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Private equity is not, in itself, a problem.

Leveraged buyouts however are starting to become a serious problem. They allow the hollowing-out of functional but low-profit companies into debt-ridden shells. The most recent example in the news is Pizza Express: what is a restaurant chain doing with £1bn of debt? https://www.bbc.co.uk/news/business-49957551

This is bad for staff and bad for creditors.

It is bad for staff. Working for a company that’s been bought by a PE firm sucks. Almost always layoffs are coming and you’ll have to do more with your resources or more Witt fewer resources.

Creditors are lending their own money. If they make a bad bet that’s on them, should have done better due diligence.

What PE is good for is increasing economic efficiency more generally which redounds to the benefits of consumers in the long run.

Regarding layoffs: "We find that the real-side effects of buyouts on target firms and their workers vary greatly by deal type and market conditions... This conclusion cast doubts on the efficacy of 'one-size-fits-all' policy prescriptions for private equity."

[0] Pro Rata https://www.axios.com/newsletters/axios-pro-rata-ed716a8a-37...

It really depends on the PE firm and the company. In the software space, there are large PE firms which have a tendency to cut headcount because in their view, public market CEOs focus on growing revenue at the expense of profitability. This tends to lead to excessive full time employees over and above best practises...so if the previous CEO overhired and the PE firm fired people....then it's the PE firm that's in the wrong right...end of story? I'm not saying you are saying this but this is the underlying vibe I get in these kind of discussions....

The bad LBOs are featured much more prominently than the good ones.

LBOs create long-term value for society by disciplining managers (see Nabisco) and allocating capital more efficiently. Debtors are not forced to lend, shareholders are not forced to sell (unless the offer is so objectively great the company has a fiduciary duty to sell), so everyone is a consenting adult.

People who get fired go work for a different company eventually, and the pool of companies workers can work for only improves in a competitive society.

LBOs don't create value, they exist to transfer value from stakeholders to shareholders. PE buyouts have something like a 10x rate of bankruptcy filing compared to the benchmark.

LBO's require buying a healthy cash-rich business, loading it up with debt, an then forcing repayment and management fees to the PE fund through cost cutting, dividend recaps, and other measures to transfer cash. Plus since the PE firm themselves puts in 1-2% of their own cash, they face little risk and huge upside for taking on large debts on their PortCo. LBO firms aren't responsible managers because they don't have the same capital stake that a real owner would have.

LBO's wouldn't exist if funds were responsible for the financial liabilities they place on their PortCos.

Wouldn't it be expected that companies who are targeted by PE are more likely to go bankrupt, independent of any actions by the PE firm? They say they're targeting poorly run companies, after all. (Not to disagree with your larger point, but want to correct any mistakes in my understanding.)

A very small portion of PE is funds focused on either turning around poorly-run companies or growing small companies, mainly because this is very hard and requires specializing in a sector. Plus exit horizons are longer than 3-5 years.

Most PE activity is about finding a cash-rich company with steady returns, having said firm take out large loans to service the debt, and using fees/dividend recaps to transfer company wealth to the PE fund. PE acquired companies have a much higher bankruptcy rate than the benchmark

The fact that there are poor performing PE funds out there doesn't make LBOs an objectively evil device.

You're simply arguing investors are dumb for throwing their money at PEs somewhat indiscriminately rather than only investing in high-quality PE funds with investments that do not go bankrupt as often.

Moreover, one could argue that the mere existence of LBOs forces managers to be more disciplined and act on behalf of their shareholders, which marginally reduces the challenge that agency costs pose on public corporations

The LBO model inherently makes operational flexibility difficult.

The whole idea that shareholders are the only ones that matter is both recent and poisonous to the long-term health of the economy.

> The whole idea that shareholders are the only ones that matter is both recent and poisonous to the long-term health of the economy.

They are not the only ones who matter, just the ones who matter the most. My point was more about corporate kleptocracy and whimsical managers running wild. I did not claim shareholder value trumps everything else.

In fact, the agency costs of appointing managers to run a business affects not only shareholders but every other stakeholder.

But for the record, Unocal v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) established that takeover offers ought to be evaluated in the context of all stakeholders – "shareholders, creditors, customers, employees, and the community"¹ – with Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986)² later modifying this test to put shareholder value above all other stakeholders in certain circumstances ("Revlon duties").

Whether that is "poisonous to the long-term health of the economy" is most certainly not a foregone conclusion and a bold claim to make, particularly given that we're currently in the longest period of prosperity³ and LBOs are everywhere to be found


1. https://en.wikipedia.org/wiki/Unocal_Corp._v._Mesa_Petroleum...

2. https://en.wikipedia.org/wiki/Revlon,_Inc._v._MacAndrews_%26....

3. https://www.cnbc.com/2019/07/02/this-is-now-the-longest-us-e...

Cost cutting is one view, increased efficiency is another.

Have you, by chance, read Barbarians at the Gate?

Not only have I read it, I have also provided financial / strategic advice on several LBOs

Isn't it great to make claims about entire industries based on single data points?

Why do these companies somehow deserve to exist? Why can't the creditors make their own decisions on who to lend to and pay the price if they are wrong?

