Statistically, private equity ownership carries an increased risk of failure. PE portfolio corporations are about ten times more more likely to go bankrupt than non-PE-owned corporations. Granted, one in five corporations going bankrupt doesn’t robotically mean failure, nevertheless it’s a scary statistic. The rejoinder, after all, is that PE firms deal with struggling corporations, a practice that lowers their success rate.
But to grasp what private equity is at its worst, we want to get personally and professionally energetic. We need to watch the precise 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 amass portfolio corporations. And they aim to show a profit inside just a few years.
He emphasized the impact of personal equity on the U.S. economy, stating that the leading private equity firms collectively employ hundreds of thousands of individuals of their portfolio corporations. 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 corporations, job losses, and negative impacts on industries akin to retail and healthcare. He cited three primary reasons: private equity firms’ short-term investment horizons, their heavy reliance on leverage and charges, 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 corporations, 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 corporations 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 might be, especially if the owner only wants to take a position within the business for just a few years. If you could have a long-term view of a business, a sale-leaseback could make sense.
However, a personal equity firm might buy the business and operate it primarily to maximise short-term value reasonably than ensure a great real estate situation for years to return. 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 just a few years. Through some contractual arrangements, it might probably have significant control over the corporate despite a small equity stake (1% to 2%). This often ends in 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 sensible for the PE firm, but leaves the corporate with debt that it could not have the option 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 basic issues we discussed earlier. PE firms have operational control over their corporations, 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 akin to sale-leasebacks, roll-ups, and dividend recapitalizations could also be appropriate for a lot of corporations 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 provide you with 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 considering.
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’s important to grasp 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 akin 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 various 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 purported to work. We ideally need a level playing field where everyone competes fairly, not one where those with the correct 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 big investment banks became bank holding corporations 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 corporations became more stringent, making it harder to lift money in public markets. It is now easier to lift money in private markets. As a result, there are about half as many publicly traded corporations 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 dearth 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 it is a future crisis, but I even have spoken to individuals who share this fear and it’s actually an area to look at 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 conventional 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 considering. To improve the economy and make it work higher for everybody, we should always encourage corporations and investors to take long-term perspectives and accept responsibility for his or her actions. While this shouldn’t be 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 corporations 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 realize 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 consequently, states could hold them answerable for financial losses. This is consistent with the principle that call makers ought to be accountable for his or her actions, and that is how corporate law is designed to work.
