Private Equity

Matt Stoller wrote a highly informative piece on private equity. I loved every word and wanted to summarize the best points (it’s all great, so maybe just read it instead).

If you’re like me, you’ve probably heard the term but don’t actually understand what it was. Like most of the financial sector, it’s fairly elusive to ordinary people. The stock market is purposefully confusing; it’s a system created by winners to benefit winners. Those who make the rules benefit. Those on the outside are losers.

We assume private equity is part of our lovely capitalist meritocracy, whereby smart and deserving business people make savvy, responsible decisions and get rich. Private equity is part of that world. The truth, however, is that it has been described as “fraud” and the “most vampiric of all industries.”

Let’s start from the top. What is private equity? In Stoller’s words:

A private equity fund is a large unregulated pool of money run by financiers who use that money to invest in and/or buy companies and restructure them. They seek to recoup gains through dividend pay-outs or later sales of the companies to strategic acquirers or back to the public markets through initial public offerings. But that doesn’t capture the scale of the model. There are also private equity-like businesses who scour the landscape for companies, buy them, and then use extractive techniques such as price gouging or legalized forms of complex fraud to generate cash by moving debt and assets like real estate among shell companies.

In simple terms, private money buys companies and reorganizes them with the goal of making money. But, to be fair, let’s give the private equity guys a chance to define their vocation. Stoller continues:

According to them, PE takes underperforming companies and restructures them, delivering needed innovation for the economy. PE can also invest in early stages, helping to build new businesses with risky capital. There is some merit to the argument. Pools of capital can invest to improve companies, and many funds have built a company here and there. But only small-scale funds really do that, or such examples are exceptions to the rule or involve building highly financialized scalable businesses, like chain stores that roll up an industry (such as Staples, financed by Bain in the 1980s). At some level, having a pool of funds means being able to invest in anything, including building good businesses in a dynamic economy where creative destruction leads to better products and services. Unfortunately, these days PE emphasizes the “destruction” part of creative destruction.

A recent example of private equity in action is Toys “R” Us. Prior to their bankruptcy, Toys “R” Us had debts of $1.86 billion. After it was purchased by Bain Capital, KKR, and Vornado in 2005, described as “an albatross placed around their neck,” its debt rocketed to just over $5 billion. Despite declining sales before the deal, they managed to remain steady even as the 2008 crash hit.

Stoller summarizes:

By 2007, though Toys “R” Us was still an immensely popular toy store, the company was spending 97% of its operating profit on debt service. Bain, KKR, and Vornado were technically the ‘owners’ of Toys “R” Us, but they were not liable for any of the debts of the company, or the pensions. Periodically, Toys “R” Us would pay fees to Bain and Company, roughly $500 million in total. The toy store stopped innovating, stopped taking care of its stores, and cut costs as aggressively as possible so it could continue the payout. In 2017, the company finally went under, liquidating its stores and firing all of its workers without severance. A lot of people assume Amazon or Walmart killed Toys “R” Us, but it was selling massive numbers of toys until the very end (and toy suppliers are going to suffer as the market concentrates). What destroyed the company were financiers, and public policies that allowed the divorcing of ownership from responsibility.

So Bain, KKR, and Vornado buy Toys “R” Us. They add massive debt, but aren’t responsible for it. They pay $500 million in fees to consultants. This new debt crippled their ability to innovate. And, according to one report, “KKR and Bain partners earned from those fees more than covered the firms’ losses in the deal.”

Despite Toys “R” Us going bankrupt, which was hastened by the private equity acquisition, the purchasers walked away with profit. This is typical of private equity as deals are essentially all upside with minimal risk.

Most importantly, how did this affect the employees of Toys “R” Us. According to Ann Marie Reinhart, a longtime employee of Toys “R” Us, she noticed a “change in dynamic” with how the store was run after the takeover.

Twenty-nine years ago, Reinhart was a new mother buying diapers in a Toys “R” Us when she saw a now hiring sign. She applied and was offered a job on the spot. She eventually became a human-resources manager and then a store supervisor.

She stayed because the company treated her well, accommodating her schedule. She got good benefits: health insurance, a 401(k). But she noticed a difference after the private-equity firms Bain Capital and Kohlberg Kravis Roberts, along with the real-estate firm Vornado Realty Trust, took over Toys “R” Us in 2005. “It changed the dynamic of how the store ran,” she said. The company eliminated positions, loading responsibilities onto other workers. Schedules became unpredictable. Employees had to pay more for fewer benefits, Reinhart recalled. (Bain and KKR declined to comment; Vornado did not respond to requests for comment.)

Employees are, thankfully, now receiving some severance. They cheques range between $200 - $12,000. But this is not enough, according to CBS:

The money comes from a $20 million financial assistance fund established in November by private equity firms Bain Capital and KKR, two of three companies that took over Toys R Us in a $6.6 billion leveraged buyout in 2005.

Under pressure from workers and advocates, Bain and KKR each contributed $10 million to the fund, which is still short the estimated $75 million owed to former employees under policies in use for decades at the iconic retailer. 

Here’s another private equity example, as described in The Atlantic (although this one has a relatively happy ending):

Private-equity firms helped buy out the retailer Mervyn’s in 2004, loading it up with $800 million in debt and spinning off its real-estate holdings. The company went bankrupt in 2008 and liquidated its stores, yet according to bankruptcy-court filings, its owners pocketed $200 million in fees and dividends from 2004 to 2006. Vendors such as Levi Strauss, which had sold clothes to the retailer and wanted to be paid for its goods, sued the private-equity owners. They secured a $166 million settlement, arguing that the owners had played a role in driving Mervyn’s into bankruptcy. (The owners did not admit any wrongdoing.)

Possible the most famous example of private equity, described by Stoller, is that of private equity pioneer William Simon, who purchased Gibson’s Greeting Cards for $80 million in 1982. He borrowed $79 million to complete the deal while him and his partner only put down $330,000 each.

They immediately paid themselves a $900,000 special dividend from Gibson, made $4 million selling the company’s real estate assets, and gave 20% of the shares to the managers of the company as an incentive to keep the stock price in mind. Eighteen months later, they took Gibson public in a bull market, selling the company at $270 million. Simon cleared $70 million personally in a year and a half off an investment of $330,000, an insanely great return on such a small investment. Eyes popped all over Wall Street, and Gibson became the starting gun for the mergers and acquisitions PE craze of the 1980s.

While these returns are nothing short of remarkable, Matt contends there has been little analysis on how profitable private equity has been for investors or lenders. There is one study, however:

But I found this paper by Brian Ayash and Mahdi Rastad quite useful. What Ayash and Rastad noted is that companies bought by private equity are ten times more likely than comparable companies to go bankrupt. And this makes sense. The goal in PE isn’t to create or to make a company more efficient, it is to find legal loopholes that allow the organizers of the fund to maximize their return and shift the risk to someone else, as quickly as possible. Bankruptcies are a natural result if you load up on risk, and because the bankruptcy code is complex, bankruptcy can even be an opportunity for the financier to restructure his/her investment and push the cost onto employees by seizing the pension.

The takeaway here: the goal is not to increase efficiency but rather to maximize the rate of return while transferring risk to someone else.

And here are the paper’s findings, in it’s own words:

Tracking a sample of 484 public to private LBOs for 10 years after going private, we find a bankruptcy rate of approximately 20%, an order of magnitude greater than the 2% bankruptcy rate for the control sample.

Private equity comes with the potential for massive financial upside. But the financiers should bear the consequences if things go bad. I have no problem with the idea of ‘big risk big reward’ in our society, but we need to add ‘big consequence’ the equation, because right now, the game is rigged.