Private Equity Wants in on the Bailout? Spare Me
bloomberg.com
bloomberg.com
> For some years, these purchasers accurately called themselves “leveraged buyout firms.” When that term got a bad name in the early 1990s – remember RJR and Barbarians at the Gate? – these buyers hastily relabeled themselves “private-equity.” The name may have changed but that was all: Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases. Indeed, the amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company.
> Later, if things go well and equity begins to build, leveraged buy-out shops will often seek to re-leverage with new borrowings. They then typically use part of the proceeds to pay a huge dividend that drives equity sharply downward, sometimes even to a negative figure. In truth, “equity” is a dirty word for many private-equity buyers; what they love is debt. And, because debt is currently so inexpensive, these buyers can frequently pay top dollar. Later, the business will be resold, often to another leveraged buyer. In effect, the business becomes a piece of merchandise.
Left unsaid is what happens if things do not go well. Saddled with as much debt as possible, the business by design has been put in a position such that it cannot survive even a modest decline in revenue without raising significant additional capital.
Therefore, if government assistance is not forthcoming, the economic shock of COVID-19 looks likely to put a majority of leveraged buyouts in bankruptcy.
I agree, but I think it's important to qualify what you mean when you say the "business can't survive". Because this implies that if a company can't meet its debt obligations that it will cease operations.
As long as operational cash flow is positive, then no amount of leverage or debt distress will halt the continued operations. The business might "fail" in the sense that the entity is legally re-structured and the equity owners, or even junior debt owners, are zeroed. But there's no reason in a country with well-developed bankruptcy law for this to have any impact on the employees, customers or operations of the business.
The issue with coronavirus and failing businesses is that it's causing many businesses to have negative operational cash flow. In this sense the business may fail and the operations discontinued simply because revenue is no longer exceeding expenses. But if the operations are cash flow negative (and capital markets are unwilling to extend financing in the hope of future cash flow) then the business will fail regardless of its capital structure or leverage.
You're naively assuming the equity owners meekly turnover the operations to the debtholders in bankruptcy when business performance suffers but cash flow is positive.
Equity holders are going to inflict a ton of pain on the employees and customers of the company first. They are going to layoff employees to the bare bones, sell otherwise performant assets, play games with vendors/receivables, and otherwise do anything else they can do to squeeze more runway before giving things up in bankruptcy.
Your assumption is kind of predicated on the belief that people lending to PE are making rational choices...they aren't.
The reason why LBOs took off was because S&Ls needed high-yield paper (and, to a lesser extent, there was a big buildup of Middle Eastern funds in US banks). All these deals allow the lender to risk up their portfolio, and take (in retrospect) equity risk. If you were an LBO firm, you can just sit there, create this paper...maybe it works out, it probably doesn't, and (tbh) you don't care because you get fees either way (most PE firms aren't really fund managers, they generate transaction fees for principals...that is why they employ bankers, instead of people with any experience of business). Btw, if this isn't convincing this same dynamic also caused a bubble in emerging market debt (i.e. banks needed high yield paper, bankers went to EM govts and got it).
And in a downturn, this process goes into reverse. People rush into cash, and sell whatever is liquid. It isn't anything close to rational (I feel like this should be obvious, I am seeing stocks with close to monopoly positioning selling at 3x earnings...is that rational?).
Now, the complexion of these deals has changed but what really drives finance is supply and demand. Another good example is CDOs, that was all supply-driven...banks wanted paper (there was a huge build up of dollars in exporters like Germany/Japan...China too but the state controlled dollars domestically), Basel rules meant there had to be some trickery i.e. banks needed to say CDOs were AAA but there was not enough AAA supply so CDOs had to convert junk into debt...but the point is...they needed the paper, so it was supplied. Totally irrational, no-one looked or cared about fundamentals but...the fundamentals don't really matter. Liquidity drives everything (if you have liquidity, you buy anything...if you don't, you sell anything).
