THE BEAR'S
LAIR The
illusions of private equity By
Martin Hutchinson
The controversy over
Mitt Romney's work at Bain Capital has led me to
realize that private equity is a poorly understood
business whose economic effects have not yet been
fully explored and are in many respects
pernicious. This is not a knock on Romney, who in
my view would be a mediocre candidate for
president however he had made his fortune
(although that view might be modified if he had
gained it through supreme business creativity
like, say, Jeff Bezos of Amazon.)
It is
also not a knock on Bain Capital, which appears to
have adhered to the standard practices of the
private equity industry. However that industry
itself is of questionable economic utility and
many of its practices
can fairly be described by Governor Rick Perry's
term of ''vulture capitalism''.
I know,
because I have been there, and done that - or at
least seen it done. As a banker in Croatia I was
responsible for a portfolio of over 50 private
equity stakes the bank had acquired, mostly
through debt-equity swaps in bankruptcy. In some
of those cases, adding management value was fairly
easy.
For example we owned the largest
naturist camp on the Mediterranean, whose
management claimed that naturism was going out of
style because their guests were getting older and
older, now with an average age of 58. It turned
out that management spent almost nothing on
marketing - and I can assure you from observing
naked and gloomy 70-year old Germans grilling
bratwurst that word of mouth alone did little to
attract the more youthful demographic!
The
one feature of private equity investing we did not
especially use in Croatia was leverage, since the
bank already owned the private equity stakes
concerned. However leverage, creatively applied,
is the key to private equity's remarkable track
record of returns - and to its much less
attractive record in creating economic value.
In its initial phase, in the early 1980s,
the private equity industry, then known as the
leveraged buyout industry, scored some spectacular
successes, both in terms of profit and value
creation. In January 1982, Wesray Capital,
controlled by an investor group led by former US
Treasury secretary William Simon, acquired for $80
million (of which the downpayment was rumored to
be $1 million) a greeting card company, Gibson
Greetings; when this did a $290 million Initial
Public Offering just 16 months after the original
deal, Wall Street naturally sat up.
At
that period, after a decade of inflation and low
stock market returns, assets were available at low
prices and there were a number of cases in which
sizeable companies had been mismanaged by
''country club'' management, so a turnaround was
easy. Leverage was used, but interest rates were
so high that only low asset prices and easy
turnarounds made the business profitable - it
flourished primarily by picking this ''low-hanging
fruit.'' The growth of the LBO business was
spurred by two additional factors: the existence
of Michael Milken's new ''junk bonds'' trading
operation at Drexel Burnham Lambert and the
beginning of the long secular decline in interest
rates, which allowed buyers to refinance deals at
lower than anticipated costs, making them
spectacularly profitable.
Inevitably this
exceptional profitability drew in additional
money. Bain Capital, for example, had begun in
1984 by doing traditional venture capital deals,
in which it financed fledgling companies and
helped them grow, ideally realizing its investment
through a stock market IPO. This initial business
unquestionably created jobs, most famously at the
office products retailer Staples, founded by my
Harvard Business School classmate Tom Stemberg
with Bain Capital financing.
However
venture capital was a chancy business, often
taking several years to produce returns and was
not especially well suited to Bain, since Bain's
consultants were more used to advising much larger
companies. Conversely the well-connected Bain was
well able to attract large pools of capital once
it had a track record, and was highly plausible
when claiming expertise in turning round companies
subject to leveraged buyouts. The migration of
Bain's business from venture capital to LBOs was
thus unsurprising.
The Drexel crash of
1989-90, the struggles involved in the US$31
billion takeover of R J R Nabisco and the tight
credit period of 1990-92 caused a recession both
in the returns of the LBO business and in its
public reputation. The latter problem was solved
by rechristening the business ''private equity''.
Theoretically, this term applied to unleveraged
portfolios such as I managed in Croatia, and even
to the traditional venture capital business. In
practice, the vast majority of the capital
involved continued to be devoted to LBOs.
In an era of low and declining interest
rates, they were by far the most profitable sector
of the private equity market, and in those years
they required very little ability to carry out.
With interest rates low and declining, leverage at
unprecedented levels was easy to obtain, at least
until 2008 - after all, since the LBO business
only got started after interest rates peaked in
1982, its loss experience was excellent.
High and cheap leverage has a number of
effects. First and most important, it magnifies
the returns available from what were at best
marginal improvements in operations. Indeed, the
return on saving $100 in operating costs is trebly
leveraged. First, if the company is saleable at a
multiple of say 7 times EBITDA, an extra $100
saving in the most recent year increases its value
by $700.
Second, by squeezing hard in the
last year before sale, a seller can improve the
profits trend, and produce apparent growth in
margins where no such growth truly exists -
thereby increasing the EBITDA multiple itself.
