Statistically, private equity ownership carries an increased risk of failure. PE portfolio firms are about ten times more prone to go bankrupt than non-PE-owned firms. Granted, one in five firms going bankrupt doesn’t mechanically mean failure, nevertheless it’s a scary statistic. The rejoinder, after all, is that PE firms deal with struggling firms, a practice that lowers their success rate.
But to know what private equity is at its worst, we’d like to get personally and professionally energetic. We need to observe the particular and repetitive activities that profit the operators and nobody else.
During our discussion, Ballou focused on leveraged buyouts (LBOs). PE firms typically invest a small portion of their very own money, a significant slice of investors’ money, and borrowed funds to accumulate portfolio firms. And they aim to show a profit inside a number of years.
He emphasized the impact of personal equity on the U.S. economy, mentioning that the leading private equity firms collectively employ tens of millions of individuals of their portfolio firms. Despite their significant presence, their activities remain largely unknown to the general public.
Ballou highlighted several negative consequences that include private equity ownership, including the next likelihood of bankruptcies for portfolio firms, job losses, and negative impacts on industries comparable to retail and healthcare. He cited three predominant reasons: private equity firms’ short-term investment horizons, their heavy reliance on leverage and costs, and their insulation from legal consequences.
He presented two case studies to point out how private equity firms can use financial engineering to their very own advantage, harming firms, employees and customers in the method. There are ways to mitigate the negative impacts of personal equity, he stressed, and argued for regulatory changes to align sponsors’ activities with the long-term health of firms and communities.
Slightly edited excerpts from our conversation
Brendan Ballou:
It’s hard to decide on only one or two. Sale-leasebacks, for instance, aren’t necessarily problematic, but often may be, especially if the owner only wants to speculate within the business for a number of years. If you’ve a long-term view of a business, a sale-leaseback could make sense.
However, a non-public equity firm might buy the business and operate it primarily to maximise short-term value quite than ensure a great real estate situation for years to come back. This was shown very vividly within the acquisition of Shopko, a regional retailer like Walmart. The private equity firm did a sale-leaseback and locked Shopko into 15-year leases. In retail, owning real estate is beneficial due to its cyclical nature, and it’s helpful to have assets to borrow against. The private equity firm took those assets away from Shopko.
The second example is dividend recapitalizations. The basic concept is that the portfolio company borrows money to pay the PE firm a dividend. The challenge is that a PE firm may only put money into the corporate for a number of years. Through some contractual arrangements, it will probably have significant control over the corporate despite a small equity stake (1% to 2%). This often leads to the PE firm doing a dividend recapitalization, instructing the corporate to borrow money and repay the acquisition costs. This way, the PE firm takes the burden off the acquisition and turns subsequent revenue into pure profit. This approach is smart for the PE firm, but leaves the corporate with debt that it might not have the ability to administer.
These examples show that misalignments in PE acquisitions often result in problems and controversy.
This might be a really justified criticism. it goes back to the elemental issues we discussed earlier. PE firms have operational control over their firms, but often have little or no financial or legal liability. This signifies that PE firms can reap all the advantages when things are going well at an organization, and sometimes even profit when things are going poorly. However, when things are going poorly, there are often only very minor consequences for the PE firms.
Tactics comparable to sale-leasebacks, roll-ups, and dividend recapitalizations could also be appropriate for a lot of firms under different circumstances. But whenever you mix these tactics with a business model that operates on a “heads I win, tails you lose” basis, the result is commonly, perhaps more often than not, destructive for everybody involved except the PE sponsors.
?
Absolutely. First, I often say that lawyers within the United States give you a problematic business model about every 20 years. Currently, I might say it’s leveraged buyouts. Twenty years ago, it was subprime loans. Forty years ago, it was savings banks. Sixty years ago, conglomerates. 100 years ago, trusts. We can simply create laws and regulations that encourage short-term, extractive pondering.
To be clear, I consider myself a capitalist. However, our laws and regulations can and sometimes do channel these positive energies into destructive outcomes.
Second, it will be important to know that personal equity firms are sometimes successful not because their leaders are operational or engineering experts, but because they’re expert in legal and financial engineering, in addition to lobbying. They are successful in highly regulated industries where effective lobbying can produce desired results. In the United States, private equity firms have develop into energetic in sectors comparable to municipal water supply, prison telephone service, and various parts of the health care system that receive significant funding from Medicare.
Their effectiveness in these areas is due partially to the hiring of key former government officials, including Speaker of the House, Secretary of the Treasury, Secretary of State, Secretary of Defense, a Vice President, and diverse Senators and Members of Congress. These individuals now work for personal equity firms, helping those firms achieve their goals in highly regulated industries.
That’s not how capitalism is imagined to work. We ideally desire a level playing field where everyone competes fairly, not one where those with the appropriate connections can shape regulation to their advantage.
In the United States, private lending has grown for several reasons. One is that after the Great Recession, the massive investment banks became bank holding firms regulated by the Federal Reserve, which imposed higher capital and regulatory requirements. This led to a shift in financial activity from the investment banks to non-public equity firms, which then expanded their private lending offerings outside of the general public markets.
At the identical time, regulations on publicly traded firms became more stringent, making it harder to boost money in public markets. It is now easier to boost money in private markets. As a result, there are about half as many publicly traded firms within the United States today as there have been 10 to fifteen years ago, which has fundamentally modified the way in which money is raised and spent.
My biggest concern with private credit is the shortage of transparency. The industry is opaque, which makes oversight difficult. Some firms within the private credit sector depend on lesser-known credit standing agencies to secure AAA or investment grade rankings. This is comparable to the issues of the 2007-2008 financial crisis, although to a lesser extent. The fundamental problems of secrecy and lack of transparency are similar.
I’m not a financial expert so I cannot say definitively whether this can be a future crisis, but I actually have spoken to individuals who share this fear and it’s actually an area to observe closely.
The largest private equity firms now call themselves alternative asset managers, with leveraged buyouts only a portion of their business. It is interesting to see how rising rates of interest and challenges within the business real estate sector are putting pressure on these firms. Whether this pressure is just a part of the traditional economic cycle or points to something more systemic will develop into clear in the approaching years.
Although my work is primarily focused on the United States, I can still offer some general advice. There are several US organizations that take care of these issues that you simply might find helpful to learn and stay informed. I like to recommend subscribing to newsletters from groups like Americans for financial reformThe American Economic Freedom Projectand that Private equity stakeholder project.
As professionals, we must recognize that existing legal and regulatory frameworks can sometimes encourage short-term, extractive pondering. To improve the economy and make it work higher for everybody, we should always encourage firms and investors to take long-term perspectives and accept responsibility for his or her actions. While this isn’t at all times feasible, encouraging a long-term perspective can actually help.
Whether I prefer it or not, it seems inevitable. BookI’ve described private equity as something that may reshape the economy this decade, just as big tech firms did last decade and subprime lenders did the last decade before that. Private equity is indeed a transformative force within the economy. Its growth should come as no surprise. That same capital can profit the economy whether it is used more productively or if PE firms take more responsibility and think long term.
But concerted motion is required to attain this. Change will come through regulatory efforts. State and native legislators and regulators must act. For example, states like New York, California, or Minnesota could impose requirements on private equity firms operating of their jurisdictions. If firms engage in a sale-leaseback, dividend recapitalization, or roll-up transaction and jobs are lost in consequence, states could hold them accountable for financial losses. This is consistent with the principle that call makers must be accountable for his or her actions, and that is how corporate law is designed to work.
