Judge’s Ruling Offers Peek into Private Equity’s Secret World

There are also tax benefits, http://dealbook.nytimes.com/2013/04/15/the-top-10-private-eq...

"Right at the core of the private equity business model is taking a company private, loading it up with debt that was used to finance the acquisition and using the interest deductions to shield the portfolio company from tax liability."

>Most people who run a company will not behave like this.

No, but companies that are taken over by PE firms are fairly special.

In any case, since the fund is forced to sell the company after a few years, they're still interested in LT value maximization.

Also, high debt levels aren't just a way of taking back some of the money the fund put in. Debt helps to fix the companies. The PE business model essentially focuses on fixing principal-agent issues (i.e. management working against the best interests of shareholders). Improved governance, high equity ownership by management, and high debt loads are how they do it. "Debt disciplines management" because it forces them to eliminate -NPV projects and increase cash flows.

> Most people who run a company will not behave like this. The idea is not to have a company that is constantly on the brink, but to pay out some dividends when it's safe to do so.

Dividend recaps (as they're called in PE jargon) are frequently being used by entrepreneurs and/or owners of stable businesses who don't necessarily want to exit but want extra (personal) liquidity.

Like anything, it's a tool that can generate great rewards when used properly. Waiting for profits to roll in over many years can be inefficient (from a wealth building PoV) when, for example, the stock market is booming now (but won't be in 3-5 years).

It's not because not many people know about this, or use it, that it's a bad idea to use it. PE levels might sometimes be a bit excessive, but it's still a good way to unlock some of your wealth.

The line between this and the classic fraud called a "bust-out" is very thin.

A bust-out can take many forms, but the basic idea is that control of a reputable company can be leveraged into an unjustifiable quantity of cash, which then disappears along with the perpetrator.

For example, a business might order more than the usual amount of stock from suppliers on credit, take out a commercial loan to cover expansion, and run a huge sale - even below cost - to pull in cash. Then the money and the owner disappear, leaving the business with debt to the suppliers, debt to the bank, and no cash.

On an individual scale, the same thing can be done with fraudulent credit accounts: establish a record of repayment, get a big advance, go. Identity theft is useful, since you can use someone else's credit-worthiness.

That appears to be equivalent to what's going on in PE.

>the company is a large going concern that is used to borrowing some money from its lenders

That may be more typical (I don't know), but in this case at least, according to the article, Hellas had no prior debt.

The moral being that, in these kinds of dealings, you are allowed to cripple a company, but not outright destroy it.

Well it seems that in this case PE firms have managed to cripple the firm and then sell it. Strangely the details of that sale are not discussed in the article.

When accounting tricks can hide national debt (for a time), using it to hide corporate debt is likely to be relatively simple in comparison.

You have the company (which you now own) pay you money, which pays off your debt, but puts the company into debt.

Because you borrow money as a new company called NewCo formed offshore and then you buy the old company with a loan tied to the assets and performance of old company. This loan is also contingent on NewCo completing the acquisition of old company. Ideally you give no personal guarantees so the bank only collects assets of old company if it fails and you walk away with your fees and dividends that you've received since then.