Comment by civilized
2 years ago
I have the same question every time I see one of these articles. I think I've even posted the question in previous HN threads on private equity shenanigans. The question is:
Why is this profitable?
If the land is worth $1.5 billion, it should have cost PE more than $1.5 billion to buy the company. Then there would be no way to make a profit by selling the land, paying yourself, and letting the company go belly-up.
Why does PE keep doing this? Presumably because it works? But why does it work? Are the sellers less sophisticated at asset valuation than the buyers, and frequently lowball themselves? Or maybe owners/stockholders are sometimes just tired of holding this asset, want cash to reinvest somewhere else, and are willing to cash out at a discount?
Because, contrary to public belief, PE firms are skilled and sophisticated managers.
Most deals are successful under their management, and this is why banks usually lend 70-90% of the purchase funds.
They specifically target companies that are undervalued, in distress, and can be turned around or liquidated for more than the cost.
PE isn't an exotic business philosophy. It is literally just a private buyer.
> PE isn't an exotic business philosophy. It is literally just a private buyer.
With a complex tax-favorable structure, https://www.ropesgray.com/en/insights/alerts/2019/02/tax-iss...
Great read! The 6 layers of corporations with different functions was fascinating.
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"Most deals are successful under their management"
Although often to the detriment of customers as I have seen with several vets and my former dentist. Prices suddenly doubled and tripled or even more.
I'm not sure those vet deals are profitable yet. A lot of the deals in the last 10 years will be looking for their exit soon and I'm not sure there are buyers.
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I thought the PE model was to buy one of these companies, leverage them with many multiples of debt while paying themselves out massive fees and bonuses, then letting the huge interest and debt load take its toll on the husk of the company.
It often is, but this isn't some kind of free money tree that only rich people can access. Loading up a company with debt requires a creditor. Selling underlying assets requires a buyer. If these counterparties don't offer enough money to offset what PE spent to buy the company, PE loses. And this often happens, including, apparently, in this case!
“ us what happened with Toys “R” Us—how it went from a successful and iconic retail chain into bankruptcy [and] left employees with a $60 severance, while the private equity-anointed CEO cashed out with a $2.8 million exit package. It’s a really fascinating story. And I think it illustrates a lot of what works and doesn’t work in private equity. [In] 2005 a coalition of three firms, KKR, Bain, and Vornado, bought up Toys “R” Us for several billion dollars. Now, here’s the trick about private equity: They invested a little bit of their own money and investor money, but most of the acquisition was paid for with debt. And it was [not debt] that the private equity firms would hold—it was debt that Toys “R” Us would be responsible for paying. And that [debt] turned out to be enormous, and enormously burdensome. In fact, the common story around Toys “R” Us is that it was defeated by Amazon, that the wave of e-commerce made their business obsolete. That wasn’t actually true. In fact, Toys “R” Us was profitable the year before it filed for bankruptcy. The challenge that it had was [that] it was spending as much on servicing the debt as it was on actually making income. So part of the problem with the private equity acquisition was the reliance on debt. The other [problem] was the disinvestment in the business itself. Reportedly, the private equity firms slashed investment in basic things like store upkeep to such an extent that people were complaining that so much dust gathered in the rafters that it was...falling down onto customers like snowflakes. Beyond just disinvestment, they executed various tactics that brought money from Toys “R” Us to the private equity firm—things like extracting an estimated $180 million in fees.“
https://open.substack.com/pub/adaml/p/a-conversation-with-br...
So the sucker here is the bank? Can't say that I care that much about that. It's just business and the banks apparently suck at it. They can foreclose on the business and sell it off to someone who relaunches it.
Yep, and banks come out ahead on average too. That's why they choose to lend to PE.
Some mortgages and credit cards end in bankruptcy too. They set their interest rate according and it is a cost of doing business.
Don't the banks just print the money when they lend out anyway? Before the loan the money didn't exist. I suppose the bank is still holding the bag for the unpaid debt.
I think the sucker is always regular people. The ones that worked at these companies, and the collective us that the banks pass these costs down to
The leverage game is much tougher to do now that ZIRP is thankfully over.
But why would anyone lend to a company which has been bought out by a PE firm then? Wouldn't banks turn around and say "hold on, I know this old trick, you're going to take loads of my money and then give it to yourself and default, and I get nothing"?
The PE firms use the debt from their purchase of the business to load them up. They don’t even put their own money into it.
Because the asset is worth the net present value of its future cashflows. Unless you take over the the thing and liquidate it, the value of the property is far in the future... so arguably the takeover and liquidation increases its value.
