For as long as there have been private corporations, there have been private individuals or other corporations that sought to buy all of part of existing corporations. Often, these purchases take place on the public markets (i.e., the stock exchange), allowing investors to share in the profits of a company, but often not conferring any real ability to direct that company. Sometimes these purchases take place through private negotiation, and since one person or company may not have enough money to buy a company on their own, private investors often pool their money together for acquisitions. Since these investors may not be able to identify good targets for acquisition, professional investment managers often direct these pooled funds, granting the investors the benefit of their experience in evaluating companies. As part of the selection process, these investment managers may look at companies which have good "bones" but could be worth substantially more if they were reorganized or simply had more experienced, professional management teams to help take them from the start up phase into mature companies. This is what private equity funds do, in the simplest of terms. They solicit private investors, identify companies to acquire with investor money, and then hold or restructure them and install professional management teams before selling them in a few years (hopefully at a profit). Unfortunately, reality is not so simple, and the actual mechanics of how these simple goals are achieved can be staggeringly complex. Since the deals are private and the complexity is high, private equity companies have often operated at the periphery of society's awareness. All of that is changing now that Mitt Romney (founder and former CEO and managing director of Bain Capital) is running for president.
As many of you know, I am a tax and employee benefits lawyer who focuses on private equity. My job gives me the rare opportunity to see and be heavily involved in how private equity funds operate all the way from forming a fund and soliciting investors to selecting and acquiring companies, and designing incentive compensation plans for management, to ultimately selling those companies in a few years time. Watching the media describe and discuss private equity has been somewhat surreal for me, in part because concepts I take for granted seem to be entirely opaque or arcane to the media (and the general public) and as a result, a lot of misinformation is disseminated. My goal in this thread is to try and continue the conversation that was started in the election threads about what exactly PE is, how it works, and why the industry is so confusing to outsiders. I really believe that anyone can understand how PE operates, but that most people simply are not given the opportunity to do so, since much of what is written about the industry is incomplete, misleading, or simply inaccurate. To that end, I welcome any questions people have about PE, and will endeavor to answer these questions to the best of my knowledge, based on my experience. One important caveat is that I cannot discuss specific PE firms or deals (unless those deals are public record and I was not involved in them) out of confidentially concerns.
My hope is that people will walk about from this discussion better informed, and better able to engage in open debates on the merits of and problems with the PE industry.
For reference, I am including the text of some of my posts from the election threads which explain how PE works:
1. On the structure of PE funds:
I think it may be helpful if I briefly explain how these funds are structured. A PE fund is generally structured as a limited partnership. This is an entity which allows the investors to purchase and hold an interest as limited partners, without having a say over the operation of the fund, and most importantly, without having any liability for the fund's losses beyond their investment. By law, a limited partnership is required to have at least one general partner who has unlimited liability. Since GPs have unlimited liability, no one wants to risk the assets of one fund by associating them with the GP of another fund, so each fund has a new entity set up as a GP to firewall the liabilities of the various funds from each other. Another consequence of the GP having unlimited liability is that it basically means no one wants a GP to do anything but the absolute bare minimum. The solution to the unlimited liability of the GP is to have investment managers actually control and carry out the business of the funds. There are many advantages to this structure, including the ability to have a single manager entity run multiple funds without cross polluting them with liability for other funds. The people who will be working on the fund through the investment manager are disclosed in the materials sent to investors to solicit their investment. Another consequence of the structure is that PE funds do not have boards of directors (only corporations have those).
So that is management. Now onto ownership. As mentioned above, Funds are generally set up as limited partnerships, but for a variety of tax and regulatory reasons, certain investors may not be able to invest in that partnership. To accommodate these investors, the fund will set up additional limited partnerships, corporations and other vehicles in various countries, and all of these entities have GPs or boards of directors, but none of them do anything, because these extra partnerships and corporations are required to just invest in the main fund and do nothing else. Administrative tasks are handled by the investment manager described above.
What is important to keep in mind is that the investors in a PE fund are all equity holders. Even if the main fund has no investors other than alternate vehicles, those vehicles are equity holders. The managers who work for the investment manager also have an interest in the funds (whether direct or indirect). So if you see an entity that claims it has a "sole shareholder" then you know it is not the fund or one of the main entities. The investment manager may only have a single owner, but unless that owner is listed in the investor disclosure, he is not involved in operating funds, and is just a name on a certificate of formation or comparable document.
One last point on guys with their names on documents. Forming a corporation is not that big of a deal. You file a form with the state, pay a nominal fee, and file a form governing document. The forms require that the initial owners, officers and board members be listed, and since you usually want the corp set up as fast as possible, you just get whoever is around to put their name on the documents (usually the most important person you can find). If the corp has a real purpose, then you will substitute the appropriate people into those roles. If the entity only exists for regulatory or convenience reasons but doesn't do anything, then you probably never bother.
