Comment by andrewla
2 years ago
These private equity deals are the convergence of a couple of phenomena.
The most obvious is low interest rates, which is fortunately dying off. The ability to borrow lots of money is something that smaller, well-run companies, are reluctant to do. Why bring in a bunch of cash to expand and take on debt when you are operating at a reasonable profit?
The secondary is the undervaluing of customer goodwill -- what PE firms can do is directly monetize that goodwill by squeezing those customers. The income stream from a reliable customer can be translated into present value, and prices and quality can be adjusted to the point where you can drive a customer's goodwill down to zero while extracting something that approximates the present value of the lifetime income stream from that customer.
Inflation plays a role -- businesses are reluctant to raise prices because they don't want to sacrifice goodwill, but the supply chain costs keep going up. They have to somehow maintain margins, but they do so by raising prices slowly. PE has no such scruples.
I'd add that it's also a function of revaluing the assets, and then determining if the return on asset value is appropriate.
Take a small restaurant. Grandad bought the building 50 years ago. That's long since paid off.
The restaurant makes say 10k a month. Good honest business. But the building/land is worth say a million.
The owners don't care, it's paid off. The business makes a good living.
So I come along and offer 500k for the business. That's basically 4 years profit up front. They want to retire soon, so that's good deal. But I turn around and sell the land for a mil. I've made a big profit, and since rent is now 10k, in only a few months the restaurant goes under.
The root problem is that the business is delivering a really poor return on asset value. Which opens the door to someone buying the assets, not the business.
That's what it looks like to me too. All of the Red Lobsters I know of in California are in some very high volume locations, often in large multi-block shopping malls where everyone in a several mile radius goes to shop. They did a good job front running the state's population growth and locking in some great locations before they became really expensive.
It's pretty much a license to print money as long as the restaurant can maintain competitiveness in quality and cost. All of the restaurants in the strip mall that holds my nearest Red Lobster have been around for over a decade and half of them for over twenty years. The turnover is really low because everyone rakes it in as long as they don't mess it up. Looks like Red Lobster messed it up.
Private equity takeovers are often just scams to convert customer trust to short-term profits, but labeled as growth.
You can get away with cutting quality for a little while, but eventually customers are going to lose trust and you're not going to get it back.
the whole point is to flip the business in 5ish years.
Sometimes it is. The more cynical version of this, though, is to engage in a protracted liquidation of the business, and get as much return on the assets as possible in the short term, with no intention of the business surviving into the long term.
Optimistically, you could see this as a way of freeing operating assets from underperforming businesses and putting them back into circulation, clearing the way for superior competition. But that only works if there is superior competition to fill the gap, and the whole economy isn't saddled with dysfuction, perverse incentives, and bad leadership. Unfortunately, it seems like we're getting closer and closer to that latter situation every day.
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So goodfellas, basically: https://www.youtube.com/watch?v=ZPtjyqgZAUk
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But that is the PE playbook. Take businesses and squeeze as many profits out of them before they die.
https://www.nytimes.com/2023/04/28/opinion/private-equity.ht...
PVH is the first time I realized this is what everyone was doing. I have never been able to put it so succinctly though, thank you.
>but the supply chain costs keep going up.
A good portion of this is cartels that could be squashed. Notably, real estate (commercial and otherwise, driving up the single biggest cost of business/living). But, then, you'd have to deal with the people who rely on cartel-ized pricing power for their income, investment collateral, etc. (But someone is going to get thrown under the bus, so might as well be them.)
Private equity is mostly driven by state pension funds that are basically unfunded entitlements. They have to pay out more now as the boomers retire, but they have no money so seek ever-increasing rates of return, even above market rate. They can't find anything on the 'public' market, so they turn to these alternatives. Meanwhile, those on the supply side see that there is money that needs to be invested in these sorts of vehicles to have any shot of paying out, and they oblige.
People will say it's all about greed, or whatever. But it's not 'the rich' buying these PE investments. It's public pension funds (i.e., government workers, teachers, mailmen). It also has nothing to do with the interest rate (although that certainly enables it, it doesn't explain the demand for the investment vehicle itself or the source of funds).
According to a study from UNC Chapel Hill [1], public pensions comprise 31% of investors at PE funds and 67% of capital.
That means that, while it's true that perhaps the other 69% of investors are the supposedly greedy rich, if it were just them investing, PE would be 3x smaller than it is today.
We have to face the truth which is that these sorts of deleterious economic effects that occur as a result of PE takeovers are due to unfunded public pension liablities.
[1] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4283853