PE here acts like a fungus unlocking the energy stored in dead trees that have fallen to the forest floor. :P If this is good nor not depend on if you're one of the creatures that has made their home in the log, if you're the fungus, or if you're the newly growing shoots that appreciate clearing out the obstructions.
I debate if PE unlocks or unsustainably accelerates. I think it comes down to should a small minority get very rich quickly, or should a going concern support a much broader ecosystem. I have seen PE "wreck" a few companies first-hand, so my selfish preference is the former.
I have less of an opinion on specific cases or even the overall effect-- but I do think it's important to realize that there can be non-incidental public benefits or even when there isn't a benefit specifically that the outcome was sometimes inevitable and in which case if you're to attribute fault to the PE it ought only be for the acceleration.
Not every case is a success, but the bad ones are hugely over represented in the media.
These articles are not written to inform the reader.
In bankruptcy the term is called “fraudulent transfers.”
because the people who have spend years of their life trying to build something, whether that's a brand, an experience, a product, whatever, have an emotional attachment to it and don't want to see it destroyed. so when they're struggling, the look for a lifeline. PE provides that lifeline as a cash infusion in exchange for ownership.
PE "vulture capitalism" is profitable because it takes advantage of vulnerable people who want to see their dream continue. and yes, the execs at $1.5bn companies can still be vulnerable people who want to accomplish something in the world.
the argument that PE firms are skilled managers only holds water if they actually turn the companies around and make them succeed. but more often than not they don't, they're burning things down to milk as much profit as they can before the end.
This may be true but it doesn't have to be so cynical.
Most people don't have experience on how to squeeze the last drop of value from a struggling company. And many don't know how to quantify the value either. So if the average corporate executive tried doing this, they might not recoup the full value than if they just sold to the "experts".
It's not. They paid $2.1 billion for Red Lobster and sold the land for $1.5 billion. Now it's bankrupt so they lose $600 million.
No, this isn't true. First they no longer own it; we don't know what the sale terms were. Second (and more importantly) PE is a term-based play; if you do it right you get both the returns over the life of your fund by directing more revneues to payouts, aggresively cutting costs and eroding long-term investment (like commercial real estate) AND you sell at the right time to generate a multiple return (before all those unfavourable leases start to impact financials). Red Lobster 18-24 months ago could have sold at a premium to the $2.1B purchase price.
Are you accusing the PE fund of defrauding the buyer? If not then it's just a bad investment on their part and lucky for the PE fund, but if you are then you damn well better provide some actual evidence.
Good point. I think this changes the story a bit. It's not exactly that PE is predatory. If PE were unlocking the value of assets held by an underperforming company, the transaction could be explained as the creative destruction of capitalism making room for something better to hold those assets.
In this case, it's more like private equity wasn't as smart as Red Lobster's owners, so now Red Lobster's owners have extra capital to allocate in the economy. Which is also arguably good.
If you liked the restaurant, of course, none of this is much comfort. But if nobody with a ton of money thinks Red Lobster is a good use of capital, from either a financial or sentimental perspective, it may go the way of the dodo.
Correct. Everything is working fine. If those individual Red Lobster locations are making money, they will continue to exist because the lenders will get paid back more by cutting a deal and continuing to operate than by closing the restaurants. If the individual restaurants are not making money then they will close, as they should. The overall demand for restaurants is unchanged in either scenario, so if they close, their place will be taken by other restaurants.
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The PE playbook (assuming 5 year term):
1. buy asset-heavy companies with good cashflow and add to you portfolio. 2. aggressively cut costs on long-term investments like R&D, major capital projects, and squeeze OPEX 3. at the same time focus solely on S&M. If possible get everyone on multi-year contracts that last until year 6 (often with heavy discounting on the back end) 4. shed impressive dividends over the term 5. years 3-4 make signalling investments that hint towards hockey-stick growth: (real life) examples: 1. replatform your database from on-prem to AWS, 2. move OFF aws to fixed-provisioned (I'm not making this up) 6. shop for a new PE fund to sell. Look for a 3x or higher multiplier on initial investment 7. sell, repeat, parchute in your bench of executives.
Eventually you've got a bunch of companies that look like subprime-backed CDOs
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it's a bust-out, you identify a patsy and you stick it to them.
sometimes the company is worth more dead than alive, the parts are worth more the whole, especially when you can leave someone holding the bag, and the PE company gets paid to make them dead.
in any event the company is worth more to an extremely unscrupulous buyer than as a going concern in public markets.
https://www.dailymotion.com/video/x4348lj