Private Equity is an arbitrage on bloated companies. Typical cycle is innovative startup -> efficient corporation -> beauracratic corporation. PE firms buy the companies late in the cycle and then cut the fat. Commonly also seen in activist investors. This is a needed function that will never go away.
It's a bit of a romanticized view. Like a junk yard mechanic opining on the circle of life.
Some PE firms definitely resurrect companies. But a lot are junk yards for companies: they buy to divest & accelerate lifetime profits to today, knowing they'll just dispose the husk at the end. Others are monopoly plays: "roll ups" of local/regional players until there's just one option left and they can raise prices. Still others are growth plays: they're willing/able to take bigger risks, for bigger rewards. And others exist too.
Notably, all would likely describe themselves as arbitrage on bloated/mismanaged companies.
But that doesn't make it true, really
A lot of people view companies as fundamental and bankruptcy as bad because companies are the biggest "things" you can point to in the economy. But the economy itself doesn't think in those terms (it doesn't really think in any terms, not being alive). The fundamental assets in the economy are land, labor, capital, and information, and a firm is just a way to organize those factors of production to do something useful. Over time the optimal way to do things often shifts so that whole companies become obsolete, but the incentive of everyone involved in a company is to make sure the company keeps existing.
The role of a P/E firm or corporate raider is to buy the company, strip all the assets off, sell them to other companies that will use them more efficiently, lay off all the employees, and force them to get other jobs. Which sounds utterly cruel if you think of the company itself as a thing whose existence you want to preserve, but if you think of the company as an organization of convenience which should be dismantled and reconfigured when economic & technological conditions change, you are just paving the way for other companies to flourish.
My only quibble is how you frame "optimality" as an objective parameter, shifting with the tides of time.
Monopolies are usually optimal for the owner. Similarly, PE rollups are optimal for the owners. You're right, of course, that when you value a company in terms of "fundamental assets" then PE strategies make total sense.
But if these companies are simply organizations of assets, then why create them? The general purpose of companies is production: to make a profit, yes, but also to provide a value surplus to customers.
People dislike PE not because they're cruel, but because people get that they "optimize" for owner profit over customer surplus.
A necessary tool? Certainly, it often is. But optimal use is important too. With a cost of capital near 0 ... why wouldn't the tool be overused, destroying economic value it was meant to create?
In the absence of competition misallocation can occur, and that's why it's the governments job to stomp out monopolies. (Something that they've been sucking at, but if you want to argue for better anti-monopoly enforcement I'm all for it.)
There's wide-ranging literature on why companies exist [1], but it's not for production. Individual laborers independently contracting with each other can produce value, and do so without the monopoly risks mentioned in the last paragraph. Usually theories of the firm center around transaction costs: it takes money to identify, review, trust, and collect payment from other firms you do business with, and so you can improve efficiency (up to a point) by centralizing all the producers in one firm under a management hierarchy that doesn't pay them directly but is tasked with optimizing output. Other theories of the firm have shown that management doesn't actually optimize output and (surprise surprise) optimizes for their own status, promotions, and other human motivations instead, but as long as the deadweight loss from them being self-interested is less than the search costs of contracting with another company, it's economically rational. P/E operates essentially by taking on that search cost of dismantling the company and selling it on the open market, and pockets the difference between the deadweight loss of manager principal-agent problems and those search costs.
Cost of capital being 0 is a separate issue. The effect of this is to make any investment with positive returns a good one, regardless of how good it is, which creates a lot of bloat and misguided investments in companies. It's essentially making the economy a target-rich environment for P/E.
I'd humbly suggest that the system is comprised of more than mere owners.
> There's wide-ranging literature on why companies exist [1]
Indeed. Are you suggesting they describe examples of firms that don't produce, and never intends to do so? I'd be very interested to learn about them, as I'm surprised to hear someone imply The Theory of the Firm describes organizations without output.
Think of like the commercial equivalent of the United States and every constitutional republic that has followed. We don't have kings. Institutions should outlive regimes. Dynamic markets are healthy markets. Chaos is a ladder or something like that.
