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Comment by devchix | Hacker News Reader

Please explain? Why is there the association that private equity creates corporate debt?

Private equity companies exist to purchase existing companies from their current owners and then run them better/extract more value from them. The canonical example of this is purchasing a public company by acquiring all outstanding shares.

This is often a fantastically expensive enterprise that requires that the new owners raise tons of money. The new owners do this by structuring a deal where the company will take out a ton of debt (basically its entire market capitalization of the company, plus a premium) to purchase the outstanding shares. This is known as a leveraged buyout (LBO).

So if a public company has $100M in outstanding shares and zero debt before they go private, by going private the private company will now have $100M of debt (rough numbers, illustrative but not necessarily realistic). That's why going private often results in dramatic sell offs and cost cutting- the new company needs to get the debt load down, and fast.

Definitely read Barbarians at the Gates, it's a great book and explains a lot about private equity from a dramatic case in the 80s.

Thanks for that. But why is the company now worse off than before? A company can be funded with equity or debt (different terms and obligations, I understand) but if a company converts 100% of its outstanding shares to debt, why does anything change? I assume this is what happens when a company takes itself private to escape the grind of quarterly earning, short-term growth, tyranny of Wall Street analysts, etc. If I could run a company better/extract more value from it, say, by decreasing expense, increasing revenue, and therefore profits, I'd write myself a big check quarterly and continue running the company. Something else extractive and zero-sum (I gain but the company loses) is going on and I don't know what that is.

Becuase the risk of investment is now structured differently with leverage. Let's pretend we live in world where companies are always worth 10x earnings + assets. Our pretend company $100M makes $5M in earnings and has $50M in assets (cash, real estate, etc..)

To take the company private, the lenders require an interest of 10% and 10% principal

Some PE company (or the CEO, whatever) thinks they can make this work, so they come up with $10M of principal, take the lenders money and buy the company. The first thing they do is sell as many of those underlying assets as they can to pay down the debt. You now have a company that has $5M a year in earnings before debt, $10M in assets (the principal, serviving as the required reserve for the lenders), and $50M in debt, with a debt service of ~$5M a year (so really 0 earnings).

If the the PE company does a great job managign the company and the economy is good, so they double earnings to $10M, then the company is now worth $50M ($10M in income x 10 + assets - debt) and the PE company made a 5x return already (FYI- I know I'm abusing my financial math, fake numbers, but its illustrative).

Now lets assume they were wrong and a global pandemic breaks out, and the companies start losign money to the tune of $1M a year. If the company had stayed publicly owned, they might have to cut their dividend and burn through reserves, maybe sell off some assets, but other than that all their employees and the majority of their assets are probably fine. The company's market cap is a lot less, but shareholders don't go to zero eithier.

The world where the company went private in an LBO? That $10M cushion runs out in less than 2 years. They are bankrupt. They might get a few more chances to restructure debt and such, but eventually the lenders give up and liquidate the company a la Toys R Us. The employees get fired and local landlords lose tenants. Pension funds disappear. It's not fun.

This was helpful to me. How does the PE company fare in the bankruptcy scenario? Have they put up collateral or are somehow on the hook to the lenders?

It's my understanding that the bankruptcy applies only to the purchased subsidiary, so the PE firm only stands to lose the principal they put in at the start.

If so, it sounds like the PE firm gets all the upside, but is less exposed to the downside. So they are incentivized to rachet up the risk.

> This was helpful to me. How does the PE company fare in the bankruptcy scenario? Have they put up collateral or are somehow on the hook to the lenders?

All deals are different. You're probably not going to have any collateral put up by the actual PE firm in most cases.

> It's my understanding that the bankruptcy applies only to the purchased subsidiary, so the PE firm only stands to lose the principal they put in at the start.

In most cases this is true. Depending on how aggressive the firm has been and how long they've been involved, they might have already dividended out their principal.

> If so, it sounds like the PE firm gets all the upside, but is less exposed to the downside. So they are incentivized to rachet up the risk.

This is a correct but simplified conclusion. They're incentivized but there's usually a set of checks and balances in the form of banks providing financing and investors willing to finance deals. This system of checks and balances typically erodes as the business cycle/bull market rides on.

