Private equity is a scam?
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The scam is that people on wall street who know nothing about building or running a business have used their political connections and existing cash to become even richer and more powerful through government bailouts, selling off assets whose long-term value they don't understand and defaulting on pensions -- in other words, without actually creating any new wealth. Blackstone/Schwarzman is abusing the fact that starting a new hospital is difficult, even if the only one in the city is incompetently managed. They are not creating new value, and so should not be getting so rich. The people who do the actual work of starting and running successful businesses should be.
EDIT: Specifically, Schwarzman et al are abusing what economists call short-term "stickiness." It is not economically productive, as the firms with artificially high profit margins are not competitive and so a new equilibrium will eventually be established, putting them out of business. (That's why so many ultimately do) This property makes Schwarzman's behavior a form of rent-seeking, and not capital investment as he would probably have you believe. Anti-trust law is designed to limit the abuse of stickiness in the economy, but as rent seeking becomes the source of wealth for an increasing percentage of western elites, anti-trust and other financial regulations designed to combat abuses have become increasingly difficult to enforce.
Here is Matt Stroller’s take on Private Equity. https://mattstoller.substack.com/
The reason why US is being decimated by COVID-19 is we’ve lost a ton of our competitive edge by offshoring and the rich wankers want to profit at any cost. Even if it means other people die.
U.S. workers might be better at assembling iPhones than Chinese people, but if we let them assemble while we design iPhones, build it's software systems and apps, and accessories both countries come out far ahead. Chinese get paid far more while escaping brutal rural labor jobs, we develop far more software developers and designers, who get to work remotely during COVID-19 and are in higher demand than ever.
Tell the "total wealth has increased" shtick to the millions of American workers who are poorer because of offshoring, or the thousands who will die of the novel corona virus because we can't manufacture enough masks to give them to health care workers, let alone ordinary people.
Paying someone $30k a year to assemble computers isn’t a good job, nor is it good business decision when it would be a great job for workers in other countries at $10,000 per year.
The law of comparative advantage tells us the path to Greater wealth is to specialize at what you do best.
Imagine if you were a lawyer and an amazing typist and you want to make as much money as possible. You could spend 20 hours a week typing up your own documents because you do it twice as fast as any secretary you could hire. But you make $200 an hour for legal work and the secretary costs $20 per hour. You can do everything yourself, and make $4000 a week, or hire a full time secretary and make $7,200 a week.
Apple saves money assembling iPhones in China, which helps them to price more competitively and sell more iPhones, creating more engineering, marketing, app developer, designer, tester, and manager jobs here.
I’d rather have those jobs here instead of assembly work.
China could destroy Apple in a heartbeat by ordering FoxConn to charge a much higher premium for Apple phones than their own local brand.
Your argument boils down to: "well they haven't outsourced my job yet!"
With all the manufacturing happening in China, it's only a matter of time before Alibaba and Oppo dislodge Apple and Google.
Most PE firms are just investment funds run by people trying to make the best decisions they can. They provide very important liquidity to entrepreneurs and early stage investors so they can actually be rich. Few are great operators, but the successful ones understand value and capital structures very well.
To quote Tommy Boy, "Sometimes you have to take a few companies behind the shed and bash them on the head with a shovel". Warren Buffett took control of Berkshire Hathaway through a hostile takeover, threw out the management and drained it of all it's operating capital and profits until the original business died. He did that because the original business was dying, and management was destroying investment capital trying to keep it alive. Warren didn't know how to run a successful US based textile firm, but he was smart enough to know at the time it was almost impossible and that the management couldn't do it and would kill the company trying. Today Berkshire Hathaway employs hundreds of times more employees at far higher income levels than it did then.
Successful PE firms are good at separating productive assets from failing businesses, and funding good businesses that need scale, and those are things that create a lot of value.
https://www.counterpunch.org/2020/04/03/hospital-bailouts-be...
https://www.bing.com/search?form=MOZLBR&pc=MOZI&q=private+eq...
