This from The Wall Street Journal’s Overheard on the Street is the stat of the day (okay, it ran yesterday):
Nearly half the 163 U.S. nonfinancial companies that defaulted last year were backed by private equity.
Now I don’t have a number for how many U.S. nonfinancial companies overall are backed by private equity, but you can bet it’s nowhere near half. This disproportionate failure isn’t because private-equity companies are really bad at picking investments. It’s because they levered up their acquisitions with cheap debt to goose their returns, and now these companies, who employ (or employed) lots of people, can’t meet their debt service, much less invest in the business. That’s helping choke the economy.
This raises a critical point about private equity: Why isn’t that industry being included in financial reform? What about Blackstone?
If these firms destroy or hobble companies by loading them up with debt, sometimes to pay themselves massive dividends that recover all their equity with no earnings, where’s the legislative scrutiny. How many jobs have been lost because of the excess debt loaded onto otherwise healthy companies? It can’t be insignificant.
Should there be a limit on the amount of debt you can pile on an acquisition? Isn’t this a debate we should be having?
And for that matter: Why are hedge funds getting off so lightly?
It would be tough to outlaw limited liability companies for one group and not for another. The limits on debt typically come from the lenders, who don't want to lose money. Sometimes the lenders can get recourse, but most often not.
La Rochefoucauld once said, "The best banker is a stupid banker." True if you are the borrower, and big enough to threaten the solvency of the bank, but not for anyone else. It would be difficult to regulate leverage levels on companies, private or public, without a lot of unintended consequences. Same for limited liability.
#1 Posted by David Merkel, CJR on Fri 26 Mar 2010 at 03:55 PM
The New York Times's Julie Creswell covered this in October, looking at the case of Simmons, the mattress company who filed for bankruptcy after being flipped multiple times....worth a read.
http://www.nytimes.com/2009/10/05/business/economy/05simmons.html
http://www.nytimes.com/packages/html/business/2009-private-equity/index.html
#2 Posted by Annie Lacey, CJR on Fri 26 Mar 2010 at 04:28 PM
Thanks, David and Annie.
David, I'm sure it would be difficult to do, but I haven't even heard the issue discussed.
#3 Posted by Ryan Chittum, CJR on Fri 26 Mar 2010 at 06:53 PM
Each day I edit a steady stream of stories on loans and bonds. And, like clockwork, these private-equity companies rear their heads from within the companies they've acquired. The highly leveraged taken-over company is usually trying to take out a loan so that it can pay a fat dividend to its shareholders (the private equity company). You know the acquired company is going to crater in a year or two underneath the debt. It would be risible if it weren't nauseating.
#4 Posted by Finance Journalist, CJR on Fri 26 Mar 2010 at 08:11 PM
There will be no financial reform of any consequence. Dodd can get a sweet position after he leaves the senate.
Our government is bought and paid for.
We are worse off than those countries whose corrupt governments we scoff at.
This is because we think we are not corrupt .. Hah !!!
#5 Posted by theopaine, CJR on Sat 27 Mar 2010 at 08:22 AM
Ryan Chittum: great article. I was wondering when someone was going to finally delve into how private equities and their dubious financial machinations played a role in this whole financial services collapse. As a person who ended up leaving a good job in a company owned by a PEF (with reluctance I need to add), and to find himself unemployed for 13 months after the fact, I have always wondered why PEF's managed to stay under the radar of scrutiny during this entire financial services fiasco. I am looking forward to reading more on the subject over the next few weeks.
#6 Posted by guy desrochers, CJR on Sat 27 Mar 2010 at 02:23 PM
I agree 100%
This is the classic case of assymetric outcomes. The PE guys structure deals in heads we win, tails we win. If the company fails down the road, so be it, they extracted their equity - and compensation. If countless working lives are ruined from their actions, who cares.
