
Private Equity Should Not Exist - fourthark
https://mattstoller.substack.com/p/why-private-equity-should-not-exist
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lacker
This article really overstates the importance of private equity.

 _private equity, the financial model in commerce which more than any other
defines the Western political landscape_

That doesn’t seem accurate. Public companies controlled by the stock market, a
board of directors, and a CEO are far more important, both politically and
overall, than the small number of companies which have been taken over by
private equity.

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batmenace
I might well be biased since I do work in an investment bank that caters
mainly to private equity clients, and having spent a decent amount working in
a PE fund, but this article also conveniently focuses solely on the bad part
of the industry. Of course, not all PE is perfect, and not all are the same.
There are high leverage funds, debt funds, distressed investment funds, large
cap funds investing billions of dollars, small cap funds financing companies
worth just about 10m. The fund I worked for, for example, focused on buying
only a few companies (3-4 portfolio businesses) and then building these up
over 5-10 years to become market leaders, by investing in the companies
capabilities both through add-on acquisitions and R&D spending. Of course, PE
can also mean that in order to improve the company, some parts of it have to
be restructured or shut down, but the blame for that cannot go only to the
fund, but also to the management of that company letting divisions become
lethargic. Not all PE is the same - some funds are bad, focusing on just
stripping as much money out of a business as possible and then getting rid of
whatever is left. But generally, PE's make most money with businesses that
grow beyond their original scale, and innovate more than their rivals. Also,
thanks to the investment time frame and relative freedom that investors give
the funds, a lot of good can be done with capital, such as investments in
emerging economies and local champions.

The point is, the PE landscape is infinitely more complicated than just saying
it is good or bad.

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mcv
Maybe, but there are definitely a number of popular behaviours that are very
clearly bad. Buying companies with borrowed money, then offloading that debt
to those companies, and driving them into bankruptcy while sucking them dry,
does not create value for anyone except the PE company itself. Funds that do
that are vultures leeching on otherwise perfectly healthy companies.

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lpolovets
(FWIW, I'm in VC, but I know very little about how PE works.) As a general
observation, businesses like PE usually don't exist unless somewhere down the
line they create some value. So if a PE firm makes a buyout offer to a CEO and
the CEO takes it, then presumably that buyout offer was better than the CEO's
alternatives (like other offers, or staying private, or etc). The problem here
is not the PE firm, but the lack of better alternatives.

One could make similar observations about the payday loan industry: most of
the firms are predatory and their offers suck, but 1) because of high default
rates, the loan offers will necessarily be poor, and 2) creating more
alternatives to payday loans would be great. But banning payday loans would be
a net negative, because the choice of "very high interest rate loan or
nothing" is better than having "nothing" as the only option.

~~~
bsder
> The problem here is not the PE firm, but the lack of better alternatives.

Were the alternatives better for the stockholders or the CEO? And, were the
alternatives better for which stockholders?

The number of firms that have started public, gone private, and then gone
public again seems to indicate that private equity doesn't seem to be adding
business value.

In addition, a lot of private equity seems to be about stripping cash from
companies in creative ways--effectively the endgame of the "hostile takeover
and then partition the company" from the 1980's. Toys R Us, Sears, K-Mart sure
didn't seem to benefit from private equity.

~~~
zaroth
If the alternative was better for the stockholders and the Board disregarded
it, then the shareholders will sue, and win. There were some recent cases
where Delaware courts awarded some pretty significant damages using
hypothetical valuation models that were extremely favorable to the
shareholders (Dell is a famous recent example [1]).

PE firms, once they own the company, can strip all the cash they want to from
the company they own. There’s no law saying a company can’t be harvested for
its assets if the shareholders believe that’s the most effective way to
extract value from the asset.

[1] - [https://corpgov.law.harvard.edu/2017/12/19/analysis-of-
delaw...](https://corpgov.law.harvard.edu/2017/12/19/analysis-of-delaware-
supreme-courts-dell-appraisal-decision/)

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sokoloff
Toys R Us, Sears, Radio Shack, Montgomery Ward, and dozens others failed
because they didn't sufficiently adapt to the business climate and
competition.

It's not like "but for Private Equity firms, these would be vibrant,
competitive, going concerns". At most, PE was a specific _acceleration_ of
their demise, but it seems overwhelmingly likely that the reaper was coming
for them anyway...

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downrightmike
"Toys R Us, Sears, Radio Shack, Montgomery Ward, and dozens others failed
because they didn't adapt to the business climate and competition." Not
really, they could have survived and had run way to make changes if PE didn't
burden them by taking out loans against the company's assets and taking that
out of the company in the form of management fees. Leaches.

~~~
icebraining
But who is making these loans to companies that will be obviously unable to
meet their payments? I never saw that part in the PE-sinks-companies story
properly explained.

~~~
charlesdm
Who? Easy: banks. Bank debt generally has first call in the event of a
liquidation, so if everything goes to hell the assets will be liquidated and
banks will be the first to be paid back. They likely don't end up losing a
lot, if anything at all.

The article makes it seem super obvious that these deals won't work out. But
that is actually not the case. Many / most PE deals actually do work out, and
end up making the sponsors a lot of money.

And why would banks allow this? Because private equity are huge profit
drivers. They use lots of debt. They also acquire many companies, so there is
an ongoing relationship.