Third, the $700 increase in value of the asset
(plus any excess from increasing the EBITDA
multiple) flows through entirely to the equity
holders, so an asset leveraged 5 or 10 times and
squeezed operationally can produce spectacular
returns to equity investors. Even after the fees
extracted by the management company, outside
investors do well, while the management company,
typically receiving 20% on any capital uplift for
zero investment, gets rich very quickly indeed.
This super-incentive to extract the last
penny of savings from the companies they control
inevitably leads LBO companies to squeeze their
companies too hard. Typically, an LBO managed
company will stint on maintenance and research,
thereby dressing up operating results and sticking
the buyer with an asset that is in poor condition
with no product pipeline.
The effect of
Eddie Lampert's ownership at Sears exemplifies
this. After he bought the company, Lampert
determined that a retail operation could be run
with far less money devoted to decoration and
cleaning than was traditional, which savings could
both service debt and increase the value of his
investment. Unluckily for him (presumably) the
2008 crash prevented him from selling Sears
quickly enough, while customers over time deserted
its filthy and poorly staffed stores, so that now,
six years after he bought Sears, he is looking at
a loss of $421 million in the latest quarter, with
domestic same-store sales down 1.2% at a time of
4% inflation.
A second adverse effect of
leverage is to incentivize dodgy negotiating and
financing tactics. Last week, a former Wall Street
banker William Cohan described Bain's negotiating
tactics, whereby they would put in a ''final'' bid
on a company and then chisel down the price during
the ''due diligence'' process when other bidders
had disappeared (apparently this tactic was by no
means exclusive to Bain). Similarly, the habit of
extracting massive dividends, far greater than
earnings, from companies they controlled left
those companies vulnerable to the merest breeze of
recession, endangering excessively the jobs of
their employees.
Apart from making
business thoroughly unpleasant, such tactics
immensely increase the deadweight legal costs of
doing deals, as documentation and protections from
all kinds of unlikely contingencies proliferate ad
infinitum. As we London merchant bankers were very
well aware, ''gentlemanly capitalism,'' in which
protagonists can within limits trust each other
not to behave badly, is a far more economically
efficient way to do business.
A further
myth of the LBO business is that it can improve
the value of assets it controls through superior
management. This may have been true in the early
1980s, after an exceptionally flaccid period of US
management, but it has not by and large been true
for the last quarter-century.
LBO
companies typically attract graduates of the top
schools, but with an emphasis on those most
attracted by ''get-rich-quick'' schemes who are
generally not the most insightful or creative. Add
the superior pay and conditions received by LBO
staff, especially compared to management of the
industrial companies they take over, and you have
an extreme ''us/them'' problem that is barely if
at all mitigated by throwing a few top stock
options to the favored few among the industrial
company's management.
The problem is
exacerbated by cost-cutting, through which favored
projects are shut down without notice, while
comfortable pension and other benefits are
hollowed out and replaced with inadequate
money-purchase schemes. The hostility to the LBO's
overstuffed yuppies which this produces is only
exceeded by the contempt that rapidly appears for
their entire ignorance of many of the basic
features of the company's business and competitive
environment.
Naturally, with management
and workforce hostile to those controlling the
business, things go wrong and inefficiencies and
corruptions proliferate. The private equity
industry nourishes the myth that many LBO managed
companies would fail without their involvement;
against the companies for which this is true must
be balanced the others for which LBO involvement,
extracting resources and starving operations,
produces failures that would otherwise not have
occurred.
Finally, as has become clear in
the Bain discussion, the high returns achieved on
LBO investments are matched by job losses and
deterioration in working conditions - both
attractive means for the LBO companies to extract
''value.'' Even if successful LBO deals on average
break-even in job creation, with jobs lost through
cost-cutting being matched by those gained through
genuine improvements in operations, there are also
the unsuccessful deals, in which the LBO company,
having invested little, loses relatively little
money, but where bankruptcy or facility closure
result in massive job losses. For the economy as a
whole, the cost of these job losses (and the
subsequent periods of unemployment suffered by the
employees concerned) must be subtracted from the
profits made by the LBO sponsors and their
investors to get a true societal accounting.
Through leverage, LBOs often provide
investors with higher returns than true venture
capital, especially in periods like the present
when real interest rates are negative. They also
provide quicker returns, and require less effort,
because the value creation required is less.
However their contribution to overall economic
welfare is at best modest, unlike that of true
venture capital. We must therefore hasten the
return of sharply positive interest rates, which
will devastate the LBO business and redirect its
resources towards true venture capital, where they
are far more valuable to the overall economy.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found on the website www.greatconservatives.com- and co-author with Professor Kevin Dowd of
Alchemists of Loss (Wiley, 2010). Both are
now available onAmazon.com, Great
Conservatives only in a Kindle edition,
Alchemists of Loss in both Kindle and print
editions.
(Republished with permission
from PrudentBear.com. Copyright 2005-12 David W
Tice & Associates.)
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