Btw, understanding this is pretty key to successful investing. Once you realise what is occurring, investing is fairly straightforward. It is only when people try to introduce artificial concepts like rationality that they lose money in large sums.
This seems intuitively appealing, but is misleading. The Nobel-prize winning work of the Modigliani-Miller Theorem[1] that a firm's capital or leverage ratio does not prima facie have any impact on its weighted-average cost of capital.
I am unsure how this is different from the normal failure of leveraged firms. When so many are failing within 3 years in normal times, this just seems to be more of the same.
Do any of these companies?
The whole concept of bailouts create bad incentives - to me that's more the crux of the issue. But if you're gonna do them anyway then I see little justification for including/excl some just because they're listed vs private.
Plus it makes way more sense to "save" the economy at grass roots level anyway. I'd prefer more of a suddenly expanded social safety net type situation. Similar to what the US is doing with corona checks and what Germany is doing with blanket guarantees tp try and prevent layoffs.
It is why the current path begins to resemble 1929 where consumer buying power spiraled downward. If the social isolation period ends with millions of consumers cashless, and in debt then there will be no one for businesses to sell to. In this cases, businesses would have to use any bailout money to employ people unnecessarily for the months it would take until consumers have spare cash: The months of paychecks it will take for them to pay outstanding mortgage payments, back rent, personal loans, credit cards etc plus interest on those. Bailing out consumers/employees avoids this convolution, does not assume that business will act in this uncharacteristic money losing way and, avoids extra expense/risk since consumer loans are higher interest rates/risk than government borrowing.
Furthermore, the trend away from brick and mortar toward online consumption may be enormously sped up by this social isolation period. In this case, many of the businesses bailed out will never fully recover. Consumer spending power is a much better way for the market to evolve than a government guessing which companies are will be viable at the end of this.
Arguably, corporate bailouts like we're seeing now ARE a Keynesian stimulus because they're meant to keep businesses afloat while consumer demand has fallen off a cliff so that they can continue to do business (i.e. maintain demand for business inputs). Few if any of these corporations are taking the bailout money and investing it in capital infrastructure.
The bigger issue is that the "current path" is to use both Keynesian stimulus and supply-side stimulus with no regard for the deficit. At some point, unless the US has another WWII-like economic expansion, all the debt we've created to fuel these policies will need to be paid back, either explicitly or implicitly through inflation.
And if you've been watching prices for staples or the big mac index, prices have already reflected inflation from the last decade's worth of quantitative easing. I left a cushy fed job with a full secret clearance because of the TARP bailout back in 2008 and they are about to do the same thing in spades again, ugh. They should've just let Goldbag Sacks and the rest of their filthy lot fail, let the economy feel the recession pain like it's supposed to and let a reset happen. I don't really want to see the other side of this one. For sure I'm not saving too many USD in 0% interest accounts...
The basic account of "trickle-down economics", goes something like this. When you give a tax cut to a rich guy, he uses the money to buy party supplies for a celebratory yacht party. The guy who owns the yacht party supply store sees an influx of cash from rich guys spending their trickle down tax cuts on yacht party supplies and orders a pizza to celebrate, and gives the pizza guy a big fat trickle-down tip. As you can see, the tax cut started out at the rich guy, but before long even the lowly pizza delivery guy is getting a piece of that sweet trickle-down cheddar.
Notice an interesting thing about this account: it is fundamentally a _demand-side_ story. In this story, the trickling down happens as a result of people spending extra money on goods and services. It is not about creating supply. So it's _not even an accurate representation_ of supply-side economics. People rightly point out that it's a flawed story, because poorer people probably have a higher marginal propensity to consume than rich people, so you'd be better off giving the tax cut or equivalent transfer payments to poor people if you want to stimulate economic activity. Well, yeah, no shit, that's because this is a complete straw-man and no economist actually believes that this story is true.