The binding constraint in most of these deals is how much leverage you're able to get away with.

You are at the limits of my understanding- in my simple example, the entity that took the company private is only on the hook for the principal, but these deals can be super complicated- multiple layers of companies transfering or lending money to each, and PE companies can be both a lender and an owner through these arrangements.

Thank you, I understand better now with the numbers worked out. Although in this example, outcome is dependent on circumstance and LBOs are not covers for malfeasance the way they're frequently talked about.

I think the reason LBOs are so hated is difference in utility between the capitalists and the community. The capitalists (PE, management, and lenders) are putting a boatload of money at risk to make an even larger boatload of money, and are empowered to take that risk. If the bet doesn't work out? They'll lose money (but probably have lots left over) and maybe their jobs if goes bad.

The community (workers, local suppliers, and governments) are seeing their jobs, livelihoods, and institutions put at risk, and they likely are seeing no reward for success. They are not empowered to decline the increase in risk, even though they certainly have a stake in the future of the company.

> I think the reason LBOs are so hated

It feels like economic strip mining to me.

p.s. thank you for the clear explanations

It isn't always- there are certainly times where a PE company recognizes that a fundamental good company is doing stupid things with its assets. One of the reasons why LBOs and "corporate raiding" was such a cultural meme in the 80s is that there really were a ton of companies that weren't allocating capital well, and sometimes were run for management's benefit to the expense of the shareholders. A totally made up example might be a furniture manufacturer that also happened to own a some water parks and a bunch of real estate, because the CEO liked water parks. A corporate raider/PE firm might do the math and conclude the water park segment was dragging down the rest of company and the real estate would fetch a ton if the company actually sold it. So they take over the company with debt, pay off a chunk of the debt by spinning off the water park segment, sell off a bunch more real estate to people who want to use it, and then the core furniture manufacturer actually ends up with more free cash flow because they aren't supporting the dead weight businesses.

That's the idealistic case, and it does happen. But then there are the counter examples we all know...

I think it's more because the examples people are familiar with are cherrypicked "heads I win, tails you lose" examples that have recently been recognizable American brands. Someone linked a list of LBOs elsewhere in here and TXU was at the top of the list. A lot of people lost a lot of money on that deal but you didn't see the kind of press Toys R Us got. I'm guessing a tiny percentage of people here even know what TXU is. Toys was a brand everyone recognized and PE got paid on that even though they went under.

They're required to pay a fixed interest rate on the debt. So during an economic downturn when profits dip, they can become insolvent. By comparison, when the capital came from stock, the dividends could adjust up and down with their profits.

Like any form of leverage, it magnifies both the upside and downside risks.

It's a bust-out. It's much easier to look at the examples in mob movies, like when they took over the outdoor store in the Sopranos or burned the nightclub in Goodfellas.

They take over a business with existing good will and loot it, using that good will to delay the collapse until they've extracted all the money and left others holding the bag, usually creditors (especially tradeline partners like suppliers, or landlords) and employees.

Ref: https://www.experian.com/assets/decision-analytics/white-pap...

> If I could run a company better/extract more value from it, say, by decreasing expense, increasing revenue, and therefore profits, I'd write myself a big check quarterly and continue running the company.

If you can. If you can't and your cash flow either stays flat or declines, you now have more debt to service. The more debt you have, the less leeway you have to execute on your plan. That's assuming you don't screw anything up in the business without considering any macroeconomic factors.

Right, and in that case I've made a bad decision and now I "own" a company that is not doing well and have more debt to service. The company declares bankruptcy, gets restructured or folds. How does that help me? That is to say, if it ends this way frequently, or fair odds ending this way, why do PEs keep structuring leveraged buy-outs? (This thread makes it sound like it's frequent enough that one person can say, Debts? Lemme guess, PE? Right you are!) There's an incentive to do this and the edge is ... what?

PE is very cyclical and rates have been very low. Massively levered PE transactions are usually tied to the business cycle. When the economy is doing well you're able to get away with larger and more levered transactions than normal. If you add on low rates to this, you can get away with larger transactions.

