
Private equity is a scam? - vo2maxer
https://twitter.com/doctorow/status/1246445485860118528
======
etrabroline
None of the dismissive comments here are addressing the actual points raised
by @doctorow.

The scam is that people on wall street who know nothing about building or
running a business have used their political connections and existing cash to
become even richer and more powerful through government bailouts, selling off
assets whose long-term value they don't understand and defaulting on pensions
-- in other words, without actually creating any new wealth.
Blackstone/Schwarzman is abusing the fact that starting a new hospital is
difficult, even if the only one in the city is incompetently managed. They are
not creating new value, and so should not be getting so rich. The people who
do the actual work of starting and running successful businesses should be.

EDIT: Specifically, Schwarzman et al are abusing what economists call short-
term "stickiness." It is not economically productive, as the firms with
artificially high profit margins are not competitive and so a new equilibrium
will eventually be established, putting them out of business. (That's why so
many ultimately do) This property makes Schwarzman's behavior a form of rent-
seeking, and not capital investment as he would probably have you believe.
Anti-trust law is designed to limit the abuse of stickiness in the economy,
but as rent seeking becomes the source of wealth for an increasing percentage
of western elites, anti-trust and other financial regulations designed to
combat abuses have become increasingly difficult to enforce.

~~~
nojvek
The problem is anti-trust is sleeping with PE folks. Our government has people
coming in and out of corporations with conflict of interests.

Here is Matt Stroller’s take on Private Equity.
[https://mattstoller.substack.com/](https://mattstoller.substack.com/)

The reason why US is being decimated by COVID-19 is we’ve lost a ton of our
competitive edge by offshoring and the rich wankers want to profit at any
cost. Even if it means other people die.

~~~
valuearb
Off-shoring has greatly increased the wealth of the United States by allowing
us to focus on higher value work, while at the same time providing poorer
countries higher value work themselves. It's the law of comparative advantage
in action.

U.S. workers might be better at assembling iPhones than Chinese people, but if
we let them assemble while we design iPhones, build it's software systems and
apps, and accessories both countries come out far ahead. Chinese get paid far
more while escaping brutal rural labor jobs, we develop far more software
developers and designers, who get to work remotely during COVID-19 and are in
higher demand than ever.

~~~
etrabroline
That is a false dichotomy. Americans used to both design _and_ manufacture
computers in the US. IBM and Apple both did until into the 2000's. Jobs for
both engineers and blue collier factory workers are possible if this cult of
GDP is put to rest.

Tell the "total wealth has increased" shtick to the millions of American
workers who are poorer because of offshoring, or the thousands who will die of
the novel corona virus because we can't manufacture enough masks to give them
to health care workers, let alone ordinary people.

~~~
valuearb
American median incomes continue to climb, and unemployment was at record lows
at the beginning of the year.

Paying someone $30k a year to assemble computers isn’t a good job, nor is it
good business decision when it would be a great job for workers in other
countries at $10,000 per year.

The law of comparative advantage tells us the path to Greater wealth is to
specialize at what you do best.

Imagine if you were a lawyer and an amazing typist and you want to make as
much money as possible. You could spend 20 hours a week typing up your own
documents because you do it twice as fast as any secretary you could hire. But
you make $200 an hour for legal work and the secretary costs $20 per hour. You
can do everything yourself, and make $4000 a week, or hire a full time
secretary and make $7,200 a week.

Apple saves money assembling iPhones in China, which helps them to price more
competitively and sell more iPhones, creating more engineering, marketing, app
developer, designer, tester, and manager jobs here.

I’d rather have those jobs here instead of assembly work.

~~~
nojvek
The problem is that we are slowly losing our specialization. China is learning
how to manufacture better than us. Then they learn how to assemble better than
us, they copy + improve.

China could destroy Apple in a heartbeat by ordering FoxConn to charge a much
higher premium for Apple phones than their own local brand.

------
Lazare
So, the author claims that PE is a scam where PE firms profit at the expense
of lenders. If this was true, you could easily check to see how well lenders
have done, on average, lending to PE firms. The author has not done this.

You could also look at lawsuits between lenders and PE firms (there have been
a few interesting ones, I believe), and see how they've ended up. You could
also look at the terms of loan covenants (agreements between lenders and
borrowers intended to stop this precise sort of thing), and how their wording
has changed during the rise of PE firms, or after high profile PE failures.
The author hasn't done this either. You could also look at what sort of rates
PE firms pay, or what difficulty they have raising loans, or if PE firms which
have failed to repay loans have faced any consequences compared to ones which
have not, but...well, you can probably guess.

In short, the author has identified a somewhat interesting topic (is there
something systematically wrong with the loans PE firms take out with large
lenders, and if so, why is the legal system and/or financial system not
dealing with it as you would expect?), but failed to provide _any_ information
about any part of it, presumably because research is hard, and writing tweets
is easy.

If you know so little about your topic, you're not really going to be able to
provide any value when you try and explain it to others.