What some economists actually do believe is that the path to prosperity is via the supply curve and not the demand curve. Making things cheaper to make and cheaper to buy makes people better off faster than just giving them money to buy things at existing levels of production. And the way to do that is investment—investment meaning, in the economics sense, spending on things like factories and equipment. There is a huge body of theory and evidence to support this idea—higher levels of investment do lead to faster growth. So supply siders believe that things like taxes on capital gains are harmful to the economy on the margin because they reduce spending on investment, and may even encourage spending on consumption, which is a bad outcome to the supply-sider. They also believe in reducing barriers on production—things like government regulation and income taxes. They also believe in, you guessed it, helping make sure that corporations don't go out of business amidst a once-in-a-century black swan event — call it a "corporate bailout".
The crisis will end with sky high unemployment, no consumer saving but massively increased personal debt. To raise the deficit solely so companies can make twice as many widgets with half the employees would be the worst possible response. And even this assumes supply side policies do what they claim.
Nobody knows this for sure.
At the moment, the official policy of the Federal (and most State) government is forced unemployment: a planned shutdown of the economy. To accommodate this, the CARES act includes $2400/month (on top of State UI) unemployment insurance, and that’s not even including the flat $1200 check. If you live in Minnesota, you’re looking at $5,360/month (!!!). The full state breakdown can be seen here [1]. In every state, the unemployment insurance is higher than the median wage. Businesses know this, and are proactively laying off their employees so that they may collect this benefit, with the intention of hiring them back once the planned shut-down ends. This can only happen if the businesses stay solvent, hence the corporate bridge loans.
The odd thing about bailouts is that if you bailout businesses, they can't really spur consumer demand, and if you give it to individuals it tends to end up re-concentrated in the financial economy. If you want to ensure cashflow into the open economy, you need to ensure that the money that people have gets spent on goods, not financing.
Isn't bankruptcy exactly this, on a firm level?
No I think the last four words of this quote are the problem.
This needs to be more about humans and less about corporate entities. And I'm not talking socialism here. We just need to move away from economy = listed companies and more towards economy is the aggregate of people's actions.
>These two options for saving the economy: corporate bailout vs social safety net essentially correspond with belief in trickle down vs Keynesian stimulus.
What?
Social safety net: Here is a place to sleep tonight Mr Homeless
Keynesian stim:
>Keynesian fiscal stimulus is a decision by the government to increase government spending financed by government borrowing
Quite a far stretch equating those.
>Quite a far stretch equating those.
In reality it really isn't.
I'd argue yes, to a certain extent. The government has ordered suspension of businesses for the good of public safety and welfare. Yes, they deserve some sort of compensation for that, I would suggest.
If you're going to tell me I cannot open my business to pay my employees under threat of arrest, then it would be fair to provide some compensation during the time I am ordered to not work so I can pay my staff and keep my existing obligations paid (or forbearance, etc)
This depression is not the result of a lack of demand, but a government-ordered stoppage of work.
That said, there are secondary and tertiary effects on businesses and the economy here beyond wages and paying rents that will be detrimental to share value and equity values (or ability to pay debts used for other purposes like share buybacks). Equity holders should not be bailed out. As an equity holder you're an owner. You're the last to be paid.
> congress won't sell us out.
Uh, didn’t it already happen, again?
Propping up aerospace and banks again with taxpayer money, sending only a fraction (call it a “token”) to SMBs, with near unchecked disbursement powers, seems like they’ve continued on their same general strategy of wealth consolidation.
Made painfully clear with the messaging that “hey, a lot of people die from car crashes and the flu every year” directly followed by quotes of “these great American companies such as Boeing are NOT replaceable”.
IOW: old and/or poor people are commodities easily replaced.
Step 2: bail out market each time as it’s politically untenable to let the broader market prices decline
Socialism, but the higher % of total equity you own, the better the socialism works for you. Bonus if you have connections to people who can help you finance purchases, especially when the market is down.
