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[Private Equity] in the Public Eye
spacekungfuman
Poor and minority-filledRegistered User, __BANNED USERS regular
Poor and minority-filledRegistered User, __BANNED USERS regular
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.
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.
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I was referring to "Retirement Heist" by Ellen E. Schultz. Sorry I didn't make that clear.
This is the nature of principal-agent problems, where the agent - the employee - has a certain amount of discretion that the principal - the employer - cannot fully monitor. At equilibrium the principal hires fewer agents than at full-information, promises them a greater expected wage, but conditions this wage more on how the continual employment relationship evolves. Virtually by definition, the inability of the employer to carry out cost-efficient monitoring prohibits legal enforcement of the same, so such principal discretion is often informal. In English, when your boss promises you a raise if the project does "well", asking him to define just how well may backfire.
But when the business is bought over, the new buyer naturally does not feel obligated by any of the previous promises. Why not? He certainly did not make those promises. Those were not included in the investor's brief. Now all he sees is an angry and infuriated labour union screaming about a "looting" which has no legal premise.
The possibility of there being such new buyers unburdened by any informal promises effectively means: don't trust informal promises! Which is plausibly described as ethically fine if all involved know that informal promises are not worth the paper they are not written on (so to speak).
Observe, of course, that if an economy has a lot of companies that get by on informal promises and abandoning these promises are suddenly legally enabled, a lot of people are going to stand to cash out by aiding in doing so.
Second, an economy with very low levels of trust in informal promises is going to put a lot of stress on the legal system.
Third, management typically have superior information over a company's expected solvency. This is especially true in businesses most relevant to private equity takeover, which do not have to write regular reports to public investors. Bankruptcy and discharge of obligations is a legal possibility if the company is insolvent and therefore even formal promises are tied to the necessarily informal promise that management isn't hiding something about its balance sheet from you when it makes any legally-binding commitments!
Is there a big difference between maximizing jobs (within reason) and maximizing profits? Do PE firms have a lot of relevance to this? Do PE firms somehow increase the number of factories that are shuttered? If not, is there a simple reason they are sometimes painted as Gordon Gekko?
What's the relationship between PE firms and outsourcing?
It seems like they've decoupled success with profits. They've rigged the game so they make money no matter what, which means they don't have to care about the long term health of their investments, which in turn makes the decisions that fucks the middle class easy to make.
Question 1, based on the spoiled quoted text below: So the purpose of PE is basically capturing and restructuring companies for profit's sake no matter the stakes beyond the investor's own money? It has nothing to do with 'creating jobs' and can be considered a success if jobs were lost in the process? (Edit - This question is super political at the end actually, apologies)
Question 2: So "general partners" (by the way, are these individuals or other companies?) are established but do next to nothing, so that everyone else has no legal accountability, and since the GP does nothing, the can only be legal accountability they have is... well, nothing?
Question 3: Legal semantics to protect investors, right? "Definition of 'is' is" type stuff?
I'm gonna take a break at the "pension looting" bit.
There is actually a fundamental problem with this (quite appealing and elegant) theory for why PE firms are viewed as corporate looters (this is seperate from pension "looting" since all components of a pension plan are required to be in writing). When a PE firm acquires a company through a stock deal, it becomes liable for all of these promises to the same extent as the Seller was. This is a real issue, and we deal with it by requiring sellers to represent in the purchase agreement that there are no unwritten arrangements with employees, and requiring sellers to indemnify buyer for any expenses incurred under any such arrangements. If anything, the purchased by PE has the effect of defining and clarifying these types of promises, since the Seller will need to disclose them (and buyer will typically agree to honor them for at least 12 months) to avoid being in breach of the contract with Buyer.
PE firms look for increased efficiencies. One of the favorite tools of a PE firm is to buy and combine multiple companies in the same line of business, to create a more competitive market player. This often results in redundant employees or even redundant factories, and those people get fired and the factories get closed. This is where I think a lot of their bad reputation comes from. While this is undoubtably bad for the employees who are let go, the side that isn't often articulated is that these companies are often too small to last long term in their respective industries, so while PE is definitely accelerating job losses for some workers, they may very well be the only reason the remaining workers do not also end up losing their jobs. PE firms also love to buy companies in or near bankruptcy, since they can get them cheap, and so to the extent those businesses turn around, PE may be credited with the continued existence of all those positions. But to your first question, the goal is profit, not jobs. Outsourcing can also be a tool that is used to enhance efficiencies. I know that may seem cold, and it may well be, but being somewhat cold and making hard decisions that management who built the company and know the employees would never make is part of how PE adds value.