~~~
zzleeper
It's not just lending to PE firms but to the original businesses before they
get bought.

Say Basecamp gets a ~ small 100m loan from syndicate. Basecamp is quite
healthy, well managed, low leveraged, so they secure 4% rate for 5yrs, without
many covenants.

Then PE buys Basecamp, leverages it to the sky and beyond, Basecamp sells, and
suddenly the original 100m loan is now junk-grade. The original lenders never
interacted with the PE firm, but they still got screwed.

Could they have prevented it? Sure, with lots of covenants, but they have lots
of added costs for all parties and often have ways around them. Which means
every possible firm that _might_ get bought by PE is now a) having to deal
with lots of covenants, and b) paying 6-7% instead of the 5% they would get if
the likelihood of PE acquisitions was lower.

~~~
travisoneill1
When a company is recapitalized in a PE buy the existing lenders need to
either be paid back in full or explicitly approve of having their debt rolled
over into the new structure. They can't be forced.

~~~
zzleeper
You don't need to change the structure. Change management, new management
raises all the new debt.

Unless there is a bullet proof leverage covenant, then the existing lenders
can't do zip about that. Thus, their only option is to go to the table and
"accept" the new structure.

~~~
valuearb
You are exactly like the author. You don't understand enough to make the
conclusions you make. Lenders aren't stupid in general. They have covenants to
protect themselves.

In the case of Basecamp, which likely has almost zero physical assets, any
loan is going to be very contingent on protecting the levels of profitability
necessary to repay it. Whoever owns Basecamp won't be able to get a credit
card in it's name without lender approval.

Source: I spent the last year working for a firm that is funded by venture
capital loans. Every other loan & credit line had to be made subordinate to
theirs, and we could not borrow anything new without their approval. It
wouldn't matter who we sold the business to, they'd have to agree to the same
restrictions or no sale.

------
dehrmann
These tweets are about how it's a scam to lenders, not PE as an investment.
The way PE works, even as he lays it out, is pretty easy to understand. Why
lenders keep lending? Who knows.

Playing devil's advocate with PE is where it gets a little interesting because
PE tends to go after firms that are close to dying. Are they actually causing
these failures, or are they just the ones delivering the bad news? Do they
deliver shareholders some value by selling off what they can for scrap?

~~~
valuearb
There all sorts of companies PE invests in, few are dying. Typically it’s
companies where your firm can add value. They can be

1) Poorly run, just needing better management. 2) Poorly capitalized, just
needing access to more capital to prosper. 3) Businesses that can be
franchises, like restaurants. 4) regional businesses that can be combined
(rolled up) into a more valuable national business. 5) National businesses
that can be expanded internationally. 6) Liquidations, where the operating
business is no longer viable but there are assets (real estate, buildings,
patents) valuable enough to turn a profit on the purchase. 7) Inefficiently
run with hidden assets. Companies that might own their real estate for
example, but don’t reflect that in their price. You buy the company and sell
the real estate to fund part of the purchase.

PE firms are no different than any VC, hedge fund or investment partnership.
They usually have their own investors and get paid a yearly percentage for
managing the investments, and a share of the profits.

Some of their investments will fail, some will succeed. If they make good
profits for their investors they’ll get rich and do it as long as they want.
If they lose money or struggle, they’ll lose their investors and have to close
shop.

~~~
cheriot
Yet it's also common for PE to take a perfectly fine business, lever it up in
pursuit of higher returns, and watch it shrivel under the debt load. That risk
may be fine for PE investors, but there are a lot of industries where the
"creative" side of creative destruction can't keep up with the debt cycle.

~~~
dehrmann
Does PE usually go after "perfectly fine businesses?" Usually they go after
businesses with some sort of problem.

~~~
cheriot
Kraft wasn't taken over buy 3G because it was loosing money, it just wasn't
profitable "enough". That someone thinks there's more money to be made is not
the same thing as a problem.

The Sealy LBO is another one that got more attention than usual because of
Mitt Romney's association.

------
_bxg1
My only question is, if the lenders are part of who's getting scammed, why do
they keep lending? Do they end up getting paid enough by the predatory looting
that it works out?

