal circumstances, if you can’t pay for the mortgage, you would be in trouble. But by the LBO rules, you’re only responsible for a portion. If you pay for 30 percent of the house, the other 70 percent of the asking price is debt placed on the house. The house owes that money to the bank or creditor who lent it, not you. Of course, a house can’t owe money. But under the private equity model, it does, and its assets — its factories, stores, equipment, etc. — are collateral.

But because of the debt companies end up owing creditors as part of a deal, they sometimes find themselves with such high interest payments that they can’t make the investments necessary to be competitive or even stay afloat. Plus, companies often take out additional loans to pay private equity investors dividends, and then they pay a fee if and when they are sold. If they can’t pay off the debt, the companies are on the hook, and their employees and customers are the ones to suffer the consequences.

And private equity’s No. 1 priority isn’t the long-term health of the companies it buys — it’s to make money, and as is the case in so many facets of investing today, to make money fast.

“Some of the larger private equity firms, they’re not retaining investments in the long-term. They are designed to produce short-term returns, and if there is nothing left of the company at the end, that’s okay,” said Rep. Katie Porter (D-CA) in an interview.

The controversy surrounding private equity is that whatever happens to the company acquired, private equity makes money anyway. Firms generally have a 2-20 fee structure, which means they get a 2 percent management fee from their investors and then a 20 percent performance fee on the money they make from their deals. Basically, if an investment goes well, they get 20 percent of that. But regardless of what happens, they get 2 percent of the money they’re managing altogether, which is a lot.

Moreover, private equity firms can take out additional loans through their leveraged companies to pay dividends to themselves and their investors, and the companies are on the hook for those loans too. The share of profits private equity managers earn, carried interest, gets special tax treatment, and is taxed at a lower rate than regular income.

It’s heads I win, tails you lose.

In July, Sen. Elizabeth Warren (D-MA) rolled out a plan and accompanying legislation — the Stop Wall Street Looting Act of 2019 — taking direct aim at the sector. Her proposal would overhaul how private equity collects fees, who’s responsible for an acquired company’s debt, and how stakeholders are paid in the event a company does go bankrupt. It would also close the carried interest loophole that keeps private equity’s taxes so low. While Warren’s bill wouldn’t end private equity, it would change incentives and force firms to have more skin in the game.

While people in the private equity industry may be complaining that it’s been unfairly caricatured, they’re not the victims. The victims are the workers who are collateral damage in deals gone bad. All those Deadspin writers who walked away from their jobs in solidarity are entering an extremely tough journalism environment right now. Just ask anyone who ever dreamed of working in local media.

More than 30,000 Toys R Us employees lost their jobs when it went bankrupt. Initially, they weren’t paid severance, even when the private equity firms walked away with millions. After months of protest, two of the investors — Bain and KKR — gave a combined $20 million to an employee severance fund, but the third investor, Vornado, abstained. According to one recent study, US retailers owned by private equity firms and hedge funds have laid off nearly 600,000 workers over the past 10 years alone.

One of the latest big companies to fold after being taken over by a private equity firm is the iconic dairy company Borden that was taken over by a private equity firm in 2017. As is often the case, the company that was already troubled due to decreased milk consumption and a shrinking source of dairy providers could not recover from the additional burden that was the increased debt load that the private equity owners saddled it with.

Comments

  1. brucegee1962 says

    There are quite a few issues where I disagree with Elizabeth Warren, but this right here is why I may end up voting for her anyway in the primary. She’s smart, she’s tough, and she’s willing to go after the bad actors like nobody else is.