This is a popular criticism now, but it is based on a misunderstanding. A PE firm's goal is to have the investments by any fund be winners on net, since the only way to attract investors to your next fund is to make your current investors a profit. The money PE firms get even if the investment goes south is just management fees, which, like salary for workers, gets paid regardless of performance. Since the management fees do not get added into the profitability for purposes of paying investors, management fees do not help the firm to raise another fund. The management fees are very small next to the money the firm gets if the fund is successful, so they are definitely incentivized to make as many investments winners as possible. A firm which was just focused on getting its management fees would cease to exist after just one fund.
This is very specific to the company, the industry, and the PE firm. Some companies are bought for their IP or customer lists (or even just the executive team) and in those cases, employees may not be a priority. But there are also deals that happen specifically because the workforce is strong, and in those cases, keeping the workers is obviously key. In general, I would say PE sponsors tend to maintain or improve health and welfare benefits, get rid of pensions (on a go forward basis, they never take the money out of them), and change bonus structures to be more focused on long term performance (I.e., giving people more stock options or retention bonuses, and scaling back yearly cash bonuses). If you are keeping the work force, you obviously care about keeping them happy, and some firms bend over backwards to do so (at their own expense).
1. Creating jobs is never an end unto itself for a PE firm. It may be a means to achieving the goal or return on investment, and so PE are certainly job creators in the sense that companies they own hire people, but they do not set out to hire people for the sake of doing so (that said, in general no business hires people unless doing so will generate a net profit for them, but management may be sentimental and keep people on for noneconomic reasons, or may choose to keep more people on staff then are needed to provide better quality of life, and PE generally does neither).
2. Limited Partners are not completely shielded from liability, their liability is just limited to the amount they invested. By contrast, all of the general partner's assets are available to satisfy the fund's debts. This is why the funds are structured to avoid having the GP do anything or hold any assets. I know this sounds like a dodge, but remember that in a corporation or even an LLC (which has the exact same tax treatment as a partnership) no one has unlimited liability.
3. More to allow investors to invest without violating law. PE (and modern finance generally) has developed at a much faster rate than the law, and so many entities are technically not able to invest in PE funds directly. The regulators generally acknowledge that these restrictions make little sense, and may even explicitly state their approval of the structures that permit these investments.
A buyer that honors informal promises for "at least 12 months" is not different than a buyer that makes no guarantee to honor informal promises within Ronya's model.
It has to be the latter, but it's early in the morning so I want to make sure.
I'm not in PE, but from what I've read the GP of most partnerships (that are set up to minimize liability) is actually a corporation specially created to be the GP of the partnership. Of course, any reasonable set up will make sure that corporation has no assets and only a figure head in charge (who of course has no liability for the debts of the GP corporation). Essentially, the GP must exist but the set up is like having no GP exist in practical terms and thus nobody has any liability beyond the amount they invest.
Sorry Space if I misrepresented anything in the above, correct me if I'm missing something special in how PE does it.
However, Robert B. Reich has some pretty impressive credentials. So I would love to hear from @spacekungfuman about exactly which parts of that video are inaccurate, both in regards to private equity in general, and Bain Capital, specifically.
Robert Reich is no lightweight. I see no reason to dismiss his video out of hand, if anyone's trying to do that.
Yeah, I'm glad that SKFM can come in and explain how everything works but it just makes me more and more convinced we need to nerf these things like yesterday.
This just makes me think of that bit in Austin Powers where Dr Evil asks for a hundred billion dollars in the 1960's. I mean it's just a nonsense sum of money, 21 motherfucking trillion dollars??? I can't even make sense of such a number in my head.
At what point do we call bullshit on allowing $EARTH to be controlled by a few thousand people, trained from birth to be entitled asshats?
No offence SKFM, I'm sure as an individual you're an ok guy to sit down and have a beer with, but frankly, you and people like you are a cancer to civilised society and you need to be stopped.
That's about 2 dollars for every single human cell in your body.