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ikeboy
The theory is wrong.

Perhaps you can do it for pension funds, although most pensions are government
backed anyway.

But investors are taking a known risk. These are all sophisticated adults. If
a bank _wants_ to sign a contract that they will lose money if the company
goes under, who is Warren to say they shouldn't? They're getting well paid for
that risk, they know it's a risk.

If you ban debt-funded PE, you'll just have banks in-house the PE firms or any
number of other structures that have the same result - people buying companies
with other people's money and only sharing in the upside. Because that's a
structure that benefits both sides (the banks and the PE companies) and they
both want it to work.

~~~
gridlockd
Nice theory, but in practice many banks do not actually carry risk, because
they are “too big to fail”. LBOs fall in the same category as credit default
swaps - useful in theory, huge moral hazard in our version of a “free market”.

~~~
ikeboy
If you think the risk of debt is too high, then require banks to be
capitalized higher against that kind of debt. Don't ban them from funding
certain kinds of debt.

There are no banks that failed due to defaults from LBOs.

Besides, the plan goes well beyond banks. If a private investor wants to lend
money for an LBO, this still prevents it.

~~~
gridlockd
I am not arguing for a ban, nor am I saying that LBOs cannot work. I am saying
your bank risk argument in favor only works in theory and therefore we will
have for more LBOs that cannot work.

Of course LBOs are not significant enough to single-handedly cause a bank to
fail. However, they can still cause companies to go bankrupt that would have
otherwise survived.

In any event, in a system where banks are not allowed to fail, I cannot see
how they should be allowed to finance LBOs.

~~~
ikeboy
>However, they can still cause companies to go bankrupt that would have
otherwise survived.

If a company's operations aren't profitable, it wouldn't have "otherwise
survived". If it is profitable, then bankruptcy will wipe out debt and permit
it to continue operations, hence it will continue to survive. It's the
difference between Chapter 7 and Chapter 11.

>In any event, in a system where banks are not allowed to fail, I cannot see
how they should be allowed to finance LBOs.

What work is LBO doing in this sentence? Financing LBOs carry some risk of
loss, as does everything except Treasuries. Why would LBOs be special as
something banks shouldn't be allowed to finance? Why are banks uniquely bad at
risk analysis of LBO debt as opposed to, say, regular corporate debt, or junk
bonds, etc?

~~~
gridlockd
> If a company's operations aren't profitable, it wouldn't have "otherwise
> survived". If it is profitable, then bankruptcy will wipe out debt and
> permit it to continue operations, hence it will continue to survive. It's
> the difference between Chapter 7 and Chapter 11.

Debt is wiped out after _liquidation_. Most companies do not survive this.
Debt service can make the difference between profitability or unprofitability.
Remember, this is debt that was forced on the company externally.

> Why are banks uniquely bad at risk analysis of LBO debt as opposed to, say,
> regular corporate debt, or junk bonds, etc?

I never said they are bad at risk analysis, I am saying they do not truly
carry the risk in the first place. The difference is in the outcome. An LBO
that should never have happened is worse than a corporate loan that should not
exist.

~~~
ikeboy
>Debt is wiped out after liquidation.

Nope. I get the feeling you don't know the difference between chapter 7 and
chapter 11?

>An LBO that should never have happened is worse than a corporate loan that
should not exist.

Why?

~~~
gridlockd
> I get the feeling you don't know the difference between chapter 7 and
> chapter 11?

Same here.

Chapter 11 doesn't "wipe out debt", that's what Chapter 7 does. Chapter 7
implies liquidation.

Chapter 11 may reduce debt obligations, entail partial liquidation, and so on.
It _doesn 't_ just wipe out the debt.

> Why?

Because of the moral hazard. If I can just get a loan for an LBO to buy a
company and squeeze it out like lemon, that's highly destructive. Unlike when
issuing a junk bond, I have no real interest in the companies long-term
survival. I guess you can make an argument that debt-financed stock buybacks
have similar issues, but that's a topic for another day.

In the short term, even a bad LBO looks good for both the bank and the PE
firm. Meanwhile, the company has a debt burden that paid for nothing but the
privilege of having been bought out, likely requiring them to charge higher
prices, which is a strong competitive disadvantage. This leads the whole
argument of "restructuring companies to be more efficient" ad absurdum.

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Havoc
>But that one’s for my book, [...] which you can pre-order here.

Well that was an impressively elaborate sales pitch

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kccqzy
Kudos to Elizabeth Warren for trying to tackle this problem. But the entire
financial services sector would lobby against her in many ways legal and
illegal just so that she wouldn't become President.

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chrisgd
The banks who agreed to lend so much debt that they were barely able to make
payments get off relatively free in these cases. There are plenty of instances
where PE levers up and the companies do well but we don’t discuss those. Plus
PE makes way more growth oriented investments then LBO type investments
because there are more smaller companies than larger ones.

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crb002
Markets with imperfect information exist. As in the Pentagon example they need
to put in contracts that the Petntagon may outsource parts to prevent gouging
as long as an IP fee goes to the owner of the original design.

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Jgrubb
A good proofread is arguably not as important in a 5 minute blog read, but in
a 20 minute read it really adds up.

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qrbLPHiKpiux
Further, private equity should not be involved at all in healthcare.

I’m in healthcare and they tear it apart.