Socialism is social ownership of the economy, what you're describing the opposite. There's another word for what you're describing, which is the extreme capture of the state by corporate entities: corporatism. The extreme form of which is fascism.
Having a large portion of the population with fractional ownership over a broad portion of the economy (via ETFs, etc.) sounds a lot like "social ownership of the economy" to me.
Unless, by social, you mean "equal" ownership (as GP points out).
I mean, they send me their prospectus. I can listen on the call. That's about it.
And that's not even accounting for the fact that the majority of citizens don't even have retirement funds to get them through.
Not sure why, but there it is: https://turbotax.intuit.com/tax-tips/jobs-and-career/can-you...
Why isn't it reasonable for the government to compensate businesses (and people) who are suffering as a result of the government's screwup?
The state is created by the class of people who own capital, in order to mediate, protect, justify and manage a world in which they continue to own and profit from their ownership of capital.
In the US, at least, this is a very large class.
Is it a problem that the government disproportionately benefits the top 40%? Yes, absolutely.
But you’re making it sound like the state is a conspiracy of the 1%...sure those folks get disproportionate benefits even above the other 39%, but the state doesn’t only exist because of the 1% — it benefits a much greater collection of people!
Not to mention it's very easy for us in the technical class to not even notice that the vast majority of the country isn't like us. Waiters at restaurants, house cleaners, and the typical taxi/Uber driver own 'capital' in only the most pedantic sense of the word.
Honestly, with the wealth gap is wider than it's been since the 19th century, respectfully I think you're wrong.
[1] https://www.ft.com/content/2501e154-4789-11ea-aeb3-955839e06...
The formal mechanisms of the modern nation state were the outcome of a 200 year process, a development over time. The nation state _emerged_ along with the capitalist market system. Before that we had feudal autocracies. What we call a government now is a product of push and pull, trial and error, experimentation. And the dominant force shaping it has been the need for those with wealth to preserve a market of private ownership that keeps them wealthy, and to keep the simultaneously emergent forces of popular democracy from threatening that.
The Marx quote might make it sound conspirational, but in the context of all the text around it, that's certainly not what he meant.
For what it's worth, you don't have to go looking in Marx for this kind of analysis. Classical liberalism would also admit this role for the state -- just with a positive spin.
It should be considered remarkable that Marx's observations need only minor adaptations after one hundred fifty fucking years.
Are you saying because they (maybe barely, if at all) own the car, they are capitalists?
Anyways, Marx isn't scripture. Just a dude with some interesting writing some of us find cogent still. Marx himself would have bristled at being treated as some sort of biblical style authority. Of course it needs adaptations. But maybe not the ones you are suggesting.
I also think the definition of "industrial labour class" has changed significantly. The analysis still applies.
In the Anglo-American world we get caught up with Marx's use of the word "class"; because to us it has the connotations of social class; aristocracy, gentry, etc. But Marx had a very specific technical economic meaning, and it had to do with proximity to economic power and control. I don't think that's substantially changed, though it has become more subtle. In large part because of the post-WWII settlement between labour and capital in the west that created the 'middle class', which was really just a prosperous section of the working class.
That segment of society is shrinking though.
I obviously don't think it's nonsense, but it doesn't surprise me it gets downvotes. I think it's sad though.
This creates some really bad incentives for companies and their executives.
If you are not in the position to have such an impact, either good or bad, then nobody will ever bother to bail you out.
It's more like, they get bailout based on how big they can convince lawmakers, in an environment of little public debate, that will be.
I know, it sounds like a nitpick, but sometimes the distinction is big.
No, you're right. It's always about the perceived value or impact. And that perception can be formed by deceiving, bribing, showing your books, etc.
Suits empty the company in good times and when shit hits the fan they put their hands in the air and say "well I did my best".
You may be replying to the wrong comment. I explained the reasoning for bailouts in general. Your characterization is besides the point. I only gave Tesla as an example of investing based on future expectation of value, similar to the reasoning behind some bailouts.