Outside of a your theoretical framework that is not what creating new wealth means to any normal person. If some businesses fail then so be it. You are trying to conflate that with what is being discussed by @doctorow. How about this. In turn, explain to me how these three activities create wealth instead of just redistribute it upwards:
- government bailouts
- selling off assets whose long-term value PE doesn't understand or care about
- defaulting on pensions
Those are the points I'm making, if you want to discuss something else, go ahead.
>PE firms are good at separating productive assets from failing businesses
Good for whom, and no, many of these businesses are not failing when PE sells off all their assets. Boeing did the same thing with much of the 787 production line and weren't in any financial trouble at all. EBITDA is just a short sighted power grab by finance capital.
>provide very important liquidity
The banks are just middle men for the Fed at this point, and stingy ones at that. The banks are so bad, it would be better for the Fed to just give the money to businesses directly.
>funding good businesses that need scale
This is more a critique of leverage in general, but this is how amazon put profitable competitors out of business by not turning a profit and is now cranking up profits probably beyond the point of sustainability. Also see https://qz.com/1250772/didi-vs-meituan-vs-ele-me-chinas-food... and https://supchina.com/2018/01/09/didis-war-century/
You could also look at lawsuits between lenders and PE firms (there have been a few interesting ones, I believe), and see how they've ended up. You could also look at the terms of loan covenants (agreements between lenders and borrowers intended to stop this precise sort of thing), and how their wording has changed during the rise of PE firms, or after high profile PE failures. The author hasn't done this either. You could also look at what sort of rates PE firms pay, or what difficulty they have raising loans, or if PE firms which have failed to repay loans have faced any consequences compared to ones which have not, but...well, you can probably guess.
In short, the author has identified a somewhat interesting topic (is there something systematically wrong with the loans PE firms take out with large lenders, and if so, why is the legal system and/or financial system not dealing with it as you would expect?), but failed to provide any information about any part of it, presumably because research is hard, and writing tweets is easy.
If you know so little about your topic, you're not really going to be able to provide any value when you try and explain it to others.
If the lenders are banks, they will do well no matter what because the money which they loan is printed out of thin air and they have 0% reserve requirement so it doesn't affect their business if the PE borrower doesn't pay back. The banks' liabilities just keep going up with no consequence; just like government debt keeps increasing without consequence.
Banks would like it if they could just constantly keep making direct loans to themselves to pay off their own old debt, that would be a simplified version of what is happening now. Unfortunately for banks, they need intermediaries to funnel the money back to them; any make-believe business such as PE firms will do. Bigger PE firms provide more throughput.
Moreover, even if the Fed decides to increase the reserve requirement % some day and the bank is suddenly forced out of business, the managers/executives of the bank still walk away with the huge salaries and bonuses from the time they were making the loans and collecting free interest - There is 0 risk for them... They will probably get even better paid jobs at some of the PE firms that they helped.
The reality of the current system is that everyone who holds or earns cash ends up paying through inflation; most inflation these days does not show up in the CPI; because rich people can only buy so many bags of potatoes; there are other factors beyond price which limit demand for consumer products (this is what CPI ignores)... Inflation among the rich will not show up in CPI; instead it goes straight to the stock market and speculative investments.
A bank can't survive loaning itself money, that's ridiculous. Every day it's burning cash paying salaries, rent, marketing costs, it has to earn significantly higher returns on money it loans out than it pays depositors and interest to the fed, or it burns through it's capital and dies.
But the general point that "complexity is a subsidy" stands. If one does not understand an investment well enough to explain it, then it might not be worth the risk.
Say Basecamp gets a ~ small 100m loan from syndicate. Basecamp is quite healthy, well managed, low leveraged, so they secure 4% rate for 5yrs, without many covenants.
Then PE buys Basecamp, leverages it to the sky and beyond, Basecamp sells, and suddenly the original 100m loan is now junk-grade. The original lenders never interacted with the PE firm, but they still got screwed.
Could they have prevented it? Sure, with lots of covenants, but they have lots of added costs for all parties and often have ways around them. Which means every possible firm that might get bought by PE is now a) having to deal with lots of covenants, and b) paying 6-7% instead of the 5% they would get if the likelihood of PE acquisitions was lower.
