Private equity impacts across markets

In a short span of time, private equity firms have come to dominate the business landscape in the US. Globally PE firms managed $6.3 trillion in assets in 2021, more than four times what they oversaw in 2007. PE firms are conglomerates, with Blackstone the $1 trillion leader itself owning mortgage lending, infrastructure, television and film studios, entertainment companies, pharmaceuticals, and even the dating app  Bumble.

PE firms have gone from investing in what are traditionally profitable businesses to dull and hitherto considered margin sensitive mass market and bottom of pyramid (BoP) goods and services. Their investments range from mobile homes, prison health care, emergency medicine, ambulances, affordable apartment buildings etc. This is an NYT series on PE investments in infrastructure services. 

This post will examine a few stories on the impacts of private equity investments in different sectors and discuss the value of PE investments in these market segments. 

1. This from the US experience of asset stripping and quality problems with private participation in railways

The railroads have shown great enthusiasm for cutting costs by any means possible — reducing staff by 30 per cent in the past six years, harming the freight system’s reliability while returning nearly $200bn in the past decade to shareholders. From 2019 to 2022, Norfolk Southern reduced its headcount by 23 per cent, returned more than $14bn to shareholders while investing less than $7bn back in its network, and saw its accident rate climb every year — by 25 per cent in total... American freight trains derail tens times as often as their British counterparts, according to the industry’s own data.

2. This article is about the accumulation of mobile home trailer parks by private equity firms which is driving up prices in the only few remaining affordable housing option for the poor in the US. The residents of such parks generally own their houses but have to rent the land their home sits on. The unique nature of the property means that they fall into a regulatory gap between the rights of owners and tenants, a feature that private equity firms have spotted as an opportunity to make money. Further, once a home is placed on a lot, shifting it to another park can be expensive, costing between $5000-10000, thereby making them captive to the park owners. 

The article documents how Harmony Communities, a manufactured-home operator with 5000 residents in 33 parks across Western US took over a park in Golden Hills, Colorado and immediately increased rents by 50% and mandated several changes to park rules that entail trailer owners having to alterations to their homes. Residents have little or no control over the changes that happen when a park ownership is transferred. Sometimes they don't even come to know that the park ownership has changed hands. 

Industry leaders are blunt about the business model: According to materials for a “boot camp” for aspiring mobile-home park investors prepared by Mobile Home University, which is run by two of the largest mobile-home park owners in the country, “the fact that tenants can’t afford the $5,000 it costs to move a mobile home keeps revenues stable and makes it easy to raise rents without losing any occupancy.” 

Real Capital Analytics, a market research firm, said in a June 2021 report that institutional investors had accounted for 23 percent of manufactured housing park purchases over the previous two years, up from 13 percent in the two years before that. That has made the investors among the country’s largest landlords. Some 22 million people live in manufactured homes in the United States, according to the Manufactured Housing Institute, a national trade organization. And Fannie Mae said that manufactured housing represents more than 6 percent of the nation’s housing units.

If residents of mobile-home parks can’t keep up with rising rents, or can’t afford to make the often extensive alterations to porches, gardens and awnings that are required under the new management’s rules, they are swiftly replaced. With prices and rents for all kinds of housing soaring in many parts of the country, demand for manufactured housing is climbing. Many young professional families and college students turn to mobile home parks as a final vestige of relatively affordable housing.

Another article in The New Yorker writes

In the past decade, as income inequality has risen, sophisticated investors have turned to mobile-home parks as a growing market. They see the parks as reliable sources of passive income—assets that generate steady returns and require little effort to maintain. Several of the world’s largest investment-services firms, such as the Blackstone Group, Apollo Global Management, and Stockbridge Capital Group, or the funds that they manage, have spent billions of dollars to buy mobile-home communities from independent owners... Some of these firms are eligible for subsidized loans, through the government entities Fannie Mae and Freddie Mac. In 2013, the Carlyle Group, a private-equity firm that’s now worth two hundred and forty-six billion dollars, began buying mobile-home parks, first in Florida and later in California, focussing on areas where technology companies had pushed up the cost of living. In 2016, Brookfield Asset Management, a Toronto-based real-estate investment conglomerate, acquired a hundred and thirty-five communities in thirteen states.

3. This article is about the acquisition of franchises of various kinds by private equity firms. It ends up resulting in higher franchise fees and stringent other requirements that franchisees have to abide by. The article discusses the impact of the purchase of The Little Gym toddler nursery franchise by the PE firm Unleashed Brands.

