Given that the leveraged buyout firms of the 1980s became know as corporate raiders, was this business practice ever a good idea? The industry would soon adopt the sterile financial moniker “Private Equity” (PE) and roll in through the decades simultaneously elevating its financial engineering techniques and strengthening its brand as a necessary actor in a capitalist market.
My First Brush with Private Equity
As an employee, I was subjected to a private equity takeover. When the company made the announcement, they chose to ask the employees to meet in two separate groups at the same time. My group was asked to join a meeting in a small tented venue nearby. They kept us waiting a bit, and then they came in. While I had very little understanding of what was transpiring, I could feel the cold arctic winds preceding these three strangers in suits. Later I found out, the other larger group was let go. We were the lucky ones, or were we?
What ensued in the meeting was surreal. The main PE bro, albeit a late fifties bro, took the floor and began a Wolf of Wall Street-esque diatribe. He expounded on how great he was and how foolish the current CEO was. The current CEO was a mission-driven man beloved by the employees who was asked to sit in the front row by design. The sheer nerve of the PE bro to communicate this way became even more surreal by the catastrophic blunders the PE firm was able to achieve in the months ahead. Yet I now realize this creep almost certainly extracted a small sum for himself before sucking the company dry.
Don’t Let the Name Fool You
PE firms have traditionally been quick to brag about acquisitions in tech, but they are more careful sharing their involvement in other industries. In fact, PE has gotten such a bad rap that it’s a wonder any of them still associate themselves with the term private equity. Many of the largest PE firms refer to themselves in other ways such as __ and even hedge funds. I totally get why they are not owning up to who they are. In fact, it astounds me that other firms or individuals proudly speak of themselves as PE companies, executives or employees. Perhaps they feel their firm is different, or perhaps they are tied to their other reputation for being exclusive and making big salaries and bonuses. Perhaps they are more proud, status-driven or twisted than they are interested in adding any real value to the economy.
Private Equity Hallmarks of Value Destruction / Financial Engineering
In the paragraphs that follow, I summarize what I have learned from the book Plunder by Brendan Ballou. I highly recommend the book for its revelation of the PE industry’s impact on all of us. Ballou provides a plethora of mind-blowing examples as well as suggestions for fixing the problems created by the industry, pervasive problems that worsen the lives of average citizens more than most of us realize. Pay attention to the following tactics so you can identify what is really going on when PE firms, or whatever they choose to call themselves, employ them.
While many of them try to avoid the bad rap by disassociating with the industry, the majority of the American public is not even aware of them. It is important for business people, students, employees, politicians who are not bought, and anyone that cares about how business is done in the US, or the US reputation for leadership, capitalism, and entrepreneurship, to understand the reality of private equity.
1. Real Estate
Private equity firms force the target to sell their underlying real estate resulting in two major benefits to the PE firm.
- Instant profit from the sale to a third party. The profit goes to the PE firm, not the underlying business. This is simply value destruction or value transfer depending on how you look at it.
- Transaction fees to the PE firm for handling the sale
This causes a negative situation for the underlying business.
- No more real estate assets to buffer or borrow against during recessions or downturns
- Rent increases from below market or” zero net rent” (paid to itself when it was an independent company)
- Decrease in facility related investments and improvements by the PE firm resulting in a less desirable operating environment for the target company and potential additional strain as the target lays out its own cash for critical maintenance and repairs
Many profitable firms that own a lot of real estate may have more value tied to the real estate than to the business itself. Even ailing firms can be acquisition targets if they have considerable real estate assets. This is a gold mine for PE acquirers who extract real estate value, thus having little concern for the health of the business other than to continue extraction until a worthless shell is all that remains. No value is created by the PE firm for anyone but themselves. This is simple financial engineering.
Who would buy real estate where the tenant, the PE target, is under financial hardship? The answer is that real estate is valuable regardless of temporary tenant issues, so if the tenant goes under, the new landlord can eventually find a new tenant. In fact, the buyer is typically a real estate investor which could be, wait for it …, a real estate focused PE firm.
2. Dividend Recaps
Private Equity firms primarily use other money to acquire their targets. This includes pension funds, and wealthy individuals, as well as considerable leverage via loans from banks. The PE firm will invest a small amount in the acquisition, but already has a plan to get back its investment quickly and eliminate all risk. This is where a dividend recap comes in. It is a requirement for the target company to borrow yet more money in order to pay the PE firm a dividend.
Who would lend for the purpose of dividend recap? Lenders are financial engineers in their own way. They will charge higher interest for higher risk loans. Ultimately, they have done their risk-reward calculations that enable them to make the loan. The entity that is harmed by their high interest rates is the PE owned business. The PE firm itself is not harmed because they have taken back their own small investment in the business without giving up any ownership.