Unless there is a bullet proof leverage covenant, then the existing lenders can't do zip about that. Thus, their only option is to go to the table and "accept" the new structure.
In the case of Basecamp, which likely has almost zero physical assets, any loan is going to be very contingent on protecting the levels of profitability necessary to repay it. Whoever owns Basecamp won't be able to get a credit card in it's name without lender approval.
Source: I spent the last year working for a firm that is funded by venture capital loans. Every other loan & credit line had to be made subordinate to theirs, and we could not borrow anything new without their approval. It wouldn't matter who we sold the business to, they'd have to agree to the same restrictions or no sale.
If it's a general business loan with no physical assets to secure it, you can bet your bippy they'll demand covenants restricting how much other debt you can have and that those covenants survive change of control.
You say "not a lot of covenants", but change in control covenants are pretty standard, and would be triggered in the simple form of your example. As you note, there's often a way around these things but without examples, this feels awfully tenuous.
This guy is Cory Doctorow. I wouldn't say he has no idea what he's talking about.
I hadn't never heard of him but going through his wikipedia I don't see any reason to believe his understanding of business, economics, or finance is any more advanced than the impression I get from his tweets.
The people who loan money to private equity are very smart individuals who have backgrounds in finance business and economics. They tend to be very sophisticated entities. If you're going to make an argument they are being repeatedly screwed it needs to be more sophisticated than "look at this company owned by a PE that failed " or "look at this company owned by a PE that did a dickish thing to maximize profits".
Oh you mean like the guys that ran Enron? Like the guys that "invested" with Bernie Madoff?
The author's main argument is not in relation to lenders, but the bankrupting of viable business by offloading debt to them.
The author doesn't understand the process of how private equity is able to use debt in their purchase process. Bankrupting a company you just bought by over leveraging often means you took a massive loss. In the cases where it doesn't, means the business was no longer viable to begin with and a necessary separation of viable assets from a dying business occurred.
No, the company took a loss. You took dividends.
Then the company went bankrupt.
Do you disagree that's what happened with Toys'r'Us? https://www.theatlantic.com/magazine/archive/2018/07/toys-r-...
Certainly a case can be made that those fees, given how poorly Toys "R" Us was doing, were ridiculous.
However, if you buy something for $1.3b of your own money, extract a bit less than $500m in fees, and then drive it into bankruptcy, zeroing out your investment, you haven't come out ahead, and in fact have made a major loss.
Even to the extent that PE and LBOs are about looting companies at the expense of other stakeholders (which is debatable). Toys "R" Us is a pretty clear example of PE firms selecting a target in a dying line of business and getting burned.
(It's worth noting that large toy chains have been flaming out globally. In most countries the large chains have either gone under or are closing stores rapidly. If a bunch of large toy store chains are having issues, but only one was bought by PE, what's the common factor here?)
They bought Toys R Us for a price of 6.6 billion and had 5 billion in debt after the sale. So PE borrowed 5 billion against Toys R Us and invested 1.6 billion in cash.
There is no way an institutional investor let them pay themselves 1.6 billions in dividends while the company struggled.
Here's an article that basically says all the PE companies lost all their money on the investment.
https://www.forbes.com/sites/nathanvardi/2017/09/19/the-big-...
And if the lender is getting screwed out of 80 million dollars why do they keep lending to private equity?
It's not his main argument but it's an assumption that has to be true for his main argument to be true.
Playing devil's advocate with PE is where it gets a little interesting because PE tends to go after firms that are close to dying. Are they actually causing these failures, or are they just the ones delivering the bad news? Do they deliver shareholders some value by selling off what they can for scrap?
1) Poorly run, just needing better management. 2) Poorly capitalized, just needing access to more capital to prosper. 3) Businesses that can be franchises, like restaurants. 4) regional businesses that can be combined (rolled up) into a more valuable national business. 5) National businesses that can be expanded internationally. 6) Liquidations, where the operating business is no longer viable but there are assets (real estate, buildings, patents) valuable enough to turn a profit on the purchase. 7) Inefficiently run with hidden assets. Companies that might own their real estate for example, but don’t reflect that in their price. You buy the company and sell the real estate to fund part of the purchase.