I hope this is helpful, and that it sheds some light on why Romney probably actually had no real input, control or insight into anything happening at Bain while he was out running the olympics.
2. On why these structures are so complex:
If anyone is to blame for the complexity, it is congress and people like me. A client calls me up and says it wants to start a new fund. They are concerned with what the fund will actually do (i.e., what the strategy is) but I hand wave that away (because who cares about the substance) I need to focus on the important things. So I ask who they want investing and how they want to compensate people. They tell me that want to be open to everyone in the US and outside, and that they also want to have the employees share in profits (but not be entitled to a portion of the capital that investors contributed) and they also want to issue options. Sounds simple, right?
So I send them back a structure chart with 12 different entities on it that will just make up the fund (and this is before they even invested). Wanting to be open to everyone required me to form a cayman corporation for tax exempt and non US investors to go through (to avoid those investors paying tax on all of their exempt income and filing tax forms with the US despite having no US taxable income, respectively), and two aggregator vehicles which individuals who don't meet the standards of an accredited investor can use to pool their investments into a single entity big enough to be permitted to invest. Wanting to give the employees a share in the profits means I need to form a separate company for the employees to be employed by, to keep them from being taxed on their entire income as owners instead of employees (bizarrely, the government insists on this treatment despite it costing them lost tax revenue. . .). Wanting to give the employees options requires another corporation that does nothing but hold an interest in the partnership, because of a technical glitch in the rules on deferred compensation which doesn't account for the differences between partnerships and corporations (this is a problem that is so complex the IRS has thrown up its hands, and the rules everyone needs to understand how options on partnership interests work isn't even on the IRS work plan). Each entity that is a partnership also needs a general partner, which does nothing, but it needs to exist.
Believe it or not, what I just described above is a greatly simplified structure, and the actual structure, including additional vehicles for certain investors to invest through, could have four times this number of entities, before a single investment has even been made. Each investment will require at least 3, but probably more like 10-15 additional entities. And this is just one fund. A PE firm more have 30 of these things floating around out there. The business people would LOVE to get rid of all this and have a single partnership that just did everything, but it isn't even possible.
3. On why accusations of "pension looting" are not generally accurate (the book referenced below is "Retirement Heist" by Ellen E. Schultz:
This is a complex issue, and I will do my best posting on my phone for now. I'll be happy to explain further if people have specific questions.
As a baseline, pension plans (for purpose of this post I am only talking about plans subject to ERISA, not to state pensions) are required to state that (1) plan assets (money or other property contributed to a plan) is available for the exclusive benefit of plan participants (the "exclusive benefit rule"), and (2) that a participant's right to benefits cannot be assigned, garnished, transferred or otherwise alienated (except in certain limited circumstances like a court order following a divorce) (the "Antialienation rule"). Together, these rules generally prevent a plan sponsor (i.e., the employer) from making use of or benefiting (directly or indirectly) from plan assets. There are fringe cases, like where a company invests corporate assets and plan assets side by side, and the company gets a better deal on fees because the combined size of the investments is larger than the corporate investment alone, but for the most part this is a pretty ironclad rule.
Like all rules, there are exceptions though. The main relevant exception here is that a plan sponsor is entitled to the return of any money in a defined benefit plan (a plan which pays a fixed amount following retirement, as opposed to an account balance plan where you get whatever is in your account) in excess of what is needed to pay all benefits. This makes sense, because the deal with employees is that they get a fixed amount, so giving them the excess would just be a windfall, and would discourage companies from ever overfunding their plans. Since the company has a right to this excess, the company can sell this right. That is what this book is mostly referring to when it says plans were used to find reorganizations. The company effectively accelerated this reversionary interest by selling it to a third party. Once you have done this, ironically, you have the same disincentive against over funding the plan that you would have if the excess went to the participants, so the result is that you stop putting money in (remember, this is at at time where the plan is already over funded to a significant enough degree for someone to be willing to buy the right to the over funding). So while no money ever gets taken out of the plan, the employer stops putting money in.
Another way in which the company can arguably benefit from plans is by directing them to purchase employer stock. In the wake of Enron and Worldcom these rules have been made much stricter, and lawsuits against plan sponsors by plans which invested in employer securities that plummeted in value (so called "stock drop cases") have become very common now (the plans usually lose though).
Aside from these main instances of "looting," neither of which actually involves taking money from the plan, the book also refers to plans which allow money from a retirement plan to be moved into a trust to pay retiree medical benefits as looting. The problem with this characterization is that even though the above referenced antialienation rule does not apply to medical plans, the exclusive benefit rule still does apply, meaning the retirement plan assets moved into the medical plan can only be used for the benefit of the participants. However, since medical plans are not subject to funding requirements like pension plans are, it is possible for an employer to move money from the pension plan into the medical plan but then to stop putting additional money in, so that once the money that was initially moved is exhausted, there may be nothing left to pay retiree medical benefits, and the employer may terminate the plan. While this may in practice have the effect of hurting participants (if the money stayed in the retirement plan then it would have helped pay the benefits of the last person to retire, but in the medical plan it can all be exhausted by the first retiree), there is no game to be played here by employers, other than setting it up as a cost free benefit which employees are generally happy to receive.