I wrote about it here
http://www.fundmymutualfund.com/2009/10/private-equity-skewered-in-new-york.html
Everyone should read about Burger King and "how it works" here
http://www.businessweek.com/magazine/content/06_15/b3979057.htm
#7 Posted by Mark, CJR on Sat 27 Mar 2010 at 04:23 PM
the wild capitalism...a bunch of greeeeeeeed and ponzi scammers.....called INVESTORS
#8 Posted by sixfeetunderhope, CJR on Sat 27 Mar 2010 at 04:40 PM
So, Ryan, the trade has to be to identify and short the lenders dumb enough to make the big debt placements in these PE purchases, as the "surprises" unfold.
FINANCEJOURNALIST mentions a "...steady stream of stories on loans and bonds...", so, how difficult can it be to aggregate whose exposure is seasoning and drop a well-timed short while the PE purchase is predictably floundering.
I won't be the one to launch a hedge fund on this thesis, but there must be a few such funds toiling in profitable obscurity, occasionally contributing to the Dodds and Franks of the world to not mess up their hustle, as Louis Armstrong once upbraided a drug enthusiast in his band.
Perhaps FINANCEJOURNALIST would be so kind as to show a link to her/his stories, so that those of us in the top 10% income bracket, who pay 70% of income taxes anyway, can score some gains before unavoidably getting hosed for most of the cleanup bill. (Short of moving offshore and redomiciling elsewhere, and all the HEART ACT trauma that entails...) Think of it as preemptive "recovery of taxpayer moneys", in keeping with stated congressional concerns.
#9 Posted by headlocal, CJR on Sun 28 Mar 2010 at 05:11 AM
Headlocal, I think your sarcasm is showing. Of course all the companies don't default; that goes without saying. Part of what we're seeing in these latest statistics most likely reflects the economic shakeout of the last year.
But that aside: the new lending at the acquired company falls into the leveraged loan class, paying a higher rate because of ... higher default risk. So company A -- boring mattress company say -- has a nice healthy cash flow and low debt and borrows at say LIBOR plus 2% for five years. Then it's taken over and pays say LIBOR plus 5% for five years (I don't pretend that the #s are accurate; the basic point is that it will pay significantly more for credit risk following the takeover because of its leverage).
So the lender gets compensated better for increased credit risk. The PE firm sucks out as much money as it reasonably can, compensating its investors and managers. And meanwhile -- as with any firm whose credit risk has risen -- the company that's adding debt is at increased risk of bankruptcy. That's a simple fact.
Do the PE firms do some good while they're laying off a few hundred (or thousand) workers, merging operations etc.? Sure, you can argue that they improve efficiency and make the company more competitive. But PE firms also richly reward themselves -- you sound like you're in the finance industry, so you probably know. And I've seen plenty of instances where they take care of themselves pretty well and leave behind a husk of a company, saddled with high-yield debt. It's not better. It's much worse.
#10 Posted by Finance Journalist, CJR on Sun 28 Mar 2010 at 08:09 AM
It seems to me that people who stand to gain in the short term have too much power and those who stand to gain in the long term have too little or don't use it.
I can think of two groups who have a long term interest. One is employees - how about giving them some authority in corporate take overs? The other is pension funds and those who invest for them. They have a fiduciary responsibility for the long term but seem to be using it for short term gains that can back fire and actually cause long term economic problems. Is this a class action suit in the making?
#11 Posted by BizCoach, CJR on Sun 28 Mar 2010 at 11:46 AM
FINANCE JOURNALIST
a) Thanks for your courteous reply, an increasing rarity these days.
b) Not being sarcastic - such stories are far more illuminating of realekonomik (real word, BING it) and outlaws do a better job of exploring the boundaries of every system I've ever seen.
c) NO I've never been in the finance industry, but I've worked in enough companies over time to know that very few of them are optimized over a vector space of stakeholder value, and I understand enough game theory to know that this creates a gradient of advantage to those who look for it.
#12 Posted by headlocal, CJR on Mon 29 Mar 2010 at 12:29 AM