Lending at high rates is financial engineering child’s play. There are many layers to PE firms’ financial engineering prowess. Financial engineering is often the PE firm’s only skill.
3. Management Fees
PE firms charge high sums often north of $1M to the host company simply for the privilege of being managed by the PE firm.
4. Tax Avoidance
PE firms typically charge 2-and-20. This is a 2% management fee on all the money it invests and 20% of the profits above a certain threshold. While profits are supposed to be taxed at a higher rate than capital gains, the PE industry has successfully worked their magic to put their 20% profit in the capital gains bucket, enabling them to pay lower taxes than the firms they own and the employees those firms employ, many who live paycheck to paycheck. Furthermore, they have successfully pushed the 2% management fees into the capital gains bucket despite the fact that it is really earned income by all accounts.
Many PE firms shelter money offshore, paying lower taxes to a foreign country rather than higher taxes to its home country. Yet with all their financial engineering and tax avoidance “skills,” several high profile PE firm owners have managed to outright break the law through tax evasion.
5. Strategic Bankruptcies
The Pension Benefit Guaranty Corporation (PBGC) is a federal agency created by the Employee Retirement Income Security Act of 1974 (ERISA) to protect workers’ pension benefits. It is financed by general taxpayer funds from average citizens like you and me. It is easy pickings for PE firms who let the PBGC and taxpayers foot the bill for PE’s engineering bankruptcies. PE firms shift responsibility of pension obligations from themselves to the PBGC through the bankruptcy process.
In bankruptcy cases like these, the PBGC only protects a portion of pension obligations. Furthermore, companies often have separate pension plans for warehouse workers, store employees, and executives. These different pensions have different structures and fine print, and may benefit or be harmed differently in various situations including bankruptcies.
6. Forced Partnerships
Private equity firms can force portfolio companies into arrangements with other companies in its portfolio in order to maximize the PE firms overall benefit from the portfolio. For example, a company may be required to source goods or inventory from another portfolio company. How does this benefit a PE firm that owns both companies? This can be detrimental to the company being forced into the relationship and beneficial to the other company. The PE firms equity ownership interest in the two companies may be designed to benefit from this arrangement. If the PE firm’s invested capital in the company being harmed is small or has already been recovered and the sole remaining usefulness lies in whatever remaining value that can be extracted, while the interest in the other company is to prop up its earnings and business valuation for an eventual exit, then the PE firm can mastermind a double-win by using each company in a unique way.
7. Minority Stake
PE firms have ways to slip their stealthy tentacles into their targets with minority stakes in exchange for a forced partnership with one of its portfolio companies. This seemingly win-win deal turns south for the target company when the forced relationship is levered to the full advantage of the PE firm and the other portfolio company. The target company may then be forced to sell the balance of its company to the PE firm. Target companies sometimes argue this case in court to no avail because of the PE firms “skill” advantage. The playing field is not level as this is the domain of the PE firms while target companies are only sophisticated enough to operate their businesses, deliver products and services, provide value and collect modest profits for their efforts..
8. Rollups
By taking over large swaths of industries, PE firms can control and profit from, if not devastate, entire industries and the customers they serve. This is especially onerous and offensive in health care or other industries where the health and welfare of average individuals, often marginalized or elderly, are being forsaken. Rollups involve the acquisition of multiple companies in an industry. Sometimes the initial target is a larger “platform” company and subsequent acquisitions known as “bolt-ons” are added to provide leverage and scale. PE firms make money in at least three ways using this strategy.
- The value of larger entities is greater as a multiple of profits than the value of smaller companies. Simply through acquisition with no value add, PE firms can increase the value of the combined entity relative to the sum of these stand alone entities. While the owner who sold out may benefit, employees do not participate in this “value creation.”
- Greater industry power means greater buying power, industry influence, political influence, and ultimately monopoly power.
- Greater industry domination results in fewer choices and opportunities for employees and consumers, enabling PE firms and their portfolio companies to reduce costs, lower quality of products, service, or care.
Operational Efficiencies (Not a Thing)
The promise of operational efficiencies created by PE firms is still promoted by the industry. It helps young aspiring executives justify participation in the industry and speak proudly in circles that might care. The reality can be quite the opposite. While much of the financial engineering “skills” previously mentioned are diabolically next level, the operational skills of PE firms range from laughable to horrifying. Layoffs, benefits reduction, price hikes and cost cutting, all made easier with rollups and industry dominance, hardly wreak of finesse. PE firms buy product companies, yet can’t spell SKU.