Let’s be honest here, PE firms exist to make partners rich, not to reallocate misused capital and force people to get a productive job. Their mechanisms are described by the OP and may sometimes result in those things but those are not the goal or the motivation.
Bankruptcies are a necessary evil but they are always awful, traumatic experiences for employees, and often PE will force reorgs, acquisitions and layoffs not because they are best for the economy or employees but because they are best for the new owners.
Typically they cut a bunch of expensive overhead, like employees, which juices the books to make it look much more profitable, then sell to someone else left holding the bag of a dead shell of a company. Cut long term viability for short term gains.
The owners? The customers? The employees? The country? Competitors? My 401K? The creditors?
Some of these stakeholders net-win when zombies die, and some of them net-lose. The economy isn't a zero-sum game, but particular categories of actions in it can produce net-negative outcomes for one of these groups. You can't just wave a large brush and say that everyone net-wins when this happens. It's a case-by-case thing.
Eddie Lampert's corporate plundering of Sears is an example of just about everyone but him (Maybe including him? It's hard to tell) losing.
> stakeholders
I hate this term. It's a deliberate attempt to blur the boundaries of who owns something and who does not. It's not shoplifting if I'm a stakeholder in this pack of cigarettes, right?
(Eg fire too many employees to cut costs)
Total shit show.
Or maybe that's anecdotal and not necessarily the brought trend.
It isn't so wild when you consider cases like Sears, where Eddie Lampert in effect used a variety of shell companies to sell off the profitable parts to himself.
But of course that "pure market" viewpoint doesn't take into account the social costs and individual pains these operations entail.
Let’s take Debenhams in the UK as an example
- Used to own all it’s stores - Got bought by PE (who attached the debt they used to buy Debenhams to Debenhams so the PE group now owe zero) - Split the stores from the retail operation but made the retail operation lease them on ever increasing rents - Sold the stores to British Land - Eventually Debenhams retail can’t afford the rents (as they only ever increase), and the debt payments so goes bust
Similar patterns with PE acquired companies not being able to afford their debt payments is common, coupled with PE companies extracting any free cash as a dividend shortly after purchase
What PE companies are doing isn’t culling the weak but extracting the most they can from businesses and then leaving suppliers, employees, pension scheme members to pick up the cost
You look at Toys R Us, and a few other major retailers, it is as you say.
Lastly, "Cutting long term viability for short term gains." actually sounds somewhat noble. Why should a company exist for 50 years when all of its usefulness (i.e. profit) can be extracted in 5? Let everyone move on to something else productive. If you owned an oil well you could exhaust in 5 years, you'd do it, not sip at it for the next 50.
Was an article about this in the Financial Times recently
And whoever invested in the second fund, which for example may be your pension scheme, is left carrying the cost
a) why when you can hold back and affect the price b) this logic had better change soon or we are all screwed with climate
This really only exists in large cap deals. Most middle market deals are actually about long term viability...mainly because they have to sell to other PEs or strategics that will underwrite the long term viability during diligence when they go to buy. Large cap on the other hand will typically try to IPO it where the public investor might be left holding the bag (or creditors, or employees).
Or, do you think sometimes the buyers are not getting a dead shell?
It's hard to actually see what provides company value and what is actually expendable. Remember that the whole idea behind free markets is that you can't perfectly know and precalculate every input and output of an economy; you want a distributed set of economic actors making decisions for themselves. And large businesses are not immune to this - they operate not like tribes, but like little mini-economies unto themselves. If we actually could "cut the fat", command economies would have worked and America would have collapsed instead of the Soviet Union.
The best way to describe PE is as a means of exploiting principal/agent issues:
https://en.wikipedia.org/wiki/Principal–agent_problem
People take over organizations and loot them for personal gain. It's the simplest business model imaginable.
In fairness that's not the only PE model. The other model is to buy up competing businesses, engage in anti-competitive practices, and extract monopoly rents from a sector.