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Private Equity Firms Want Their Acquisitions To Profit, Not Fold [Inve

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From the article:

"Private equity firms typically invest in relatively mature companies...."

"It's a serious injustice to malign private equity firms as their critics do today. We should recognize that they're reorganization experts who aim to improve undervalued or underperforming businesses. Their profits should be admired."

This argument is painting with a very broad brush. The argument certainly applies to some cases, but it is a very different matter to assert that it applies to every case. For the other side of the story I recommend The Buyout of America which I read in full during the height of the Newt Gingrich / Bain Capital discussion. I found it well researched, even though clearly written from a more liberal perspective than my own (Austrian) view.

Anyone choosing to debate the issue would be well advised to educate themselves about a number of private equity tactics that are frequently used and yet quite inconsistent with what is implied when one thinks of "reorganization" with the intent to "improve."

I am not posting this as an attack on the Altner article. I simply want to note that the "devil is in the details." Blanket praise for "private equity" in every situation can be just as inaccurate as blanket denunciation of it.

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Anyone choosing to debate the issue would be well advised to educate themselves about a number of private equity tactics that are frequently used and yet quite inconsistent with what is implied when one thinks of "reorganization" with the intent to "improve."
What's the most damning example of a shady tactic they use? I see the article mentions interest they paid to themselves. Is that the main example?
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I would have to go back and reread to go into detail, but I think I can summarize. One of the main issues is a PE tactic of loading up a target company with debt that cannot and knowingly will not be repaid, and then using the proceeds of that debt issue to pay big "management fees" to the Private Equity company. This results in a payoff to the PE owner in excess of the amount "invested." Such a pattern appears fairly commonly, and the point to look for is that these equity extractions are not being made in order to fund new capital, new equipment, new strategies, etc -- the extractions are taken out and paid to the PE as profit with no pretense of "re-investing" them in the operation of the target company.

This is the problem with the common conception that all PE's are acting as "turnaround specialists" by investing money and knowhow into a failing company with the goal of turning it around and getting it to operate profitably and successfully in the future. Sometimes that is in fact the case. On the other hand, sometimes, as detailed in the Kosman book, the facts are such that no objective observer would conclude that the PE entered the business in order to turn it around. Instead, the financial transactions, to the extent they are public knowledge, evidence the conclusion that the goal from the beginning was to pull out all avalable cash (and even new cash through debt and otherwise) and then send the company into bankrupty.

The details are all very fact-specific to individual deals. There are indeed many "turnaround" deals that are legitmate in any fair-minded person's book, and those are the ones where the "win some / lose some" argument applies.

On the other hand, if you do the research you will see that there are deals where the overwhelming circumstances do not point to a good faith effort to turn around a company. Now in those cases one can argue (correctly) that the activities of a vulture in scavenging what's left of a dead body serve a legitimate purpose. The real issue becomes when a PE firm goes in with the representation to all concerned that it is acting to achieve a turnaround, when it's real purpose is to extract all available equity, obtain new debt under "false pretenses", and then bankrupt a company that would otherwise have continued to survive at least for some period of time. Many types of ethical issues are raised in this fact pattern in addition to the deception that is involved. I do not think that it violates objectivist principles to be concerned about the effect on long-term employees of such a company who have themselves operated under the representation that the owners intended that it remain a going concern. I would think that Nat Taggart inspired his workers to their own best efforts by his clear determination to build the best railroad he possibly could, and that his employees made decisions in their personal lives based on those representations.

Again, I do not want to be perceived as bashing the main article. The point it makes applies to many cases and maybe even a majority. But I do want to make a point to those who might find themselves debating this issue, perhaps even live in a political or other debate, that there are intricacies to certain deals which can be difficult to defend.

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I would have to go back and reread to go into detail, but I think I can summarize. One of the main issues is a PE tactic of loading up a target company with debt that cannot and knowingly will not be repaid, and then using the proceeds of that debt issue to pay big "management fees" to the Private Equity company.

....

The real issue becomes when a PE firm goes in with the representation to all concerned that it is acting to achieve a turnaround, when it's real purpose is to extract all available equity, obtain new debt under "false pretenses", and then bankrupt a company that would otherwise have continued to survive at least for some period of time.

I have limited knowledge of bankruptcy proceedings, but wouldn't a Bankruptcy Court order the PE company to pay back the money to the creditors, if they did that?

Otherwise, starting businesses just to load them up with debt would be all everyone did. It would be the easiest way to make money.

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Nicky, I "liked" your comment because IMHO that's an excellent question.

I suspect that a large part of the answer -- in those cases where it happens -- is that fraud in general and in financial cases in particular is very difficult to prove in court. An example is the mortgage crisis, where most of the people involved could honestly claim that they thought "passing the trash" was perfectly acceptable -- because of course everyone knows that "real estate always goes up."