Private equity has notched decades of high returns for investors by following a well-worn strategy: acquire distressed or undervalued companies or real estate, increase profits and then sell them. Greatest hits include foreclosed homes, highway rest stops and coal mines bought out of bankruptcy.

Franchising has become one of private equity’s targets du jour. According to the research firm FRANdata, the number of franchise brands acquired by private equity firms and other investors rose from 52 in 2019 to 149 in 2021 and was on track to nearly equal that total in 2022... The nation’s franchisees — 237,619, according to FRANdata — like Ms. Cianci, think of themselves as independent small businesses, who have often sunk their life savings into the enterprise. That’s why Little Gym owners are resisting Unleashed’s attempts to squeeze their profits to pad its own...Unlike, say, factory workers, who can be laid off at will, franchisees are supposed to be protected by legal documents that prescribe a certain business model for years at a time... 

Within weeks, long-tenured headquarters employees started leaving. In conversations with franchisees across the country, numerous owners expressed frustration that the support they depended on had evaporated; instead of calling a trusted adviser whenever they wanted, they had to file an online ticket... The company tried to impose a new payroll vendor that caused unending headaches. Certain activities, such as karate, were eliminated as Unleashed acquired businesses with similar programming; the company said it trimmed services with low enrollment to “streamline” the offerings... In the fall of 2021, the company required all franchisees to sign a new agreement allowing Unleashed to automatically debit their bank accounts. Ms. Cianci noticed that it also contained broad language allowing the company to extract any other fees that might be owed, which she believed went beyond her franchise agreement...

In November, Unleashed introduced a revised operations manual that lays out new rules and fees. It specifies the hours the businesses must be open, how quickly they must return customer calls, which architect they must use and what company meetings they must attend. Staff salaries were only supposed to make up 30 percent of revenue. The technology fee can rise to $399 from $119. The national advertising fee can rise to 5 percent of gross sales from 1 percent; part of that will go to a fund that supports other Unleashed properties. New fees appeared, including a $30,000 fee to renew the franchise agreement, and a fee of about $15,000 to relocate the facility. For some owners, the changes seem to mean that they can no longer operate profitably and will have to sell rather than renew... the company continues to try to force everyone to use its call center and point-of-sale system.

4. This about PE firms in the affordable housing market

In the last few years, private equity firms including The Blackstone Group and Starwood Capital have become some of the largest owners of subsidized affordable housing in the United States, acquiring apartment properties with more than 138,000 units backed by the Low-Income Housing Tax Credit and other federal housing programs meant to create affordable housing. Neither private equity firm has created affordable housing. Both Blackstone and Starwood Capital accumulated their portfolios by acquiring interests in existing subsidized affordable properties, raising concern about whether they will maintain the properties as affordable when current subsidies lapse...

Blackstone is by far the largest owner of rental housing in the US, with more than 300,000 units as of July 2022. Starwood Capital is the second largest owner of rental housing in the US, with more than 115,000 units. Blackstone now owns more than 95,000 subsidized affordable units, making it one of the largest owners of affordable rental housing in the United States. Starwood Capital owns more than 43,000 subsidized affordable units, making it one of the top five owners of subsidized affordable housing in the US. These private equity firms have only recently begun acquiring large numbers of subsidized affordable apartments.

This about their profits maximisation intentions, 

Blackstone, which owns most of the affordable properties through its Blackstone Real Estate Income Trust (BREIT) non-traded real estate investment trust, noted in a June 2022 prospectus of its residential and industrial real estate holdings, "Our portfolio’s rents in these high conviction sectors remain below current market rents and have short duration leases, enabling BREIT to increase revenue as leases expire." Blackstone noted in a June marketing presentation that its BREIT investment fund had generated a 30.8% profit over the past year.

5. PE firms' investments in single-family housing took off in the aftermath of the foreclosures that accompanied the Great Recession. 

Load up on foreclosed properties at a discount of 30 to 50 percent and rent them out. Rather than protecting communities and making it easy for homeowners to restructure bad mortgages or repair their credit after succumbing to predatory loans, the government facilitated the transfer of wealth from people to private-equity firms. By 2016, 95 percent of the distressed mortgages on Fannie Mae and Freddie Mac’s books were auctioned off to Wall Street investors without any meaningful stipulations, and private-equity firms had acquired more than 200,000 homes in desirable cities and middle-class suburban neighborhoods, creating a tantalizing new asset class: the single-family-rental home. The companies would make money on rising home values while tenants covered the mortgages...