In my personal experience, I’ve seen promotions from within the very few employees able to or willing to or allowed to stay. They are given nice titles, but very little true benefit in areas of pay, benefits, work hours and duties. Career development is not a topic, although these employees may feel that their lofty new title has value on their resume’. These employees may be asked to carry out messy work such as layoffs, or increase their work output thus effectively lowering their wage. Ballou highlights the outrageous impacts of PE’s heartless tactics, including families broken and bodies piling up.
Warning Signs of Private Equity Meddling
When my experience as a customer sets off negative alarm bells, my mind goes to private equity as the culprit. This is because of a prior experience, a time when I called for an internet service for my business. After reading the business’s great reviews, but then having a few poor experiences with customer service, I found out that the tech company had been acquired by private equity. Luckily for me, private equity has not affected the health or livelihood of me or my family, but I fully realize I could be next, you could be next, and past victims could be next again.
Recently I called my doctor’s office to ask the doctor to send a prescription for an allergy medication to the pharmacy. This is a medication that , despite requiring a prescription, many doctors have told me has no side effects. The receptionist asked me for my birthdate before I was done saying hello. She then told me the doctor needed to see me since it had been a year. I told her I never needed an appointment for a refill. Because her behavior stood out as different and unfriendly, it dawned on me to research whether or not this medical group was taken over by private equity. You can imagine what I found.
Are There any Private Equity Firms that Do Good?
For example, what about PE firms that invest in real estate? Surely it couldn’t hurt to have more money available to invest in real estate and provide additional liquidity in real estate markets? Well not so fast. Some real estate PE firms are direct beneficiaries of, or related to, the very PE firms that strip real estate assets from large retailers as described earlier. Real estate PE firms are profit-oriented, and while they may not completely suck out all the value of real estate in the way they can from businesses, they will still keep costs down and minimize investment, often to the detriment of the working class inhabitants and tenants in their buildings.
To answer this question and find examples of PE firms that do good, it is important to understand the major business model characteristics of destructive private equity firms. In general, the industry, if not completely bad, has a poor track record. One in five leveraged buyout firms goes bankrupt within ten years compared to 2 percent of comparable companies not acquired by PE. The key flaws in the model include:
- Short term horizon
- Load the company with debt
- Extract value vs add value
- Insulate themselves from risk, so that risk can be taken with the target company to maximize extraction
PE firms that do well may operate without one or more of these four flaws, yet still be classified as private equity simply by the nature of operating in the private company realm (private) and owning the company (equity). If a private equity firm does not use debt to acquire a company or has a long term view, potentially even continuing to own a minority share after an exit, it is more likely to give the underlying company a chance of success.
The following passages taken from a Harvard Business Review article indicate that there is inherent good in the industry and the PE firms can produce valuable outcomes.
Private equity. The very term continues to evoke admiration, envy, …
…
Private equity firms’ reputation for dramatically increasing the value of their investments has helped fuel this growth.
…
Such an opportunity most often arises when a business hasn’t been aggressively managed and so is underperforming.
…
For one thing, because all businesses in a private equity portfolio will soon be sold, they remain in the spotlight and under constant pressure to perform.
…
Finally, the relatively rapid turnover of businesses required by the limited life of a fund means that private equity firms gain know-how fast.
HBR Magazine september 2007
The above passages are from an HBR article written in 2007. Could it be that the industry has changed significantly for the worse since then? Arguably there were problems with the industry back then simply due to the fact that short term incentives always existed from the inception of the industry. The excerpt below is from an article around the same time.
Overstated private equity performance may partially explain why investors continue to allocate substantial capital to this asset class, despite our finding (forthcoming in the Review of Financial Studies) that PE funds have historically underperformed broad public market indexes by about 3% per year on average.
HBR December 2007
In reviewing articles published by HBR within the past 5 years, there is an incredible amount of defense of the industry. But why do the titles of so many of these articles signal problems with the industry and then the articles proceed to downplay negative headlines?
HBR content focuses on the craft of business management and these articles spend considerable time on how managers in the industry can improve business practices and perform better. But these articles often do so in ways that make the reader feel that while PE firms can do better, the industry is fine. With a positive tone, it shows how managers and policy makers can effect change. The articles no doubt lead young aspiring business leaders to believe they have a viable path to a noble profession in private equity. This soft-handed approach leads amateur skeptics (such as yours truly) to wonder who is writing these articles and what is their past or current link to the industry.
Are there Solutions to the Private Equity Problem?