I wish people would stop getting so riled up at the mere mention of Tesla, so much so that reading comprehension flies out the window.
This being said, at times Elon has also gone to great lengths to mislead the general public and the shareholders in order to pump up that value in critical moments ("funding secured", "virtually certain") or bailout family with other people's money (SolarCity). Court decisions already stand to confirm this. I guess everybody's "a suit" when it suits them.
It’s usually not good when the SEC is chastising and/or disciplining the CEO of a company.
I’m not long or short TSLA, just presenting the bear case :) I stick to trading the indices
Same with PE companies. They leverage up to the highest possible values, and then a bit more. They knew the risks of doing so, but the risks were worth it because they would make so much money if they paid off. But they didn't paid off. Why should we bail them out?
In fact, is there something we can do to PREVENT these colossal leverage figures? Banks don't care, regulators can't do much about it, PE companies don't care, the companies being bought out don't have a say, and neither consumers.
yes, at least these 3 things:
* remove the tax advantage of debt over equity (currently debt payments reduce tax burdens).
* remove the tax advantage of capital gains over ordinary income.
* on any bailout, massively cram down the equity holding of the PE firm(s) and all executives by issuing new shares to every other stakeholder besides them, including other shareholders (if there are any, typically not), employees, suppliers, and debtholders, mitigating the too-big-to-fail moral hazard.
IMO that's a step to far, and is a totally uneven punishment depending on how shares are held. Just make them give the government equity (or options) as part of the bailout that would dilute all existing shareholders.
Executives aren't the only ones responsible, they are hired by the shareholders.
governments taking equity positions in corporations can be bad because of the risk of corruption, self-dealing, and regulatory capture, not the principal-agent and subsequent sunk-cost risks you mention, imho.
unlike other shareholders, governments aren't strongly motivated by attaining the largest return for themselves, particularly since taxes and bonds are much easier revenue sources. and in crisis, the government has the negotiating leverage to stipulate stricter conditions upfront that aren't normally part of non-crisis investments.
If you count index funds sure
> I'm also guessing that you have never voted at the shareholder meeting of most or all of those companies.
I generally don't vote, but that isn't because I don't believe in the efficacy of shareholder voting. Just because MY (insignificant) vote wouldn't matter doesn't mean shareholder votes in general don't matter, or that shareholders as a whole don't have control over the company.
"This is still true in most young companies, which need capital to get going, and in many small ones anyhow. But in most successful American concerns which have grown to maturity, and especially in the very big ones which between them do a very large proportion of American business, the stockholders are no longer in control in any real sense: they are subordinate in authority and importance to the management... ...Suppose a stockholder doesn’t like the way the corporation is being run? Only if he is eccentric, or a special sort of crusader, or a politician (union or otherwise) trying to make a stir, does he try to oppose the management of a really big company. What he does, instead, is to sell his stock and get out... ...Looking at this segment of American business, we would almost find it appropriate to call our present economic system “managementism” rather than “capitalism.”." - Frederick Lewis Allen in "The Big Change: America Transforms itself 1900 - 1950"
Yes there is -- let them fail if they cannot service debt. If you bail them out, it only fosters the behavior further.
To me, letting an over-leveraged worker 'fail' (starve, die, become homeless, whatever it is) is categorically different than letting an over-leveraged business fail.
To put this in perspective, consider the monthly carry on rent+COBRA+food+honda (+ student loans). A one-time $1200 check wont go far.
Those who leased or bought BMWs arent really the subject of the conversation here, if they are relying on a $1200 check to get thru this, they are going under regardless (and possibly rightfully so if they got a luxury car rather than store a reserve/emergency fund.)
However, the issue is employees are also hurt, not just equity and debt holders.
Edit: I don't see how you can disagree with this statement. Literally the only job of a PE firm is retain and create value for investors. They would be out of business if they did not do that. Hence, they care about preserving capital. With the caveat that this is in aggregate across the portfolio.