Wall Street’s latest real estate grab has ballooned to roughly $60 billion, representing hundreds of thousands of properties. In some communities, it has fundamentally altered housing ecosystems in ways we’re only now beginning to understand, fueling a housing recovery without a homeowner recovery... Before 2010, institutional landlords didn’t exist in the single-family-rental market; now there are 25 to 30 of them, according to Amherst Capital, a real estate investment firm. From 2007 to 2011, 4.7 million households lost homes to foreclosure, and a million more to short sale. Private-equity firms developed new ways to secure credit, enabling them to leverage their equity and acquire an astonishing number of homes...

Throughout the country, the firms created special real estate investment trusts, or REITs, to pool funds to buy bundles of foreclosed properties. A REIT enables investors to buy shares of real estate in much the same way that they buy shares of corporate stocks. REITs typically target office buildings, warehouses, multifamily apartment buildings and other centralized properties that are easy to manage. But after the crash, the unprecedented supply of cheap housing in good neighborhoods made corporate single-family home management feasible for the first time. The REITs were funded with money from all over the world. An investment company in Qatar, the Korea Exchange Bank on behalf of the country’s national pension, shell companies in California, the Cayman Islands and the British Virgin Islands — all contributed to Colony American Homes. Columbia University and G.I. Partners (on behalf of the California Public Employee’s Retirement System) invested $25 million and $250 million in the REIT Waypoint Homes. By the middle of 2013, private-equity companies had raised or spent nearly $20 billion on single-family real estate, and more than 100,000 homes were in the hands of institutional investors. Blackstone’s Invitation Homes REIT accounted for half of that spending. 

There's a reason why PE and other investors prefer affordable housing units,

The growth of asset values has outstripped returns on labor for four decades, and a McKinsey report found that a majority of those assets — 68 percent — is real estate. Last year, one in four home sales was to someone who had no intention of living in it. These investors are particularly incentivized to buy the sorts of homes most needed by first-time buyers: Inexpensive properties generate the highest rental-income cash flows.

6. A ProPublica investigation of the multifamily housing market found that PE is now the dominant form of financing among the 35 largest owners of such units, rising from about a third in 2011 to more than  half in 2022. The article has a nice articulation of the problems with PE ownership of housing, compared to traditional landlord ownership. 

Private equity firms often act like a corporate version of a house flipper: They seek deals on apartment buildings, slash costs or hike rents to boost income, then unload the buildings at a higher price... Such firms use economies of scale to more aggressively squeeze profits from their buildings than traditional landlords usually do, tenant advocates say. The firms’ tactics can include sharply increasing rent or fees and neglecting upkeep. Sometimes landlords force out existing tenants and replace them with those who can pay more. The companies’ size allows them to influence market rates and lobby against reforms that could dilute their power. And their goals — quickly hiking a building’s profits so they can sell it at a premium — are often at odds with those of the tenants who need to live in them. In contrast, so-called mom-and-pop landlords usually look for steady streams of rental income over time while their buildings grow in value.

The fundamental problem is the returns expectations that underpin the PE model,

Private equity firms boast about outsize returns, and the most aggressive funds seek a profit of 20% or more on investors’ contribution, minus management fees. That compares to publicly traded real estate investment trusts, which, on average, pay an annual dividend yield of 4.33% and allow investors to hold the value of the trust’s stock.

The report traces the role of Freddie Mac, the largest rental housing financier in the US, in the rise of PE firms in the housing market. It has an explicit mandate of ushering in housing affordability and buys loans from private lenders so that they can make more mortgages.

Large private equity firms accounted for 85% of Freddie Mac’s 20 biggest deals financing apartment complex purchases by a single borrower, according to a ProPublica analysis of data from the industry publication Commercial Mortgage Alert... Large loans to private equity firms, researchers and advocates fear, are helping drive industry concentration and pushing up the cost of renting. The loans typically do not include provisions that increase tenant protections or that keep affordable housing rents low over the long term.

All these examples raise a simple point. Are private equity investments in these boring low-return mass and BoP market segments desirable? 

An important reason for the rapid recent rise of private equity is the decade-plus period of ultra-low interest rates. It has allowed the consolidation of the business model that uses excess leverage to acquire assets and juice up returns. The return to normalcy with interest rates should go some way in reducing the attraction of this model. But that does not mean that we can step back and allow the dynamic to play out.

