More on private equity

Nice article in Bloomberg about private equity. In terms of a confluence of circumstances which has contributed to PE's rise, this is important

But it’s possible that a cosmic alignment of lax corporate management, cheap debt, and desperate-for-yield pensions created a moment that won’t be repeated soon.

Debt is central to the underlying idea,

The basic idea is a little like house flipping: Take over a company that’s relatively cheap and spruce it up to make it more attractive to other buyers so you can sell it at a profit in a few years... Private equity couldn’t exist without debt. It’s the jet fuel that makes a corporate acquisition so lucrative for a turnaround investor. The more debt you can raise against a target company, the less cash you need to pay for it, and the higher your return on that cash once you sell... PE firms can use some of the companies they own as virtual ATMs—having the company borrow money to pay its owner special dividends. That allows the funds to recover their investment sooner than they typically would through a sale or an initial public offering.

Or about the impact of PE,

Research has shown that companies acquired through leveraged buyouts (LBOs) are more likely to depress worker wages and cut investments, not to mention have a higher risk of bankruptcy. Private equity owners benefit through fees and dividends, critics say, while the company is left to grapple with often debilitating debt... Private equity and hedge funds gained control of more than 80 retailers in the past decade, according to a July report by a group of progressive organizations including Americans for Financial Reform and United for Respect. And PE-owned merchants account for most of the biggest recent retail bankruptcies, including those of Gymboree, Payless, and Shopko in the past year alone. Those bankruptcies wiped out 1.3 million jobs—including positions at retailers and related jobs, such as at vendors—according to the report, which estimates that “Wall Street firms have destroyed eight times as many retail jobs as they have created in the past decade.”

And this

A July paper by Brian Ayash and Mahdi Rastad of California Polytechnic State University examined almost 500 companiestaken private from 1980 to 2006. It followed both the LBOs and a similar number of companies that stayed public for a period of 10 years. They found about 20% of the PE-owned companies filed for bankruptcy—10 times the rate of those that stayed public. Pile on debt, and employees lose, Ayash says... Research by Eileen Appelbaum, co-director of the Center for Economic and Policy Research, says the problem isn’t leverage per se but too much of it. She points to guidance issued by the Federal Deposit Insurance Corp. in 2013 saying debt levels of more than six times earnings before interest, taxes, depreciation, and amortization, or Ebitda.

And this is important,

A study co-authored by UC Merced’s Eaton, for example, found that buyouts of private colleges lead to higher tuition, student debt, and law enforcement action for fraud, as well as lower graduation rates, loan-repayment rates, and graduate earnings. But the deals did increase profits.

Jonathan Ford has another article on PE in the FT which has this summary of PE balance sheet,

First, it shows why pension funds are tempted by private equity’s blandishments. If you are struggling to meet your promises to members, you want every pound or dollar to work as hard as it can. Nonetheless, before getting carried away, it is worth also noting the source of this superior performance, which all comes from financial engineering, not running companies better. It is far from clear this justifies the three-times higher fees that the pension fund incurs with Acme B. It is also worth remembering that the extra return is not the free lunch it appears, coming at the cost of additional volatility. Private equity argues that the extra oversight involved in its governance arrangements allow it to deal with the higher financial risks. But its preference for debt can carry heavy societal costs, such as bankruptcy and lost productivity through shirked investment in the business. And lastly there is a big puzzle surrounding the credit that supports these private equity investments. Most of the gain comes from capital leverage rather than the “tax shield” of deductible debt interest. The scale of the leverage-related bump raises the question of whether banks are really earning a proper return through the cycle on the risks they are bearing on their private equity loans. If they aren’t, that’s a cost for all citizens (including pension fund scheme members) given the taxpayer support that banks enjoy. The clearest and biggest beneficiaries of lenders’ largesse are the recipients of swollen transaction and private equity fees.

Update 1 (23.04.2020)

FT has this story of perverse audit practices within the private equity industry (no different elsewhere, perhaps worse only in the extent of perversion). It talks about the KPMG audit which gave clean slate to Abraaj in the investigation ordered after the scandal broke about its founder Arif Naqvi diverting funds to his own ventures.

It transpired that KPMG had close ties to senior people in the business: the chief executive of KPMG’s Dubai arm had a son who worked at Abraaj, and one executive, Ashish Dave, had spent time at both Abraaj and KPMG. KPMG also worked for companies in which Abraaj had substantial investments.