In a word, it's looting. Private Equity firms are looters, predators, symptoms of overly concentrated wealth. What they do is buy existing companies, sell off their assets and load them up with debt to make a quick profit. What they don't do is make things, create jobs or contribute to the "real" economy. The only thing they make is money for their owners and investors. This is something to keep in mind the next time you hear a Republican touting Mitt Romney's business experience.
I knew a little about PE firms from reading newspaper and magazine articles. I knew that Mitt made his fortune with a PE firm called Bain Capital. I remember reading in Road & Driver that a firm called Cerberus had taken Chrysler private and I had read about a conflict of interest issue involving a politically connected firm called the Carlyle Group. What I didn't have was an understanding of how Private Equity firms operate. So I read a book. In this diary I will share what I found out.
The book I read was The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis by Josh Kosman, published in '09 by Penguin, NY. Mr. Kosman is a business reporter at the New York Post and has been covering the financial industry for 12 years. We'll get to that scary subtitle in a bit. First the basics. I've put a list of major PE firms with Wikipedia links in an appendix at the bottom.
It turns out that Private Equity is a new name for an old game: Leveraged Buyouts or LBOs. Remember those ? The most infamous was the buyout of RJR/Nabisco by Kohlberg Kravis Roberts (KKR) in 1989. This one is still No.4 on the list of the 10 biggest buyouts of all time. It inspired a book, Barbarians at the Gate: The Fall of RJR/ Nabisco by Bryon Burrough and John Helyar, and a movie with the same title. There was a boom in LBOs during the '80s set off by KKR's innovative exploitation of a tax loophole. Since interest paid on loans is deductible from corporate income taxes, the money that would have been paid in taxes could be used to pay off loans more rapidly. The financing for the 80s boom came from S&Ls and junk bonds.
Here's how they do it these days. The PE firm (or firms, they often team up) puts up some of its own money and then solicits investors in order to get up a fund. The investors could be anybody, individuals, banks or hedge funds. During the recent LBO boom it was mainly state pension funds looking for high returns after the dot.com bubble popped. The investors usually agree to invest for a period of time, not a set amount, and they can be required to put up more money if the firm needs it. Once they've got a fund together, they look for a company to buy out.
The ideal target company is a well established business with steady earnings. They don't want a new company. These are not venture capitalists. They don't do start-ups. They look for a company with the ability to pay off debt because the company will be taking on a lot of debt to pay for its own buyout. If you think of it in terms of a person, they would want someone with a steady income and unused credit. Although PE firms sometimes buy businesses from other PE firms, traditionally it is a publicly traded company that they "take private". Sometimes upper management of the target company will work with the PE firm in return for participation in the profits. This is called a "management buyout".
Now they're ready to go to the banks and get leveraged. The bank looks at the earnings of the company to be taken private and loans the company to be acquired the money to buy back it's own shares, with the PE firm's fund money, typically 30 to 40 percent, as down payment. The company offers shareholders a premium over what the shares are trading for, they sell, and the deal is done. Now the PE firm controls the manufacturing or retail company and it's time to make some money.
The PE firm will get theirs first. They charge the new company fees for putting the deal together and for managing the acquisition. The partners can often get their original investment back in fees alone, no matter how the deal turns out. Available cash will be used to pay off bank loans or pay dividends to the new owners. New loans will be taken out. There's a move called "debt-to-distribution" where the PE firm has the company take out a loan and then simply takes the money as dividends. There may be layoffs and price hikes as the PE owners seek to improve cash flow and cut costs in order to make the books look good as they prepare to sell.
If all goes well for the PE firm the bank debt will be repaid, the firm and it's investors will make 5 or 6 times their original investment and the company they raided will be sold within 5 years. That's the business model.
It's usually not such a happy ending for companies that have been bought by PE firms. Since their goal is to get in, get what they can and get out, PE firms don't manage for the long-term health of the businesses they buy. They often sell profitable divisions. They don't invest in the improvement of the companies they own. They don't want to manufacture mattresses or sell toys. They just don't care and their record proves it.
The worst aspect of an LBO is the debt that the acquired companies are saddled with. The loans the acquired companies have to take out to fund their own buyouts leave them unable to ride out any downturn in sales. This is basically what happened to Mervyn's department stores. They were bought by Cerberus in '04, borrowed $800 million to fund the buyout and were bankrupt by '08 with 18,000 layoffs. Same with KB Toys. They were bought by Romney's Bain Capital in 2000. They went bankrupt in '04, less than two years after a debt-to-distribution play where they borrowed $67 million to pay a "dividend" to Bain.
There are other unfortunate effects of LBOs, price hikes to customers, for example, and the money that should have gone to the federal government but didn't because of the interest deduction. Then there's customer service. Layoffs of employees to cut costs often mean degraded customer service. This can be a serious matter if the company doing the layoffs is a hospital and the customers are sick people. PE firms now own 7 of the 15 largest for-profit hospital chains including HCA , acquired by KKR and Bain in '06.