The problem with PE is its model, which warts and all is one of asset stripping and profit maximisation, and pass the parcel. The commercial incentives in a competitive race to the bottom are badly misaligned with the social objectives. The incentives are in turn dictated by the nature of the financing source itself and their business model. 

The competitive equilibrium does not keep the market honest because we have reached a stage in the  evolution of the market where its collective incentive is to maximise profits to the near exclusion of all else. In the process, the promotion of social well-being and customer welfare fall aside and become market failures. 

Public utilities like mass transit, water, sewerage, electricity, and solid waste management are regulated and low return assets. As I blogged here, there's a case for excluding windfall profit opportunities and explicitly regulating the various kinds of asset stripping. 

In the cases of mobile trailer parks, kindergartens, affordable housing, ambulances, mass market franchises etc, there should be a wider debate on the value add from private equity investments. 

Yes, in these cases, the entry of larger firms and newer business models can add value. But is this particular business model adding value? There's a difference between capturing value from brownfield assets, and creating greenfield assets. Yes, in theory the value capture from the brownfield assets leads in the long-run to creation of greenfield assets. But the theoretical long-run can be very long and we're all dead in the long-run. The empirical evidence points to the taking over-riding the making. 

This is also an occasion to question the blind faith among influential opinion makers in the value of academic research and theoretical evidence in informing shaping the discourse on important public issues of our times. Instead, public debates ought to be informed by practical evidence, common sense, and wisdom. 

The debate on widening inequality is a case in point. The intense academic debate on the issue cannot and should not be allowed to overlook the unambiguous reality of widening inequality and the primary role of asset prices  in contributing to it. Similarly, the debate on the reasons for business concentration should not crowd-out the stark reality of rising business concentration and its corrosive effects on the economy and the polity. On the same lines, the pervasive reality and attendant concern about profiteering and rent seeking by private equity should not be drowned out by the debate on the theoretical merits of private equity in financial intermediation. 

In general, in the context of the increasing pervasiveness of the private equity business model, there should be a wider debate on the role of the market and the business firm. Instead of tip-toeing around fuzzy and feel-good notions of stakeholder capitalism and the likes, it's time to confront the elephant in the room, the largely unrestrained and single-minded firm pursuit of profits maximisation. 

In this context, the Viennese model of social housing, gemeindebauten, is instructive,

Vienna has succeeded in curbing the craving to own. It has done it by driving down the price of land through rezoning and rent control. In general, the beneficiaries of these land-use policies are less the Gemeindebauten (they stopped building from 2004 to 2015 and now only produce some 500 units a year) and more the limited-profit housing associations, the origins of which preceded Red Vienna and have built 3,000 to 5,000 units a year for the last four decades.

Today limited-profit housing accounts for half the city’s social housing. Limited-profit housing associations are restricted to charging rents that reflect costs. Investors — banks, insurance funds — may buy shares of the limited-profit housing associations, generally to help fund initial construction. They are paid a low rate of annual interest on their shares. Any profits beyond that must be reinvested in the construction of new social housing. “It creates a revolving flow of financing for social housing,” said Justin Kadi, a professor in planning and housing at the University of Cambridge. Vienna’s main outlay toward housing is now providing low-cost financing for construction — and the government gets that money back.

The ESG discourse should be expanded to include a B, or responsible pursuit of the corporate bottom-lines (as against the illustrative scorched earth strategies). It should be ESGB. 

This is not to draw some arbitrary thresholds on profits, but proactively put the issue of margins and markups, and profits (and the means of realising them) on the discussion table. There should be simple and clear headline disclosure requirements on these. When the balance has swung to the other extreme on profits maximisation, it's time to proactively introduce a corrective to the discourse. And that may often involve elements which push in the extremes in the other direction. We can afford to be not overly concerned at this shift given the checks and balances in the economy, polity and the society on such issues.

Finally, there is the need to debate the consequences of financialisation, the driving force behind practices and market segments like private equity. Gillian Tett recently pointed to the latest McKinsey report on global wealth creation. It found that the world's stock of paper wealth (the speculative, unrealised price of all its financial assets) has jumped by $160 trillion since 2000. For every dollar of global investment made since 2000, $1.9 of debt has been added, with the leverage rising to $3.4 in the 2020-21 years. The value of global assets (mainly from real estate and equity markets) rising to 470% of global GDP to 600% since 2000. Finance has clearly become an end in itself. Do we need such finance? Should we not restrain it?