~~~
valuearb
Lenders only lend if they believe it’s going to be profitable. The vast
majority of their loans are successful, and they charge enough interest to
cover the losers and still make a reasonable return.

And predatory looting is mostly mythical. No one is going to give you large
loans and allow you to loot the assets and walk away. The loans have lots of
restrictions to prevent that.

What happens is that many PE firms like to use loans to leverage up their
investments to increase returns. If you buy a company, fix it up and sell it
for double in 7 years that’s a 100% return but only 10% a year. Borrow half
the money at 7%, and now you only net a 75% return on the purchase price, but
a 150% return on your investment, or 14% a year.

Try to borrow 80% and you can boost your returns nearly to 20% a year. Like a
mortgage there is a natural tension between what lenders will lend you. They
want to lend as much as possible, without assuming too much risk of default.

Sometimes the natural greed of the PE firm and the lender go to far, and you
get a failed deal and a default.

~~~
youngtaff
One of the problems in UK retail (before CV) is PE buyers, acquiring retailers
and then loading them with debt

Debenhams (about to go bust this week) is a classic example - until 20yrs ago
it owned it's premises, PE bought it, loaded it with debt and then split off
the property into a separate company and signed the stores to ever increasing
rents

Debenhams can't service the debt and the ever increasing rents (and they've
lost their way as a business)

PE debt killed Toys r Us, and many other retailers in the UK too

PE leveraged buyouts are generally bad for everyone except the PE firm, and in
some cases lenders

~~~
valuearb
BTW, you are dead wrong about PE leveraged buyouts, they are generally good
for everyone including the firm.

I don't know much specifically about Debenhams, but what often happens in
situations like that goes like this super simplified example. An entrepreneur
builds a successful business and eventually tires of getting up at 5 am or
just wants to secure the massive wealth they've built. So they endeavor to
sell what they built and shop it to interested parties, and the best price
comes from a PE firm. That's good #1, because of the PE firm the entrepreneur
was able to get the best price for their life's labor.

Lets say the business had annual sales of $100M, and profits of $4M, and the
winning bid was $40M (10x earnings). But the PE firm knows that the firm owned
all of it's buildings and paid no rent. Market rents would have been $2M a
year, so the actual economic profit of the business was only $2M.

The PE firm doesn't want to tie up $40M, so it goes to a bank or a consortium
of lenders to see how much they can borrow against the purchase value. Lenders
not being stupid, won't let the PE firm spin out the properties into another
company if they give a large loan, so the PE firm breaks up the company into
two parts, real estate and stores, and gets loans for each.

The real estate arm now gets $2M in income every year from the stores at
current market rents, so lenders loan it $15M at 8% interest, costing $1.2M a
year in interest. The stores now have a $2M annual profit after paying rent,
they also borrow $15M at 8%, and both subsidiaries net $800,000 a year after
paying interest. The new owner, the PE firm, takes the $30M in loan proceeds,
reducing their total investment to $10M, and they earn around $1.6M in annual
dividends from the company, or a 16% return. If they hadn't leveraged up, they
would have made $4M a year on $40M, only a 10% return.

Ten years pass. Rents in the areas of the store locations have doubled (a 7.2%
annual increase) because those locations were so well selected by the founder
to be in areas that saw a higher increase in population and traffic. Now the
stores subsidiary has to pay $4M a year in rent. But the problem is store
earnings haven't kept pace, sales have grown to $150M a year, but profits
before rent and interest have only grown to $5M a year, because there is now
also more competition from Walmart, Sprouts and Whole Foods.

Now they can't afford to keep up their interest payments, and the CEO of the
stores subsidiary asks the PE firm to make the real estate subsidiary give
them substantial discount on their rent, after all, the PE firm owns both of
them, why favor the real estate subsidiary when the stores are at risk?

But the CEO of the real estate subsidiary argues the opposite. Their real
estate is valuable, if the stores go out of business he can quickly rent their
spaces to new tenants that will gladly pay full rents, and will diversify her
portfolio of tenants to make her business more secure.

The partners at the PE firm by this point know full well what the real problem
is. Despite the boom in population, the stores aren't reaping proportionate
increase rewards because they simply can't. The founder was brilliant at
buying real estate but that covered for flaws in the stores business model.
Maybe they never had the necessary size to compete with bigger chains, maybe
they were always poorly run, or maybe the PE firm dropped the ball in who they
put in charge.