PE firms are no different than any VC, hedge fund or investment partnership. They usually have their own investors and get paid a yearly percentage for managing the investments, and a share of the profits.
Some of their investments will fail, some will succeed. If they make good profits for their investors they’ll get rich and do it as long as they want. If they lose money or struggle, they’ll lose their investors and have to close shop.
The Sealy LBO is another one that got more attention than usual because of Mitt Romney's association.
Then the article goes into how the hospital is failing because of this.
No what you had a failing hospital and a successful real estate company masquerading as a mildly profitable hospital.
The US Federal Reserve has an official policy of tilting the field in favour of those making very risky loans that are unlikely to pay off. That is what 'zero interest rate policy' and regular bailouts entails. If markets were left alone rates would be higher and lenders would need to think a lot harder before lending money.
Other governments around the world have tended to adopt similar policies.
Although I see the Fed made it to the lofty heights of 2% this cycle before giving up and lowering the rate.
(1) No one gets fired for buying IBM. The prestige money pools like Ivy-league endowments invest in leveraged loans. If leveraged loans have a nice run and you haven't invested in them, then you will get fired. You will be fired before the bubble pops. If you make big losses on leveraged loans but the prestige money pools did as well, you will not lose your job. Fads and herding are real things. See, e.g. mortgage market 2000-2007. Jeremy Stein wrote about the career aspect of this mechanism in the 1980s. [1]
(2) Bailouts. People are aware they exist. Credit ratings agencies explicitly factor the likelihood of a bailout into credit ratings [2]. Creditors know they can hold a government hostage by threating to force a critical industry/company into bankruptcy. Sometimes they explicitly frame it as "bail me out or I put X critical company in bankruptcy" [3].
Also, please read about the leverage ratchet effect [4].
[1] https://scholar.harvard.edu/stein/publications/herd-behavior...
[2]https://www.moodys.com/researchdocumentcontentpage.aspx?doci...
[3] https://www.latimes.com/archives/la-xpm-2001-jan-16-mn-12864...
[4] https://www.gsb.stanford.edu/faculty-research/working-papers...
And predatory looting is mostly mythical. No one is going to give you large loans and allow you to loot the assets and walk away. The loans have lots of restrictions to prevent that.
What happens is that many PE firms like to use loans to leverage up their investments to increase returns. If you buy a company, fix it up and sell it for double in 7 years that’s a 100% return but only 10% a year. Borrow half the money at 7%, and now you only net a 75% return on the purchase price, but a 150% return on your investment, or 14% a year.
Try to borrow 80% and you can boost your returns nearly to 20% a year. Like a mortgage there is a natural tension between what lenders will lend you. They want to lend as much as possible, without assuming too much risk of default.
Sometimes the natural greed of the PE firm and the lender go to far, and you get a failed deal and a default.
Credit markets are appallingly inefficient at pricing risk. Lenders are aware of bailouts. They are explicitly factored into credit ratings! Leverage is heavily subsidized by the tax code. The current level of corporate leverage is absurd and has massive negative externalities.
I believe the public capital markets are often efficient, but not always. I have no doubt that credit markets are less efficient. How they are or aren't, and whether they reflect bailouts, is immaterial. Lenders have to make smart lending decisions or they will cease to exist as lenders, they have every incentive in the world to properly assess risks. The fact that some times some lenders do a poor job at it doesn't change that fact. The market, red in tooth and claw, will eventually chase down and devour dumb lenders.
It's true leverage was heavily subsidized by the tax code, the interest paid was subsidized about 40% when the federal corporate tax rate was 35% (plus whatever state corporate income tax you were subject to). Ironically when Trump signed the new tax cut bill, by cutting corporate rates he reduced that subsidy to only 25%.
The best solution for ending that subsidy is simple and hugely beneficial for everyone in our country. Stop taxing corporate income, and increase tax rates on dividends and capital gains to compensate. No longer would we be taxing reinvestment creating better jobs and raising productivity faster, and we could start taxing investors investment incomes in proportion to their incomes, restoring a lot more progressively to the tax code.