If you look closely, much of the "debt" is actually between subsidiaries of the same controlling PE owner - it's possible for the left hand to loan money to the right hand, claim back huge interest payments (Maplin were paying 15%! https://leftfootforward.org/2018/03/revealed-how-private-equ... ), thereby taking profit out of the subsidiary without it appearing as profit to the taxman. The internal creditor at the high rate will have got their principal back very quickly. It's the external creditors (suppliers etc) who get stiffed.

Remember that every supplier and every employee of a business is also a creditor.

The author doesn't know how bankruptcy works. You can say the debt is "secured" all day long, but if it is held by the owners then the bankruptcy judge will immediately kick it to the back of the line by equitable subordination.

Interesting. What about the obvious follow-up question: Why do the external creditors that lend to a pizza company via accounts receivable deserve their money back? Didn't they see the scammy nature of the operation?

It’s not like suppliers of a chain this large aren’t big savvy corporations too.

<shrug> They're Pizza Express. There's one on every high street. Who would expect them to fail to pay invoices? There's a cost to credit-checking your counterparties, too. And at the end of the day, none of them are invulnerable. If you're a food wholesaler or a POS systems company, do you refuse to do business with Pizza Express? Do you have time to go through their accounts? Is £1bn even unusual? Have they been like running successfully like this for a while?

I think this particular case there might be late payment but the business is going to remain in operation and they'll eventually get paid. Thomas Cook on the other hand incurred a lot of externalised costs.

I'm really not a fan of post-hoc "ah, people deserve to lose their money because they should have known (nonobvious XYZ)". There's even a surprising sentence in the BBC article:

> its auditors were happy to conclude the chain is a viable going concern when it signed off its accounts in April this year despite the company's debts being worth more than its assets

If the auditors (chartered regulated specialists!) think it's fine, who would say it wasn't?


> despite the company's debts being worth more than its assets

Doesn't mean much if you're just comparing Book Value...

In this case they wouldn't care because the external bank debt is senior to the debt in question. The author doesn't really know anything about corporate finance as I would expect from a publication called "Left Foot Forward".

Why do the lenders that lend $1B to a pizza company deserve their money back? Didn't they see the scammy nature of the operation?

Do the lenders lend that $1B to the pizza company, or did they lend it to the hedge fund, which then transferred the debt to the pizza company? If the latter, I think the hedge fund should be considered the lender to the pizza company so they're on the hook when the pizza company goes bust.

This is what really killed Toys R Us.

PE firms essentially made TRU borrow shit tons of money from them at ridiculous rates to buy itself from public shareholders, then eventually they couldn't keep up with the interest payments.

At the time of the buyout, Toys R Us was in a sales slump, but they were still making a profit and continued making a profit until the very day they closed their doors.

Company management decided to borrow money at a bad time. You phrased that in really weird way to make it sound like some sinister external force is making them do things against their will.

If feels sinister because the company didn't need to borrow money.

A business that was adequately servicing investors, employees, and customers, has been destroyed because a small group tried to extract more wealth from the company than it could sustain.

But I would probably agree with you that just because something feels sinister, doesn't mean that it actually is. And "Toys R Us" would have been destroyed by Amazon within the decade no matter what. Gary Vanderchuck talked about how terribly poor the management was, and their failure to do any significant innovation or participate meaningfully in any of the trends around children's entertainment.

It was sinister.

Bain, KKR, and Vornado borrowed money to "buy" the company then saddled the debt with the purchased company. So in a way, they did force them.

The shareholders and board members prior to the buyout made out like bandits, which is all they wanted.

Toys R Us couldn't keep up with the interest payments on loans from Bain and KKR. Not to mention "advisory fees" and whatever bullshit they charged Toys R Us with. That's what put them under. Not lagging sales. Not bad business. Being "bought" by sinister people.

If feels sinister because the company didn't need to borrow money.

A business that was adequately servicing investors, employees, and customers, has been destroyed because a small group tried to extract more wealth from the company than it could sustain.

It looks almost like fraud, an exploit using an edge condition.

* Buy a working company.

* Borrow a ton of money, siphon it out.

* Bankrupt the company which is liquidated for much less than the amount borrowed.

* The lenders are left holding the bag.

Hedge funds and Private Equity are entirely different beasts

You can't just transfer debt like that. Otherwise I could go take out a mortgage and transfer it to a homeless guy for beer money.

It's crazy, that's almost £1.5M of debt per restaurant. I expect the independent pizza place next door has less than 10% of that on average

You can buy an existing successful McDonald's for about that cost, and McDonald's will help you succeed in paying off the loan. Of course you will need to take out additional loans once in a while to replace old equipment, or support some new product line, but overall the business plan is you work hard for 35 years, make a good income, then sell the business to someone else and retire in comfort should work out. I think any other restaurant should have similar economics. As such the cost doesn't scare me directly assuming their management is good enough to run the business.

What does scare me though as only the most successful locations are worth that much debt per restaurant. They better not have any locations that are not in the highest performing locations. Of course their returns can be difference from McDonald's. I don't have any insight into their business to know if it is reasonable for the or not, but it passes the smell test of could be reasonable.

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