I'm not sure that I follow. As part of the deal, all the informal promises will be reduced to writing, or else the Seller will remain on the hook for them. The Buyer then agrees to honor all promises (formal or in formal) or to provide benefits and compensation substantially comparable, in the aggregate to those provided presale. Once the year (or whatever period is agreed on) is up, the company can change any of these arrangements (formal or informal) just like the Seller could have.
I agree with @ronya 's contention that part of the value creation of PE is in breaking promises and thereby reducing effective compensation, but a year is probably sufficiently long for employees to reach new understandings with their employer. Also, these types of informal "build the company" incentives are very often "settled up" by the Seller in the form of deal bonuses.
That's right, with the caveat that the GP is normally an LLC, not a corporation. Corporations are a pain since there are a lot of formal requirements like board meetings and having a full slate of officers.
"These funds are structured in such a fashion as to leave as little liability on the investors as possible, leveraging the goodwill of the taxpayers to take care of excess debts. The people listed on the documents don't matter because these shell corporations are a joke anyway."
"These structures are so complex because governments do their best to prevent tax evasion. In addition to dodging what little law there is in place to prevent tax evasion, we also have to set up offshore accounts and corporations so that we are able to source investor dollars from questionable sources."
"This is a "complex" issue, and by "complex" I mean "terrible." While we won't take away any benefits the companies we buy were contractually obligated to provide, we will do our damndest to cut anything else because $TEXAS."
Reading your posts on Private Equity are always welcome, and always enlightening, but I continue to wonder how you can justify your part in business as ethical and beneficial to society, sleep at night, not hate yourself, etc. I guess $TEXAS helps? It is telling that you have to dress up a few fairly simple concepts in so many words to maintain the illusion that anything Private Equity does that is beneficial to its workers, the world economy, etc. is anything other than coincidental. While I have a better understanding of how Private Equity works having read this thread, my opinion that your entire industry is a scourge has not changed. Keep telling people how complex and hard to understand Private Equity is if it lets you ignore the opinions of everyone outside the hoity-toity Bourgeois people in your circle of friends, at least reading your posts lets me know how much the world of finance is fucking me, my country, and the world.
EDIT:
Meant to respond to this and didn't realize it wasn't in the OP. Justifying Private Equity's actions by saying it has developed at a much faster rate than the law is like justifying software piracy because cracks move at such a faster rate than DRM. Just because the legal loopholes exist doesn't mean that it is not morally reprehensible to take advantage of them in such an egregious fashion, especially given the greater, terribad context of other Private Equity activities.
Hmm. I do not think you get the nature of uncodified practices. These are not typically "well, actually we could have written these down with only the hassle of paperwork, but nobody got around to it" things. Rather these are standards which are, by nature, hard to enforce, like 'enthusiasm' or 'conscientiousness' or 'reasonable judgment' or for that matter 'promises of continued employment and promotion'.
If it were easy to standardize and meter, firms in a competitive market would just contract it out. It would not have been internal practice to begin with.
I fully understand why you would think that, but the Cayman islands are not just a tax haven. They also have very investor friendly laws, and basically allow anyone anywhere in the world to invest in a Cayman entity, which is why we use them a lot in structuring. The only time we use another country is when there is a specific reason to do so (for example, if you want to inves in India you basically have to go though Mauritius or Singapore). The Caymans can and are used in tax shell games, but this is not one, unless you consider it a shell game for a nonprofit to use a blocker corporation to pay taxes on the investment income, instead of being required to pay taxes on ALL their income. The IRS does not object to the use of this structure.
Which...
yeah...
I'm sure I'm just being sleepy and not getting it, but care to clear it up for me anyway?
This is bullshit. There's no comparison between a first order incentive (do well or face direct short-term loss) and a second order incentive (do well or face nebulous and uncertain eventual loss). I'm not sure how this is any different from anyone else on Wall Street investing somebody else's money, and that class of people probably exists in an ideal system, but Brian's criticism seems accurate based on what you've written.