It doesn't matter what the cause is, in the end the PE firm lets the stores
file for bankruptcy and surrenders it's ownership to the lenders. The lenders
will fire sale the inventory to get as much of their loans back as possible,
but still take a large loss.

But the real estate firm is now making $4M a year renting to new, stronger
tenants in great locations, likely paying higher wages (good #2). The PE firm
made around $15M in dividends from both subsidiaries before the stores went
bankrupt, and at same time they sell their real estate firm for $40M (minus
$15M in loans). So in the end their $10M earns a gain of $30M over ten years,
despite the bankruptcy. That seems like a huge gain, but it's only an
annualized return of somewhere between 15% and 20% a year depending on how
dividends were paid. That's a very good return, but not a world beater.

The PE firm lost because the stores failed. If they had just maintained their
original value so they could be sold for the $20M that they cost in the
original purchase. Now their gains are $50M, and their annualized returns are
above 20%. Very few PE firms go into deals like this planning for the main
business to fail, and to make up for it with asset sales. It greatly reduces
your long term returns or can even leave you with huge losses.

If the founder had never sold, the same problems likely occurred. Maybe he
runs the stores better, but he would still have to deal with higher levels of
competition, and finding good new locations would have gotten harder.
Eventually he would have had to wonder whether splitting the business made
sense, that he had a dynamite set of real estate properties being held back by
struggling stores rapidly being overtaken by larger and better funded
competition. The day the stores start losing money would be the day he would
be forced to take drastic action similar to what a PE firm would do.

~~~
youngtaff
Apart from the PE firm doesn't loose as they'll extract the value of the
stores they sold as a dividend long before the business fails

------
LatteLazy
Can we ban these dumb twitter rants please? They're all just examples of
"Brandolinis law":

The amount of energy necessary to refute bullshit is an order of magnitude
bigger than to produce it.

------
lixtra
> Lovell's rule of thumb is the more complicated a bet is, the scammier it is.
> If it pays 2:1 for one outcome, 5:1 [...]

I knew it! Life is a scam!

------
altmind
This seems like criticism of leveraged buyouts, than criticism of PE. Many
good companies were driven into bankruptcies when purchased for their own
money and there were a lot of talks about Bain Capital in 2012 pres elections
cycle. Actually, i was expecting a thread about how PE scams their investors,
not how buyouts are destroying busineses

------
travisoneill1
The author lays out a general rule that if a bet has a complex payout
structure, then it is a scam. Them he applies this to PE deals without giving
an example of a complex payoff structure. The reason that he doesn't give an
example is because the payoff structure to PE deals is simple. If the company
increases in value, the PE firm wins. If it goes down, they lose. I think the
author here means "scam" in the sense of "a bunch of people are making a lot
of money doing something I don't understand, and I'm not getting any of it."

------
toolslive
What a coincidence: I have that book on my night stand. Now 75% of it is card
games, loaded dice and carnivals, but the same patterns emerge over and over.

------
pragmatic
Why oh why must this be written in tweet format? Is this some kind of meta
self referential post-modern exercise that I just don't understand?

~~~
nojvek
Because Twitter is where everyone hangs out. It’s a low friction tool.

------
cryptica
The financial system is made intentionally complicated to obscure the simple
fact that businesses use new loan money to pay for their old loans.

The critical piece of information which is omitted is that the activities of
the businesses through which money flows doesn't actually matter.

This becomes obvious when you consider that:

\- All new money enters the economy as bank loans.

\- The total amount of money in circulation in the economy always goes up
every year as inflation (only some years it goes up faster than other years).

\- The inflation rate is higher than the interest rate.

Clearly, the inflation rate is sufficient to cover the interest rate.

Think about it:

2% inflation rate means that the total money supply in existence increased by
AT LEAST 2% over the cost of a year. If there was $1000 in the economy at the
beginning, it means that at the end of the year, there would be $1020 in the
economy.

Now imagine that you are a bank and at the beginning of the year, there is
$1000 in total in the economy and you print $100 out of thin air and loan it
out to people at 1% interest rate.

After you do that, the economy will have $1100 in circulation. $100 of this
amount, people will have to pay back to you PLUS 1% interest rate per year.

Throughout the year, you make more loans into the economy such that the
inflation ends u being 2%. So for that year, it means that you injected AT
LEAST $20 of new money in the economy as loans.