Business schools and their professors should denounce value destroying private equity practices – the 4 evil pillars of the business model described above – to students, other professors and staff, and the public. Institutions of higher learning need to be strong enough in their principles, leadership and finances to denounce and reject investment from PE firms and influence from PE executives and alumni. Of course this is wishful thinking.
My nephew attended a summer orientation for students accepted to a prestigious Ivy League school. He made a comment about how many students he met that intended to major in math or business, have a career in private equity, make a ton of money, and then go into academia. While youth may make them somewhat innocent to the lack of ethics and value destruction of most PE firms, I still believe they question the purpose of these firms. Perhaps the clue is that they plan to retreat from private equity to academia. Transitioning to a more noble and less controversial profession in the end helps them justify their choice to make a deal with the devil earlier in their career. They may not think about how their promising young minds will be converted and forever beholden to the industry that lined their pockets.
The private equity system is set up to incentivize bad behavior including attracting a never-ending pool of talent with high salaries and misguided prestige. Private equity prides itself on grooming highly educated employees in next-level financial engineering (not their term). But is it rocket science, or just simple math from pirates who are better at gaming the system than creating value? Do these pirates have skills other than basic math and chess master system gaming?
I do not absolve these students from blame, especially since they are supposed to be the best and the brightest. Yet they are merely operating in a system that incentivizes them in compelling ways, and is not illegal. If these students make a lot of money in private equity and then become professors or university donors, they will only serve to ensure that private equity is an attractive option for future students and professors.
Change can be difficult. Ballou spotlights several people making an impact in various ways. These are encouraging stories, but I don’t know if they will be enough. Some of the more shrewd PE firms target industries that affect low income people or prisoners, groups with little power, voice or empathy from the rest of society. Yet other PE firms target health care and pets, exposing them to potential PR nightmares. They march on in their supreme arrogance, betting on riches landing well before they or their industry is called out in a significant way. Surprisingly, they have a track record of prevailing in these industries despite the protests, negative PR and lawsuits against them.
How Can Value Destruction Exist in the US Capitalist System?
When you think about how PE firms plunder, to use Ballou’s term, something doesn’t add up.
- How did/does the owner who sold to the PE firm benefit from this?
- How do those who invested with the PE firm benefit from this?
- How do politicians let this go on?
- How do professors not warn finance students about the industry?
- How do PE firms keep going after decades of destruction?
- Why are lawsuits against PE firms not making a large impact?
The answer is revealed when you follow the money. The money, or value, transfers from an often healthy company to the PE firm and its ecosystem which includes all of the parties listed above. Survival requires PE firms to be acutely aware of the possible forces against them and skillfully transfer more value from their target companies to those who would otherwise be against them, including all of the parties listed above.
- circumvent state requirements for medical practices to be run by doctors by finding doctors who value financial incentives over obligations to patients
- making it very expensive and time-consuming for litigators to pursue guilty verdicts over settlements, thus preventing case law to accumulate against them
- masterminding a financial model so lucrative that even a few lost legal cases are merely a cost of doing business
- fuel a number of legal scholars who argue against anti-trust laws by funding, and thereby influeicning, institutions such as the Law and Economics Center which holds annual conferences for federal judges with programs that spread a conservative view on anti-trust
While Ballou offers some hope for change, the fight against PE is a fight against greed that is significantly more widespread than the PE firms themselves. Greed is part of human nature, and the fight against PE is a fight against a powerful force of nature.
Private Equity Will Become Too Big to Fail
Just as the investment banks of the Great Recession were too big to fail, this is becoming a possibility for the private equity behemoths, osme of which are appraoching $1 trillion i assets under management. Leading up to the Mortgage Meltdown and the Great Recession, investment banks like Goldman Sachs and JP Morgan were behind the securitization of mortgages, They capitalized on the high demand from all over the workd for investments backed by U.S. real estate. As real estate crumbled, the US government made sure these investment banks did not fail. They bailed them out with our taxpayer funds. Tremendous scrutiny and regulation came down on the investment banking community that curbed their behaviour, albeit too late.
However, the people and the methods from that painful episode found a way to live on through private equity, which did not come under the same scrutiny. Today, private equity firms are much larger and more diversified in the financial tricks used by investment banks which are now restricted. CEOs of private equity firms now make ten times the CEOs of investment banks. Investment banking jobs and salaries were stifled after the Great Recession, in part due to restrictions on the banks from operating the way they had before. Conversely, salaries at PE firms have grown significantly. This is just another indication of how much value they can find to extract.
However, there is a limit to the funds avaiable for private equity to grow. This forced them to look elsewhere, and successfully maneuver their way into pools of insurance money and 401K retirement funds, putting average citizens life insurance benefits and retirement funds at risk.