Now we can talk about Kosman's ominous subtitle: How Private Equity Will Cause the Next Credit Crisis. As I've said, the first LBO boom was in the 1980s. That boom ended. LBOs slowly picked up in the 90s and then took off in the mid-2000s, right along with the housing boom and for the same reasons. Nine of the ten biggest LBOs of all time happened between '06 and '08 (see appendix). Kosman cites a report from the World Economic Forum stating that the total value of LBOs worldwide from 1970 to 2007 was $3.6 trillion, with $2.7 trillion of that occurring since 2001. Call it a boom or a bubble, Private Equity firms went on a spree during the 2000s that mirrored the housing bubble that we've all heard so much about.
First of all, the Federal Reserve lowered interest rates several times during 2001 so there was lots of cheap money available to the banks. Then there was some innovation, viz. securitization. Yup, just like the banks were bundling home loans into collateralized debt obligations, or CDOs, that they would then sell to investors, they were bundling corporate loans into collateralized loan obligations, CLOs. Neat huh ?
The same thing that happened with the CDO market happened with the CLO market, a demand driven boom. The bundled loans offered a good return so investors loved them and would buy all they could get. The banks were making good fees selling the instruments, so they pressured loan officers to write more loans. In the end, just as home loans were being granted to less qualified borrowers to keep up with demand, PE firms were being given loans to buy less than ideal takeover candidates. Then earnings multiples of the leveraged companies was climbing. Companies were being taken private that had little chance of ever repaying their buyout loans. The banks didn't care because they unloaded the loans on investors.
So here's where we're at now. Credit has dried up, the banks are not so free with the money these days. Many LBOs were financed with balloon type loans, with the principal due 6 or 8 years out. These loans are going to start coming due in 2011 and 2012. Companies will not be able to pay off refinance their loans. Many will go bankrupt.
Kosman figures it like this. PE firms bought 3,188 American. companies between 2000 and 2008. An outfit called the Boston Consulting Group predicted in December of '08 that 50% of PE owned companies will default on their debt by the end of 2011. If this happens, and if the bankrupt companies all fire half of their workers, 1.9 million more American workers will be unemployed. Not only that, all the pension funds that have invested with PE firms will be in trouble. It's not a pretty picture.
There may also be another credit crunch as investors discover they have bought toxic CLOs. Mr. Kosman doesn't mention it in his book, but I'm guessing that the CLOs, like CDOs, were hedged with exotic derivatives and insurance schemes. It's deja vu all over again.
The above scenario is not inevitable. PE firms may be forced to manage their acquisitions more responsibly, to do a little less looting. The PE "industry" is hoping that there will be a recovery and a return to the old normal so the money spigots will open again. It could happen. The question is whether or not we want PE firms to return to their old ways. If the answer is no, there are some steps that can be taken.
There are three ways that regulation could rein in PE activity. First off, the tax deduction for interest on corporate loans could be removed. This was tried before after the 80s LBO frenzy and didn't get anywhere. Debt-to-equity requirements could be imposed. Kosman quotes one Wall Streeter as saying that a 50-50 debt-equity requirement would stop LBOs entirely. Finally, the SEC could reinstate bank currency reserve requirements. These reforms might be hard to enact since PE firms are well connected politically, with both parties, but LBOs are not a healthy thing for the economy and should be stopped.
For those who have waded through this entire piece, congratulations. You now know as much about Private Equity as I do, which ain't much, but at least you won't be totally clueless.
Appendix I - Major Private Equity Firms with Wikipedia links
Apollo Management, founded by ex-Drexel guys after the junk-bond related flamemout of Drexel, Burnham, Lambert in 1990
Bain Capital, Mitt's outfit
Blackstone Group, where Social Security foe Pete Peterson made his pile, hired former Treasury Secretary Paul O'Neil
Carlyle Group, Carlyle's chairman from '92 to '03 was PNACer and former Defense Secretary Frank Carlucci, hired former Treasury Secretary and long-time Republican super-insider James Baker and Oliver Sarkozy, half-brother of Nicolas
Cerberus Capital Management, involved in Madoff affair, benefited from auto industry bailout by owning both Chrysler and GMAC, hired former Treasury Secretary John Snow
Forstmann Little & Company, owns a piece of troubled broadcaster Citadel
Goldman Sachs Capital Partners, of course these guys have a tentacle in PE
KKR, the grandaddy of 'em all
Merrill Lynch, merged with BofA in great Wall St. bloodbath, now called BAML
TPG
Appendix II - Top Ten Biggest LBOs of All Time
- Bain buys Clear Channel Communications for $26B, 7/'08
- Blackstone buys Hilton Hotels for $27B, 10/'07
- Goldman Sachs buys Alltel for $27B, 11/'07
- KKR buys credit card processor First Data for $27B, 9/'07
- Carlyle & Goldman Sachs buy pipeline firm Kinder-Morgan for $28B, 5/'07
- Apollo & TPG buy casino giant Harrah's Entertainment for $28B, 1/'08
- KKR buys RJR/Nabisco for $30B, 4/'89
- Bain, KKR & Merrill Lynch buy hospital chain HCA for $32B, 11/'06
- Blackstone buys comm. real estate company Equity Office Properties for $38B, 2/'07
- ... and the number one biggest LBO of all time: TPG, Goldman Sachs and KKR team up to buy utility TXU for $44B in October of '07