Your observation that "starting businesses to load them up with debt would be all everyone did" is excellent. But of course starting from scratch is not so simple, and it is much easier to detect bad faith if the new business does not (and never had) a truly economic model. That's what attracts the PE crowd to their targets -- the targets are existing businesses which do (or did) have an economic model and were (or are) at least close to profitable and therefore had a reputation for honest dealing. That means there was (or is) a reasonable argument that a "turnaround" might work, and that asking others to lending money to them seems reasonable. In those situations, the PE operators can go to lenders and participants all along the chain, point to the company's past track record, and say that they have a reasonable hope that things will turn out all right.

And there are lots of people, institutions, and government who will grant concessions and make loans to "help the local people keep their jobs."

This is a topic closely related to the topic of "crony capitalism," and poses the same challenge - separating out the minority of cases that are illegitimate from the majority that are legitimate. Due to the complexity of the financial transactions involved it can take considerable study and command of the facts to be able to tell one from the other. Lots of conservative politicians jump on the Solyndra situation, and rightly condemn it, but similar "economic development" arrangements are put forth all the time by Republican legislators all across the country.

Probably that's why Rick Perry was so quick to come up with and apply the "Vulture Capitalist" name to PE firms during the primary campaign. As I understand it, his Texas administration has been right in the middle of many such "economic development deals," so Rick Perry was in the position of those who say "it takes one to know one."

Edited by CICEROSC
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There’s a conversation in Atlas Shrugged, I think it’s the guy who was in charge of Starnesville speaking to Dagny, where he talks about the reason one would buy a company: to drain everything out of it. As I recall the scene ends with him realizing he’s burned his dinner, maybe that’ll help with finding the scene. Also, if you watch the movie Wall Street (wow I can hear the groans of fellow OOers all the way from here!), the way Charlie Sheen’s character motivates Gordon Gekko to buy out Martin Sheen’s failing company is by pointing out that they have an overfunded pension, which Gekko proceeds to loot thus turning Sheen against him. I spent a good part of my early career working for a “corporate raider”, confidentiality agreements prevent me from naming names or giving detailed examples, but suffice to say, speaking from experience, these things do happen. Sometimes you can “make” a lot of money by putting a company out of business, and that’s just part of capitalism. It's part of what's called "creative destruction" in certain circles.

On the “mature companies” part, back during the dot-com bubble it was private equity firms that usually funded startups, with the aim of making a big pile once the companies went public. So, “typically”, well, what qualifies as “typically”?

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I suspect that a large part of the answer -- in those cases where it happens -- is that fraud in general and in financial cases in particular is very difficult to prove in court. An example is the mortgage crisis, where most of the people involved could honestly claim that they thought "passing the trash" was perfectly acceptable -- because of course everyone knows that "real estate always goes up."

Why is it difficult to prove fraud, when fraud occurred? Large scale financial transactions are well documented, everything is in writing. It's very rare for a lender to just allow themselves to be swindled without having all the promises made to them, written and signed.

I think the issue is something else: some of the things critics of these practices refer to as "fraud" aren't actually fraud. There is a discrepancy between the legal definition of fraud (which follows the traditional view of rights and responsibilities in a business transaction), and the popular definition (which follows the modern view of those rights and responsibilities).

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And this is the very deep, very difficult problem with "finance reform" in the USA right now.

There absolutely are structures which involve government-protected fraud, such as the implicit approval given to the rating's agencies.

On the other hand, there are other areas which are over-regulated.

The "Too Big To Fail" doctrine, in essence, nationalized the banking system's brain. Without the fear of failure, banks can take any risk they want, and thus will do anything regulations say they can do, including drive off a cliff. Hence the call for more regulations.

As for private equity, Bain & Co. and their imitators made much of their living on a loophole that allowed them to break contracts. The sequence goes like this:

1. Company A goes into business, does well, etc.

2. Company A's workers unionize and demand better everything.

3. Company A compromises by offering lower wages in the short run in return for a big fat pension plan (which benefits older workers aka the ones doing the negotiating).

4. Company A does this for a number of years and ends up screwed by a pension plan burden they could never pay.

5. Bain & Co. comes in to solve the problem. They make "Company A" go away, legally. They then turn Company A into Company A1. This new company is the same company, same employees, same everything except for no pensions.

Now, who's fault is all of this? If you want to say, "it's clearly XXXX's fault" then I'd say you're wrong: there's blame to go all around here. You can easily--even validly--look at Bain & Co. as a "predator" that does this flipping maneuver just to make money in the backs of broken contracts to benefit a small management team, or you can look at them as company-savers. I'm sure if you research each case, you'll find both.

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