Debenhams (about to go bust this week) is a classic example - until 20yrs ago it owned it's premises, PE bought it, loaded it with debt and then split off the property into a separate company and signed the stores to ever increasing rents
Debenhams can't service the debt and the ever increasing rents (and they've lost their way as a business)
PE debt killed Toys r Us, and many other retailers in the UK too
PE leveraged buyouts are generally bad for everyone except the PE firm, and in some cases lenders
When you own a dying business, spinning off its properties makes perfect sense. Real estate has long term value the business no longer has. And of course rents rise over time, why would your real estate business subsidize the dying business with below market rates?
I don't know much specifically about Debenhams, but what often happens in situations like that goes like this super simplified example. An entrepreneur builds a successful business and eventually tires of getting up at 5 am or just wants to secure the massive wealth they've built. So they endeavor to sell what they built and shop it to interested parties, and the best price comes from a PE firm. That's good #1, because of the PE firm the entrepreneur was able to get the best price for their life's labor.
Lets say the business had annual sales of $100M, and profits of $4M, and the winning bid was $40M (10x earnings). But the PE firm knows that the firm owned all of it's buildings and paid no rent. Market rents would have been $2M a year, so the actual economic profit of the business was only $2M.
The PE firm doesn't want to tie up $40M, so it goes to a bank or a consortium of lenders to see how much they can borrow against the purchase value. Lenders not being stupid, won't let the PE firm spin out the properties into another company if they give a large loan, so the PE firm breaks up the company into two parts, real estate and stores, and gets loans for each.
The real estate arm now gets $2M in income every year from the stores at current market rents, so lenders loan it $15M at 8% interest, costing $1.2M a year in interest. The stores now have a $2M annual profit after paying rent, they also borrow $15M at 8%, and both subsidiaries net $800,000 a year after paying interest. The new owner, the PE firm, takes the $30M in loan proceeds, reducing their total investment to $10M, and they earn around $1.6M in annual dividends from the company, or a 16% return. If they hadn't leveraged up, they would have made $4M a year on $40M, only a 10% return.
Ten years pass. Rents in the areas of the store locations have doubled (a 7.2% annual increase) because those locations were so well selected by the founder to be in areas that saw a higher increase in population and traffic. Now the stores subsidiary has to pay $4M a year in rent. But the problem is store earnings haven't kept pace, sales have grown to $150M a year, but profits before rent and interest have only grown to $5M a year, because there is now also more competition from Walmart, Sprouts and Whole Foods.
Now they can't afford to keep up their interest payments, and the CEO of the stores subsidiary asks the PE firm to make the real estate subsidiary give them substantial discount on their rent, after all, the PE firm owns both of them, why favor the real estate subsidiary when the stores are at risk?
But the CEO of the real estate subsidiary argues the opposite. Their real estate is valuable, if the stores go out of business he can quickly rent their spaces to new tenants that will gladly pay full rents, and will diversify her portfolio of tenants to make her business more secure.
The partners at the PE firm by this point know full well what the real problem is. Despite the boom in population, the stores aren't reaping proportionate increase rewards because they simply can't. The founder was brilliant at buying real estate but that covered for flaws in the stores business model. Maybe they never had the necessary size to compete with bigger chains, maybe they were always poorly run, or maybe the PE firm dropped the ball in who they put in charge.
It doesn't matter what the cause is, in the end the PE firm lets the stores file for bankruptcy and surrenders it's ownership to the lenders. The lenders will fire sale the inventory to get as much of their loans back as possible, but still take a large loss.
But the real estate firm is now making $4M a year renting to new, stronger tenants in great locations, likely paying higher wages (good #2). The PE firm made around $15M in dividends from both subsidiaries before the stores went bankrupt, and at same time they sell their real estate firm for $40M (minus $15M in loans). So in the end their $10M earns a gain of $30M over ten years, despite the bankruptcy. That seems like a huge gain, but it's only an annualized return of somewhere between 15% and 20% a year depending on how dividends were paid. That's a very good return, but not a world beater.