All debt deals have covenants and covenant protection is at an all-time low right now; investors have decided that it is worth giving up this protection for whatever the potential investment happens to be. Covenants on the amount of leverage a company can take on are common but there's no universal formula for calculating leverage. It is not atypical to have multi-page definitions of how a company calculates EBITDA. Some firms are known for being very aggressive with this and are also very aggressive with issuing dividends shortly upon the close of a transaction. Aggressive dividend policies help PE derisk transactions substantially. The more money you are able to take out of the company (and sometimes able to issue debt to do so), the more you derisk your initial investment.

I could go on for days about whether any of this is good or bad, blah blah but as far as your observation that this seems to happen with all PE deals, PE is a multi-trillion dollar industry. Just think about how the world would look if that happened with all PE-backed companies.

Your theory is good, but is it what happens in practice? In the headlines, you will find examples of "corporate raiders" who bought the company to "extract value" which means doing pretty much what a leech does. Also most of these examples showcase that the company would have been better off without the private equity buyers. Could there be good buyers, sure.

"extract value" -- what does this mean? Sell off the furniture? Fire 50% of the employees? I have image of Richard Gere saying "I buy companies that are in financial difficulties, I break it up into pieces, and I sell that off." Like stealing cars and selling them for parts, right?

Yeah, that's pretty much the canonical model. Huge in the 80s for a variety of reasons, still extremely common today.

There are other models for PE and going private- sometimes companies don't use nearly so much leverage and are effecitvely bought as part of portfolio, sometimes you see very rich individuals take their companies that they used to own private again, sometimes they do use tons of leverage but buy and run the companies mostly as is, just growing the company in place and paying down debt from cashflow.

PE's and LBOs aren't necessarily bad things at all and the economy as a whole is better for having them exist. The problem is that the risk/reward profile tends to exaberate inequality. The PE/LBO firm is already rich individuals who may make our lose millions on a bet on the company. The control their own risk and decide. The workers and communities who also have a stake in the company? They have very limited upside and the downside is that they lose their jobs and anchor institutions in their communities, and they have very little control over whether or not to accept the risk.

Stealing cars is small-time. The big deal is to steal the car factory. Or, in the case of MG Rover, sell the land the factory is built on to a holding company and pay yourself a bonus.

(The collapse of MG Rover is complicated and the directors very narrowly avoided prosecution)

it get's worse: often the same PE that's doing the leveraged buy-out is also financing it, at preferential terms and itnerest rates. see: Sears.

The company is now servicing $100m of debt. That cash went to the previous shareholders in the buyout.

The theory is that PE exists to run existing companies better than their current owners.

The financial and legal reality is that PE simply loads the target company with the debt used to acquire the company (i.e., PE doesn't actually put up any of its own money), and then pays itself by taking out more debt secured by the acquired company. And then they charge the acquired company a management fee for the privilege of having all of its useful assets being used as collateral for loans the PE company never intends to repay.

One of the tactics of a PE company is to effectively buy a company by securitizing its future revenues in the form of debt which is called a 'leveraged buy out'.

Basically a fund will invest a small amount and convince a bank to give them the money for the rest of the acquisition, which will then be in the form of debt to the company, using the revenue stream and assets of the company as collateral.

The banks get a nice loan out there and the PE firm gets full ownership with a lot of leveraged help from the bank.

There are possibly a bunch of structural benefits such as tax optimization, ie interest payments are tax-deductible etc..

It's viewed negatively because it's generally a form of financial engineering re-arranging deck chairs, not really value-creating, although it is for investors.

A company with a lot of debt can be more exposed and more likely to fail in a downturn.

See: Leveraged Buy Out.

A long history of coprorate raiders using such practices, e.g. T Boone Pickins, Bain Capital, et al

For example: https://www.investopedia.com/articles/markets/111015/10-most...

Because one of the principles of private equity is to load up a company with debt while growing the bottom line and then offloading it. When it works the banks profit, the company grows and everyone is happy, when it doesn't work they are vultures that made a bad situation worse.

Instead of painful downsizing and adjusting to actual market demand they will keep things floating until it turns around or the company is so far gone that nobody will lend to them anymore.

As with anything in life with leverage, debt-financed buyouts magnify the upside as well as the downside.

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