I don't disagree, however, that there needs to be significant regulation and social safety support for workers. I believe there needs to be significant changes to ensure we protect worker rights.
There are massive financial incentives to lever to the hilt. Back in the day social pressures restrained it. In the 1980s that all went out the window.
https://www.gsb.stanford.edu/faculty-research/working-papers...
This might be the headline intent for the public, but in practice has often not been the primary intent. PE firms often extract massive fees from the companies to recover their initial investment -- long before they realize equity based gains. I'd say VCs are more aligned on this matter, not PE.
Interest fees now encompassed 97% of operating profits.
PE firm only paid about 1.3% of the equity for the leveraged buyout, Toys contributed the rest (hence the increased debt load).
KKR and Bain stated that management fees, transaction fees and interest entirely covered, and more, the losses from the deal. $128M in transaction fees, $800M in management fees, and so on.
The Toys R Us deal had a whole bunch of issues, and the business may very well have been over-levered. I do think we should bring back stricter leveraged lending guidelines, in some form.
Those fees, however, don't cover the losses the way that you think (sometimes they cover the amount contributed from the fund itself, not from its investors). I think there were only received $180M in management fees over the nearly 10 year hold paid to the 3 firms involved.
I am arguing for worker protection. Not protection of equity value. You inherently take on risk by deploying it, and should accept the realities of that risk.
Why not simply fund unemployment checks, direct cash, food stamps, student loan deferrals, or more direct means of worker protection than handing the money to PE Firms (which by the way operate by design to squeeze workers) and hoping they protect workers?
We've seen this in 2009-2010 -- giving the money to banks doesn't magically make the money trickle down to workers. Perhaps some of it does, but why not make all of it trickle down by skipping the middlemen? What are the odds the middlemen will conveniently issue a giant dividend to themselves or do a stock buy-back or any other number of tricks that will achieve nothing for the workers.
... that would be a fine incentive if we don't bail them out. Otherwise...
Companies are already going to get better rates because of infinite QE. But they want even better valuations with bailouts.
My impression, without any data on hand, is that PE firms tend to reduce the number of jobs overall.
We should "bailout" based on just 2 criteria:
* would the business be viable if it weren't for corona and will it be viable after coronavirus?
* what's in it for us? We want equity, or juicy interest on the loan or you're industry needs to be a big net contributor of tax revenue.
We made a profit on the TARP activities. Let's do that again, then we can cut taxes and expand services. Who doesn't like that idea!
There hasn't been any real incentive to save or be fiscally responsible since the 90's. Spend as much as possible. Take on as much debt as you can. If things get bad you can either abandon ship and do it all over again or wait for a bailout which is almost ingrained in the system at this point.
In fact the more debt you have the less you have to worry.
Also, it seems a bit arbitrary that some under capitalised businesses will be left to fail, while others will make a fortune (hospitals say or toilet paper manufacturing). I wouldn't want to pick winners in normal times. But these are not normal times...
* Is the business important to society as a whole
In my opinion, bailouts aren't about if a company "deserves" to survive, they are about if it's "important to us, as a society" that it survives. If so, we group together and save it (with out taxes).
Industries will survive and return to normal if they're economically viable, whether they are socially important or not.
Cruise ships are (imho) floating cess pits that contribute nothing but pollution to our world. So we can just let them go bankrupt right? And they will. Then some billionaires will buy up the ships at auction for cheap, and reopen the same businesses under new names. They will make a killing for nothing more than being in the right place with a billion dollars. The number of ships and shittiness of the industry will not change. Maybe some mom-and-pop shareholders will get wiped out. And we will have missed the opportunity to make a fat profit for tax payers.
That's what's happening here: the bailout will happen either way. But if the state leads it, the state gets the guaranteed profit.
Now is a time to look at the benefit to our countries, not to moralise and let others privatise those benefits just because they're already rich.