private equity investing -- 10/19/22

Today's selection -- from Private Equity at Work: When Wall Street Manages Main Street by Eileen Appelbaum and Rosemary Batt. Over the last 20 years, investments in privately held companies on behalf of pension funds and other investors by private equity management firms have spread like wildfire and become a predominant category of investing:
"The extensive use of debt to take over operating companies lies at the core of the private equity business model at both levels: the higher the use of debt at the portfolio level the higher the potential profits at the firm level.

"Most private equity firms are partnerships. The firms sponsor invest­ment funds that buy out operating companies using high levels of debt ­so-called leverage. Partners in the PE firm assume the role of general partner (GP) of the PE funds. The structure of the relationship of the PE firm's partners with the firm's equity and debt suppliers concentrates the PE fund's gains in the hands of the fund's general partner, who, as noted, is a partner in the PE firm. The general partner of the PE fund makes decisions about which operating companies the fund should acquire and how much debt to use in acquiring them. The personal funds invested by general partners are a small fraction of the purchase price of the com­panies the fund acquires. Most of the PE fund's equity is supplied by pension funds, wealthy individuals, and other institutional investors who are the fund's limited partners (LPs). The majority of the purchase price of portfolio companies is financed with debt. Despite their small contribution of equity, a major share of fund gains accrues to the general partners. This asymmetric relationship creates a moral hazard problem: the general partner loses only a small amount if the investment sours, but realizes huge gains, magnified by the use of debt, if the investment is successful. With little to lose and much to gain by leveraging portfolio companies, the general partners in PE funds have incentives to engage in risky behavior and load excessive amounts of debt on the companies they acquire and control.

Diagram of the basic structure of a generic leveraged buyout transaction

"Julie Froud and her colleagues argue that private equity firms have successfully adopted the leveraged buyout (LBO) model of the 1980s and created 'a hierarchy of ownership claims for debt and equity suppliers' that enables the general partner in the PE fund to capture most of the value extracted from the purchase, management, and sale of portfolio companies. They characterize the operation of the PE business model at the level of the firm as the 'control of ownership claims.' That is, the PE firm distributes the gains accrued by a PE fund among the fund's general partners; its limited partners, who supply most of the fund's equity; and its debt providers, who contribute most of the financing for the deals to the advantage of the general partners.

"Before value can be captured by the private equity firm's partners, it must first be extracted from the operating companies acquired by PE funds. PE funds use a range of governance, operational, and financial strategies to manage, control, and direct their portfolio companies. PE owners are both investors and managers of the portfolio companies they acquire, exercising 'ownership with control' to maximize shareholder value for the portfolio company's owners over the PE firm's three- to five-year ownership horizon.

"PE ownership is painted by its enthusiasts as a superior form of business organization. In line with the prescriptions of agency theory, private equity concentrates a company's ownership in the hands of a few shareholders -- the fund's general partner and the limited partner investors in the fund. The portfolio company is actively managed by the fund's general partner, who closely monitors the company's managers. In this telling, PE firms use their superior access to finance and manage­ment know-how to unlock the untapped potential in good companies or to turn around poorly performing or failing ones. The result is a net gain for the economy as well as outsized returns to the PE fund and its investors.

"Ignored in these accounts are the cases in which general partners maximize returns for themselves and other investors in the PE fund through the use of financial engineering strategies. These may include excessive use of leverage, dividend recapitalizations, stripping of assets, tax arbi­trage, and the strategic use of bankruptcy without regard for the effects of these actions on the long-term viability of the company and the impact on its workers, vendors, lenders, and community. The need to service high levels of debt may lead to unwarranted cost-cutting to achieve short-term results that jeopardize the company's long-term viability. These actions may increase the company's enterprise value, enrich the PE fund's gen­eral partner, and earn returns for the PE fund's investors, but they do not increase economic wealth or contribute to job creation in the larger economy. Instead, these gains come at the expense of other economic actors -- notably workers, creditors, and taxpayers."



Eileen Appelbaum and Rosemary Batt


Private Equity at Work: When Wall Street Manages Main Street


Russell Sage Foundation


Copyright 2014 by Russell Sage Foundation


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