The PE firm lost because the stores failed. If they had just maintained their original value so they could be sold for the $20M that they cost in the original purchase. Now their gains are $50M, and their annualized returns are above 20%. Very few PE firms go into deals like this planning for the main business to fail, and to make up for it with asset sales. It greatly reduces your long term returns or can even leave you with huge losses.
If the founder had never sold, the same problems likely occurred. Maybe he runs the stores better, but he would still have to deal with higher levels of competition, and finding good new locations would have gotten harder. Eventually he would have had to wonder whether splitting the business made sense, that he had a dynamite set of real estate properties being held back by struggling stores rapidly being overtaken by larger and better funded competition. The day the stores start losing money would be the day he would be forced to take drastic action similar to what a PE firm would do.
The amount of energy necessary to refute bullshit is an order of magnitude bigger than to produce it.
I knew it! Life is a scam!
The critical piece of information which is omitted is that the activities of the businesses through which money flows doesn't actually matter.
This becomes obvious when you consider that:
- All new money enters the economy as bank loans.
- The total amount of money in circulation in the economy always goes up every year as inflation (only some years it goes up faster than other years).
- The inflation rate is higher than the interest rate.
Clearly, the inflation rate is sufficient to cover the interest rate.
Think about it:
2% inflation rate means that the total money supply in existence increased by AT LEAST 2% over the cost of a year. If there was $1000 in the economy at the beginning, it means that at the end of the year, there would be $1020 in the economy.
Now imagine that you are a bank and at the beginning of the year, there is $1000 in total in the economy and you print $100 out of thin air and loan it out to people at 1% interest rate.
After you do that, the economy will have $1100 in circulation. $100 of this amount, people will have to pay back to you PLUS 1% interest rate per year.
Throughout the year, you make more loans into the economy such that the inflation ends u being 2%. So for that year, it means that you injected AT LEAST $20 of new money in the economy as loans.
OK o at the end of the year, your borrowers need to pay you back $10 in interest (for simplicity, we will assume that the minimum repayment is interest only). But remember, you (as the bank) injected $20 of new money into the economy that year... So if your borrowers managed to extract just half of that new money from the economy, they will be able to meet their loan repayment for that year and still make $10 profit on top!
Note that the borrowers don't need to work or deliver any real economic value in order to get their hands on that newly created money, they just need to setup some intermediaries to take out new loans each year then forward the money to them through any make-believe business activity. It does not matter if the intermediaries go bankrupt later; new intermediaries can constantly be created.
From the perspective of the borrower, intermediaries don't even have to be directly controlled by you. If they can be fooled or coerced into taking out loans from the bank and paying you at least $10 of what they borrowed - In an expansionary monetary environment, that's all you need to be profitable.
https://www.sec.gov/ix?doc=/Archives/edgar/data/70858/000007...
Read it and learn, maybe you'll better understand how banks work. They don't make money up out of the thin air. They can loan out only in proportion to what they have already. BOA is levered about 9 to 1, so they use around $11 from investors or retained earnings and $89 in deposits and loans from the fed or others to be able to loan out $100.
Now, they can create demand deposits to make new loans, but even then in proportion to their equity. Some of the Deposits liability is likely Demand Deposit line item created from loans, not sure how much. But it appears they support their loans with mostly customer deposits and invested funds.
The small banks were the ones printing money out of thin air. A lot of that newly printed money just happened to find its way back to the big banks due to corporate centralization of capital but it wasn't enough.
You can't understand how the financial system works just by looking at the biggest banks... You have to look at all the banks in aggregate and see how the new money flows into the system.
The fact is that new money which was printed and loaned out of thin air enters the financial system faster than interest accrues on all the old loans which were themselves printed out of thin air at an earlier date.
If you're a central bank and you created your own unique currency out of nothing (which is precisely what they did) and loaned 100 units of it to some people at 10% interest over a 1 year term... How will they be able to repay you back 110 units of the same currency considering that there are only 100 units in existence? Not possible. The only way it can happen is if you keep constantly injecting new loans into the system and the credit from the new loans ends up paying for the debt and interest of the old loans.
But here's an unrolled version: https://threadreaderapp.com/thread/1246445485860118528.html