Conclusion: The Private Equity Industry is Designed for Maximum Value Extraction.
Why would a PE firm need to do anything else but simply orchestrate mergers and simplye benefit from acquisition fees and a larger combined value for the larger company than the sum of each small company? Or why not take it to the next step and find true efficiencies and synergies, thus adding more value to the larger firm they have merged?The answer to the second question is incompetence. They simply lack the skills to do better than previous executives and their employees. The answer to the first question is greed.
The PE-owned business is not an investment where the investor is necessarily incentivized to grow, to employ, or to add value to society at large. Rather than make the target company flourish, the PE firms strengthen themselves using the target company as prey. They are like parasites that transfer value from attractive targets / host companies, masterfully navigating the bountiful ecosystem that enables their acquisition, transferring decades of value built by previous employees into their own small and closed ecosystem.
They have a short term outlook and “risk” the host company’s existence, in order to maximize their gains. They take the place of employees and customers as the beneficiaries of the company. Private equity firms often target industries that employ low income workers and serve low to middle income customers. As more light is shed on their atrocities, PE firms become increasingly shrewd in selecting their targets, as any persistent virus would do to mutate and perpetuate itself.
Why stop with one or two potentially positive tactics when there is a whole bag of tricks to employ on a healthy living host that has so much more to give? The PE firm will not stop until a hollow, faceless and soul-less entity has been fully exploited. Arguably, PE firms are more detrimental to average citizens – employees and small business owners – and have a far more pervasive effect than street gangs and organized crime syndicates. The PE ecosystem, including politicians, financiers and the owners who sold out, are the beneficiaries.
Final Note
Here is an excerpt from a Forbes magazine issue. If you think Blackstone got their asses handed to them on this deal, please re-read this article from the top. If you think Blackstone will be fine because they only need a few home runs to make up for many losers, you have missed the point.
Armed with a doctorate in psychology, Granpeesheh founded the Center for Autism and Related Disorders (CARD), an autism treatment firm, in 1990. Blackstone bought a majority of it from her in 2018 in a deal that valued the company at $600 million; as part of the deal, she got an estimated $315 million in cash (pretax) and reinvested another $135 million. She stepped down as CEO in 2019 and left the board in 2022 over disagreements with its new leadership. Since the acquisition, CARD has stopped operating in 19 states but still has 130 centers in 14 states; it is reportedly in talks to be sold for about $80 million.
Forbes magazine special issue, america’s richest self-made women, page 78
These PE firms fatten themselves every single time. It’s quite possible that PE firms get fatter when their target company trades for less, not more, after they’re done with them. Elevating the value of the target company is not the goal. PE firms don’t have the skills or interest to build value the old-fashioned way. Their skill lies in identifying fat targets and maneuvering the system to “transfer” value, i.e. suck them dry. That is how they measure success.
In the same issue, other mentions of private equity include:
- 21. Kim Kardashian: Her private equity firm, SKKY Partners, headed by a former Carlyle Group exec, is reportedly trying to raise $1 billion fund to invest inconsumer and media companies.
- 54. Pamela M. Lopker: In late 2021 private equity firm Thomas Bravo bought QAD for $2 billion.
- 64. Katie Rodan: Private Equity Firm TPG , which spent $1 billion to buy Rodan + Fields in 2018, increased its stake to a majority in late 2022.
- 66. Huda Kattan: Private equity firm TSG Consumer Partners acquired a minority stake in a 2017 deal valuing the business at $1.2 billion; it likely wouldn’t fetch that much these days…
- 68. Susan Wagner: Wagner is one of eight cofounds of the investment behmeoth BlackRock, which has $8.6 trillion in assets under management… She also sits on the boards of Applle, Massachusetts’ Wellesley College, and software firm Samsara.
- 87. Ruth Porat: A Wall Street veteran, she has servied on Blackstone’s board since 2020.
- 99. Cordia Harrington: She sold a controllingn stake to private equity firm Arbor Investments in 2019 but remains CEO f the company…
This shows the involvement of some of the wealthiest individuals who have made their money in private equity or more commonly selling out to private equity. Many of the wealthy individuals mentioned in the article have yet to sell thier companies, but private equity will be a likely buyer for many of them. April Anthony’s (34) company Encompass Health recently spun out a business unit that might fetch $3 billion from private equity firms. Still others have undoubtedly sold out to firms under private equity control. These wealthy private equity operators and entrepreneur sellouts have considerable influence on business boards, academia and financial investment firms, all of which help to keep private equity insulated and trhiving. Is it possible some of them become enlightened down the road and turn against the industry? Human nature tells us it is far easier to be quiet, if not greedy, then to become a hippocrate.