The book also discusses claw backs, and this is the single type of "looting" which I think is most bizarre to include. Basically, since actuarial determinations of benefit amounts may be difficult to determine, especially for a long standing, complex plan, it is not that uncommon for plans to accidentally make overpayments to participants. There is an exception to the antialienation rule which explicitly permits plans to claw this money back, since (1) the participant was not actually entitled to it and (2) the money is needed to pay the other participants.
Finally, the book describes various benefit design decision changes, like adjusting actuarial assumptions or eliminating certain forms of benefits like death benefits. Calling these "looting" seems strange, since, like everything else, they don't result in money coming out of the plan, just changes in how much money needs to be put in to cover benefits. That said, I won't deny that these changes can hurt participants, even though they are explicitly deemed by the law to not hurt them (there is a rule called the "anti-cutback rule" which generally prevents changes which disadvantage current participants, but these design changes are all deemed to not be cutbacks). It also describes the decision to freeze a plan from allowing new participants to enroll as looting, which is very strange to me, since all that a freeze does it say "if you are in, you're in for life, and if you are not a participant, you may not participate." This is a simple economic decision about what benefits you want to offer employees, not a change that impacts the plan or current participants.
To sum up, there are lots of ways that a company can change its obligations with respect to pension plans, but none of them involve actually taking money that participants are entitled to from the plan. Instead, they are all just ways to adjust how much money the employer is required to contribute, but none of them obviate the requirement to fully fund all obligations to current participants under the plan.
4. On corporate debt and the use of leverage:
Private equity firms raise a fixed amount of capital from investors (often in the billions for a single fund) and then use that money to invest in companies, with the goal of making as much money off those investments as possible. One clear strategy to maximizing return (and the odds of having winning investments) is to diversify by buying as many companies as you can. But companies are usually pretty expensive to buy, and once you buy them your capital is tied up for at least a few years before you sell. PE firms could increase their ability to diversify by soliciting more investment capital, but every dollar of additional capital dilutes the percentage of the return which goes to investors. Since the goal is to have the highest return on investment ("ROI") possible, PE firms often look to debt financing to increase their pool of available capital. The main advantage of debt financing is that a loan has a fixed value, so if you borrow half of the cost of a company at 5% interest, when you sell you only have to pay the lender the principal amount plus the interest, and anything about that amount gets shared among the investors. Being able to deduct the interest is a perk, but it is not the main reason to do it (and indeed, it is no that uncommon for foreign debt to be treated as equity for US tax purposes, meaning the company cannot deduct the "interest").
The other way that PE firms use debt is with the dividend recapitalization. In simple terms, this involves buying a company with cash, taking out a loan secured by the company, and then using the proceeds of that loan to effectively recapture the cash you paid to buy the company, so that you can use it to buy another one. I know this sounds underhanded, but please keep in mind that the lenders are (at least in theory) highly sophisticated assessors of risk, and by agreeing to make the loan to the company, they are determining that the company will most likely be profitable enough to repay the loan, including interest (no bank wants to wind up owning the company if it defaults). As long as everything works as intended, the company is sold a few years after the dividend recapitalization and the loan is fully paid off from the proceed, leaving the company either debt free, or only carrying the debt the purchaser takes on as part of the transaction.
5. On exit options and who buys the companies after PE restructures them:
Unless you read financial newspapers, you really only hear about the PE owned companies that go under, so I understand why people would think that PE owned companies are like cardboard cut outs of companies with no substance. Believe it or not, some of the main buyers of PE owned companies are other PE funds. This might sound absurd (since in theory the first fund already maximized value) but these sales happen for purely mechanical reasons. The reason for this is that your typical PE fund has a 7-11 year lifespan, and at the end of that time, it needs to have nothing but cash on hand, to distribute to investors (the investors will not be happy if they are given direct ownership of a company). Because of this liquidity requirement, PE funds sell profitable companies which they would rather hold onto all the time, and other PE funds buy them because the recognize the long term value there. Sometimes the same firm even buys the same company multiple times if they really believe in it (I have a client who has bought the same company three times!)
The other main buyers are other companies in the same industry as the target (you see this with pharmaceuticals a lot) and the public, if the company IPOs. Strategic buyers (i.e., companies in the industry) are often in a better position to assess the health of a company than PE, since they understand the business better (they have the same legal reviews done that a PE firm would have) and IPOs involve a lot of disclosure and regulatory filings.
So in short, the people buying companies from PE firms are generally very savvy and well equipped to assess the long term prospects of the company. PE manages with short term incentives in that they want to increase value as much as they can as quickly as possible, but there is no planned obsolescence here. The company needs to be valuable, but also have long term value in order for the types of sophisticated buyers to have any interest in a purchase.