It’s no secret that private equity is in trouble. Ever since the credit crunch began, private equity deals have been falling apart. Now that the broader economy is deep into a contraction, even more companies owned by private equity firms will likely face trouble.
For some, the problem with private equity is simply its dependence on debt. There’s truth to this: heavy debt loads used for leveraged acquisitions can make it difficult for a company to survive, especially when LIBOR rates skyrocket. And when debt becomes too expensive, many deals simply no longer make sense to pursue. This can be a problem for private equity firms because it limits opportunities for them.
But there’s also a more radical case against private equity, one that basically looks at private equity managers as corporate looters. That’s the case that Julie Creswell seems to be making in the New York Times today. Although much of the article is built around an interview with Leon Black, it’s clear that Creswell finds the private equity business very suspect.
Private-equity firms raise huge sums from investors like pension funds and endowments and then borrow more from banks and other lenders so they can put ever larger sums to work.
During the period when they own a company, private-equity firms pay out some of the company’s profits to their investors — and the buyout firm itself — sometimes recouping several times their original investment in dividends before they either sell the company or take it public again.
One of the longstanding criticisms of buyout firms is that they engorge targets with debt and skim the profits for themselves. That image was reinforced during the boom with stories about buyout executives’ over-the-top birthday parties and other lavish excesses.
The notion that buyout firms were only on the hunt for quick gains was further strengthened by actions of Apollo and some of its peers. Sometimes within just a year of acquiring a company, they issued debt that was used to pay fat dividends to the funds themselves.
Besides layering more debt onto the companies, the move effectively allowed Apollo and its competitors to handily recoup some, if not all, of their initial investments.
This is a strange argument. Shouldn’t we want investors to recoup their investments? Isn’t that the goal of investing?
To put it differently: whose interests does Creswell think she is defending by criticising the debt levels of companies owned by private equity? It can’t be so-called ordinary retail investors–they’ve already been bought out. Is she defending the banks and institutional investors who are the creditors who might lose out in a bankruptcy? Aren’t these institutions at least as smart of Creswell, entering these deals fully aware of the capital structure, dividend policies and bankruptcy risks in many private equity deals? Investors in leveraged buyouts hardly need journalists to look out for them.
What’s important to keep in mind is that the dividends paid to private equity firms, often with borrowed money, are part of a long struggle between corporate insiders and owners over what should be done with free cash flow and borrowing ability. Corporate management often prefers to spend any cash that comes into a firm, even if doing so is wasteful. Think of the recent episode of The Office where they need to spend thousands because they’ve come in “under budget.”
In a company with a broad, public ownership, it can often be hard for investors to capture this value for themselves. Management will insist it needs to hold on to as much cash as possible. Private equity investors are far better at managing these agency costs and making sure they, and not management, benefit from extra cash.
It’s surprising to find a talented business writer like Creswell arguing the management side of this case.