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What is Private Equity Good For?
From the London Guardian:
More than half the profits generated by private equity firms in recent years have been made by piling debt onto the companies they invest in, according to a report published today.
The findings of the first annual report on the industry, designed to increase transparency and improve the image of private equity, instead provided further ammunition for the industry's critics.
The analysis by accounting firm Ernst & Young claims that just one fifth of returns achieved come from strategic and operational improvements.
Is it reasonable to expect that these ratios would be about the same for U.S. private equity firms?
ehboy,
Thanks for the insights. My question wasn't rhetorical, and I'm genuinely curious about how concerned we should be by the report's findings. Here's what private equity critics say about the report in the Guardian:
"Paul Kenny, general secretary of the GMB union and a vocal opponent of private equity, said the findings were of concern. He said the levels of debt had become a "source of dangerous instability" and that "drastic reductions" were needed. "Most of the excess borrowing has been undertaken by banks and private equity companies ? and not by households and non-financial companies," he said.
"The private equity industry boasts that it is often able to run firms more efficiently than incumbent management. Critics have argued instead that the high returns for the industry are a matter of financial engineering ? by raising large levels of debt to do deals and piling it on to the balance sheets of companies they invest in, leaving them more exposed in a downturn."
Josh,
I am a little confused as to your question. Are you asking one or are you making a rhetorical question as a way of calling into question the practices of the industry?
For the record, the article bits you've posted (written in England-ese) read a bit misleading to an American public. PE firms don't make money on the loans themselves, they use the loans to scale the returns they create.
In short, if you buy a $100M company but only pay $25M for it (borrow the rest), and then grow the company by 10%, you will make much more than 10% on your investment, as you will capture almost all of the $10M increase in company value while still having only paid $25M or so in up front capital.
It is safe to assume that US PE firms use leverage to increase returns. They may do so even more than in the UK, to be perfectly honest. I just don't see what's the issue there.
ehboy,
Thanks for the insights. My question wasn't rhetorical, and I'm genuinely curious about how concerned we should be by the report's findings. Here's what private equity critics say about the report in the Guardian:
"Paul Kenny, general secretary of the GMB union and a vocal opponent of private equity, said the findings were of concern. He said the levels of debt had become a "source of dangerous instability" and that "drastic reductions" were needed. "Most of the excess borrowing has been undertaken by banks and private equity companies and not by households and non-financial companies," he said.
"The private equity industry boasts that it is often able to run firms more efficiently than incumbent management. Critics have argued instead that the high returns for the industry are a matter of financial engineering by raising large levels of debt to do deals and piling it on to the balance sheets of companies they invest in, leaving them more exposed in a downturn."
The issue is when PE firms use the debt of the purchased entities to fund "profits" of the PE, by transferring cash from the purchased entity to the PE, leaving the purchased entity to the bankruptcy courts.
Take for example, Mervyns, which went into bankruptcy and now all of its stores are closing or closed.
Mervyns is suing Sun Capital and Cerberus for pushing it into bankruptcy with its sale-leaseback-driven LBO.
Basically the stores sat on valuable real estate. The real estate was sold to the investors, who then leased the stores back to Mervyns at much higher rates, making Mervyn's insolvent.
Over a hundred stores closed, thousands of employees out of jobs - all because the vulture investors were after quick money.
There are certainly cases where firms come off as predatory, but I'd like to think that the industry adds more value than it creates. A lot of everday companies (Toys R Us, Hertz, among others) have come out of a buyout stronger than they went in. In cases where the goal is to improve an operating company (which would be unlike the Mervyn's example), the BO firm is indeed aligning their interests with the interest of the company. In those cases (which are the bulk of examples), what's good for one is good for the other.
Paul, as for the Mervyn's case... I realize it's going to be easy to excoriate me for this... I don't have a huge problem with that. If a company is paying less than market value for rents, then it's the right of the property management company to charge higher rent. Charging market price = Capitalism. Sometimes there is pain, but that's the price you pay. Who knows if the next tenant on that real estate will actually employ more people and/or add more value to the system?
No, Mervyn's owned its own real estate. The vultures obtained financing based on that fact and took over, then made Mervyn's sell the land to themselves, then leased it back to Mervyn's at higher rates.