OK o at the end of the year, your borrowers need to pay you back $10 in
interest (for simplicity, we will assume that the minimum repayment is
interest only). But remember, you (as the bank) injected $20 of new money into
the economy that year... So if your borrowers managed to extract just half of
that new money from the economy, they will be able to meet their loan
repayment for that year and still make $10 profit on top!

Note that the borrowers don't need to work or deliver any real economic value
in order to get their hands on that newly created money, they just need to
setup some intermediaries to take out new loans each year then forward the
money to them through any make-believe business activity. It does not matter
if the intermediaries go bankrupt later; new intermediaries can constantly be
created.

From the perspective of the borrower, intermediaries don't even have to be
directly controlled by you. If they can be fooled or coerced into taking out
loans from the bank and paying you at least $10 of what they borrowed - In an
expansionary monetary environment, that's all you need to be profitable.

~~~
valuearb
Here is a link to Bank of America's annual report, the balance sheet is on
page 25.

[https://www.sec.gov/ix?doc=/Archives/edgar/data/70858/000007...](https://www.sec.gov/ix?doc=/Archives/edgar/data/70858/000007085820000011/bac-1231201910xk.htm#s3D739B2812375B5E8CBEF24D379EE4F7)

Read it and learn, maybe you'll better understand how banks work. They don't
make money up out of the thin air. They can loan out only in proportion to
what they have already. BOA is levered about 9 to 1, so they use around $11
from investors or retained earnings and $89 in deposits and loans from the fed
or others to be able to loan out $100.

Now, they can create demand deposits to make new loans, but even then in
proportion to their equity. Some of the Deposits liability is likely Demand
Deposit line item created from loans, not sure how much. But it appears they
support their loans with mostly customer deposits and invested funds.

~~~
cryptica
But I read in several places that smaller banks had 0% reserve requirements.
Also since covid-19 liquidity crisis, the Fed lowered it to 0% for all banks.
So this ratio of 9 to 1 is outdated and the liquidity crisis proved to us that
this 9 to 1 ratio was not sustainable to begin with.

The small banks were the ones printing money out of thin air. A lot of that
newly printed money just happened to find its way back to the big banks due to
corporate centralization of capital but it wasn't enough.

You can't understand how the financial system works just by looking at the
biggest banks... You have to look at all the banks in aggregate and see how
the new money flows into the system.

The fact is that new money which was printed and loaned out of thin air enters
the financial system faster than interest accrues on all the old loans which
were themselves printed out of thin air at an earlier date.

If you're a central bank and you created your own unique currency out of
nothing (which is precisely what they did) and loaned 100 units of it to some
people at 10% interest over a 1 year term... How will they be able to repay
you back 110 units of the same currency considering that there are only 100
units in existence? Not possible. The only way it can happen is if you keep
constantly injecting new loans into the system and the credit from the new
loans ends up paying for the debt and interest of the old loans.

~~~
AngrySkillzz
Banks have not been reserve constrained in at least a decade, the 0% reserve
requirement is a red herring. Other countries have had 0% reserves for a long
time. Banks are constrained in lending by regulatory capital requirements (see
Basel III), stress test requirements (in the US), and their own risk
tolerance.

------
superqd
Why in the name of Satan is something like this written on Twitter? I stopped
after the first 10. Twitter is not a platform for long form articles, or even
relatively short form, honestly. I cannot understand why people write things
like this on a platform not designed for it. I mean, when they're writing, I
bet they think things like, "man, I wish there was a better way to write all
my words at once and publish it for everyone"

~~~
robjan
Same answer as always: audience acquisition. This guy has nearly 500k
followers on Twitter so more people will see his idea if he just posts a
tweetstorm there. If you just post a link to a blog most people won't click
through and fewer people will join the discussion.

But here's an unrolled version:
[https://threadreaderapp.com/thread/1246445485860118528.html](https://threadreaderapp.com/thread/1246445485860118528.html)

------
battery_cowboy
Maybe he has good points, but he's a fucking writer, and when I got to "20/" I
noped out of reading anymore. Just write a damn article and get it published,
twitter was designed for ~160 characters or whatever, it's not for long-form
articles.

~~~
_bxg1
You're really going to ignore the content because you're salty about the way
it's laid out on the page?

~~~
WalterBright
There's an awful lot available to read. Poor presentation, layout, grammar,
spelling, capitalization, punctuation, cursing, etc., is pretty much a
guarantee of equally poor thinking. Hence not worth reading.

------
smabie
Sounds like everything is a scam then.