In plain English, a lot of the rules in place with regard to where entities may invest are very old, and even the regulators are not happy with them, but their hands are tied by statutory text. In order to reach a more reasonable approach then that taken by congress 30 or even 60 years ago, each major regulatory agency has released formal guidance approving these complex an Byzantine structures to avoid letting form trump substance. Everyone on both sides would like to have the form follow the substance of these transactions, but it is hard to get congressional attention to fix something. Like I said in another thread, the reason we use blocker corporations is that congress was mad that NYU bought a macoroni factory in 1947 and imposed a punitive rule which would now have the effect of banning nonprofits from making PE or certain hedge fund investments, shutting them off entirely from the modern financial market.
That doesn't seem to add up to me.
Say they take out a loan for $10K at 5% interest. At the end of the year, they owe $50 (Obviously I'm taking liberties with the numbers for simplicity). The company made $2K that year, and has a 20% tax rate. So the company would normally pay $400 to the government. Instead, they pay $50 to the bank and 20%($1950)= $390 to the government. Now the company pockets $1560 instead of $1600.
Where's the gain? Does the $10K go to the PE firm and not the company they bought? Does the $10K let them make extra money that offsets the interest? If so, why is that a bad thing? Isn't this something companies do all the time? Does it happen more often with companies purchased recently by PE firms? Why is it bad?
Almost everyone in the western world pays taxes on all their income, except huge coorperations who invest in these labyrinthian schemes. The consequences have been becoming clear over the last several decades: The money is flowing upwards and away, as effective tax rates for the rich have halved since the 60s, while their wealth skyrockets.
Everything I mentioned about obligations to honor promises is generally keyed off of an incredibly extensive definition of the word "plan" in purchase agreements, which will include all arrangements, whether formal or informal, and regardless of whether reduced to writing, regarding employment or compensation. It really is a broad concept. To the extent that all you had was a wink and a nod the last time you asked about getting a raise at the next review, that clearly does depend completely on the relationship of trust, but nothing about that relationship guaranteed that the company would not go out of business or have massive layoffs if sales dropped. I would actually argue that one of the great benefits of PE ownership is that they tend to make things more formal, so people have a better idea of where they stand.
But even putting all that aside and granting your contention, I don't think these sorts of super informal arrangements would normally cost that much in the scheme of things, and so PE sponsors are not likely to look at a company and say "if we buy that company and break the promise to give Larry a promotion to senior VP, stop letting Dave take an extra Friday off a week to visit his sick father in the nursing home, and don't hold a company picnic this year, then we'll instantly make a profit.". This seems more like a side effect of the more general strategy of formalizing and reevaluating policies and practices than it does a primary strategy.
Sorry for the confusion. In addition to being tax friendly, the Cayman Islands are also very flexible in terms of who they allow to invest, and how their entities are classified. This means that if you are tax exempt investor, for example, you may not be able to invest in the US entity, but you will be allowed into the Cayman corporation, and then that Cayman corporation will be allowed under US law to invest in the US entity.
Flexibility in entity classification means that you can have an entity which is a partnership for US purposes for a corporation for German purposes, for example, since these countries have different definitions. The US is also part o this "game" and actually allows LLCs to just check a box to be taxed as a corporation or partnership.
Honestly the explanation doesn't make the practice seem any more palatable.
And the government being OK with it doesn't really make it any better, honestly.
Not letting Dave visit his sick father on Fridays may be a minor side-effect of a cost-saving plan for the company's new owners, but it might obviously matter quite a lot to Dave - Dave who would be, reasonably, now quite aggrieved about a decline in his working conditions over which he had no input. He might leave; this takes anything that Dave informally promised to his employer with him! - training, the quid-pro-quo of greater effort on Monday to Thursday when his father fell sick, whatever.
I think it might be interesting to talk about the definition of 'adding value' as well. If company X employs 10 people for $100/year and makes $3000/year, and a PE firm notices they could do the job with 8 people and make $2850/year, buys the company and lets two people go, have they added value?
1. What they should do is hire 10 people like me, have congress pass an omnibus financial sector reform bill, and let the regulators fix this mess. But for some reason hiring people is not palatable, even if hiring then has a net positive revenue effect.
2. Investment banks can afford losses, since fees make up a lot of their profits, and even if one investor loses, there are 10 more lining up to invest. When you tie the fate of all of yur investors together in a fund, if the fund fails then the lights get shut off. I have seen PE funds where everyone starts looking for other jobs since the fund is a loser, then try sell one company for more than they expected and they're back in business.
Also, just to say it, the management fees are very small relative to the returns managers get on the equity they hold in the funds.