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Comment by mjevans | Hacker News Reader

The fall isn't covered in very much detail.

I think it might be exemplified by a personal example. I went to one near the end to buy a standard, wooden block, JENGA toy for relatives. They didn't have any in stock other than some crummy cardboard sticks version (absolutely unable to stand up to the abuse a child under 12 will dish out). I think I ended up ordering one from Amazon with Prime or hitting up a Target or something...

As for the 'category killer' thing, that's probably an example of Market Failure (regulation failure). For a fungible commodity product, there probably should be a requirement to provide access to the same price to all players in the market. That might mean that the price at a generic warehouse in one of the major shipping ports is that price. Stores / groups of stores would still need to leverage shipping and distribution networks, but it'd at least give places a _chance_ to compete.

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> they didn't have any in stock other than some crummy cardboard sticks version

Private Equity hates inventory. Their first trick in buying a retail business is slashing in-store inventory. They also treat suppliers like dogshit, playing games with payment terms, etc. End result: stores don't have the products customers want and quality suppliers fire them as customers.

How do PEs earn money in this scenario? I don't think it can spin off the brand easily? Or by real estate?

Debt

Private Equity playbook:

1) Buy a company from the stockholders by having the company take out loans (secured by future earnings) to pay for the stock. Do not pay for it with more than a token amount of your own money.

2) Slash company expenses in a way that generates short-term returns (but which normal companies don't do because it causes long term problems) like:

- don't buy new inventory to replace items sold (mentioned above)

- stop doing maintenance (saves money for a while, until everything breaks)

- delay paying outside vendors (works for a few months, until they stop shipping you stuff unless they get their money and/or sue you)

- sell physical assets (like the stores themselves) to an outside holding company (possibly owned by you) and rent them back, getting short term income for the company from the sale (but collecting the rent yourself, and also retaining the right to sell the real estate later).

3) pay yourself huge bonuses on the basis of your cost savings.

4) When the company is no longer viable, leave the empty husk behind. The company has a bunch of loans it will never be able to pay off (sucks for the lenders) but you keep your paychecks, bonuses and any assets you sold to yourself at below-market prices.

5) move on to the next company.

(basically, "the bust out" sequence from Goodfellas)

Who are the lenders and why do they keep lending when their is a history of default from the PE-owners?

Commonly, the bank that undewrites the loans will essentially do the same thing - they collect a commission but sell the underlying debt to someone else as (high-yield, because they are high-risk) bonds.

If you've heard of "Junk Bonds", this is (one source) of where they come from.

It's like a financial game of "hot potato" - you can make money as long as you're not the last person to hold the debt. So the answer to "who lends the money?" is "anyone who thinks they can sell the debt to someone else before it explodes".

In the end, a lot of it goes to "unsophisticated" individual investors, who will buy it based on "Sears (or whoever) is a great company, why wouldn't I buy their bonds" without realizing the full extend of what's happening.

> In the end, a lot of it goes to "unsophisticated" individual investors, who will buy it based on "Sears (or whoever) is a great company, why wouldn't I buy their bonds" without realizing the full extend of what's happening.

Unfortunately, a lot of these and similar financial schemes end with the phrase "...eventually retail investors end up holding the bag and taking the losses." LBOs, collateralized mortgages, crypto, every equity that gets pumped and dumped. When every layer in the banking industry has skimmed its profit and did their own renaming/reselling/repackaging of these "products" finally there's some individual investor chump who takes the loss, making the numbers add up.

This isn’t logical. A PE firm takes a company private only “sophisticated” investors can invest.

Bankers who want to secure a deal that looks good on paper. When the loan defaults it would be someone else’s problem.

Ultimately it falls on the taxpayer. The existence of the FDIC not only incentivizes but almost forces banks to be risky with their investments. It doesn’t matter if their lending fails because the government has to come in and clean it all up and those expenses are passed on to the public.

Banks aren't defaulting because they held bad PE loans. The recent memorable case was SVB, but it held quality paper, just with a duration risk. Banks aren't investing depositor funds in loans to Toys R Us.

It’s not entirely about defaults.

FDIC has exactly 0 to do with this.

Fractional reserve banking means the bank only has a small percentage of the money its customers deposit on hand (currently 0% since 2020). What do they do with the rest of that money? They invest it. They take on risky investments because it will either pay off or they will be bailed out by the taxpayer through FDIC. There is zero risk on the banks part.

Once you get as far as FDIC insurance being involved, the bank generally ceases to exist (ideally via a fire sale to another, more stable bank) and the shareholders generally get (all but) wiped out, at best.

Competent risk management so that doesn't (generally) happen is a core competency for a bank, and if regulators think you're doing it wrong they will come down on the bank's leadership like a ton of bricks.

If anybody reading this comment would like to learn more from people who understand the area far better than I do, I would recommend patio11's 'Bits About Money' and Matt Levine's 'Money Stuff.'

FDIC has as much to do with what you're talking about as the gravity that holds you down. Yes its technically correct that they're covered by both, but you're miles away from any kind of rational point.

GP is repeating the PE as corporate raiders story, but leaving out that these are often struggling, mismanaged companies, and that those loans have a sophisticated counterparty. The lenders might eat the losses, but after a few rounds, they'll demand higher interest rates once they see PE's turnaround track record. This is actually an example of where markets work; it's just ugly to see a beloved band go out like this.

I'm aware that some private equity actually does plan to make money by applying good management to a fundamentally sound company which is currently struggling (or "cheap") because of fixable mismanagement. Warren Buffet got rich by doing this repeatedly.

But that's not what happened to Toys'R'Us.

"Raider" PE doesn't care about the high interest rates because they don't intend to pay them for long enough to matter, and - as mentioned in other replies - usually the sophisticated counterparty to the loans has identified a less-sophisticated other counterparty to sell the loans to and sees this as a risk-free deal that nets them origination fees. Suckers exist. Banks make it their job to find them.

> Warren Buffet got rich by doing this repeatedly.

Warren Buffet would insist that he's not in private equity because Berkshire's stock is publicly traded and there's no lockup. He has publicly stated that he thinks being a PE LP is financial malpractice.

Warren Buffet is interested only in solid businesses, not in buying distressed assets in a fire-sale. One of his maxims: "is better to buy a wonderful business at a fair price, then to buy a fair business at a wonderful price"

He bought a bunch of newspapers when he knew they were on the decline and extracted money from them. He sold them all in 2020.

TLDR: you know how people will by crypto that has absolutely no backing of anything? Well these bonds at least back to the company. There's always another sucker there to unload your debt to after you make a profit in fees and interest.

Banks want to keep working with PE because banks have a lot of M&A business, and PE firms are the high-dealflow clients of their M&A arm. If Elliot (to pick a vulture at random) hires you to do mergers they're going to expect you to also help with the financing.

The banks don't end up being the bag-holders in any case, because they securitize the loans.

PE firms mostly make money on the management fees they charge the company, and by stripping assets, so they're often OK if they lose money on the ownership stake. In any case, the PE principals make money from their LPs with fat fees on assets under management so even if the entire investment goes south, it's the LPs who ultimately take the hit (5-10 years later) and not the principals.

Competition who benefits from stragglers being eliminated from the market ?

I've personally seen this script played out a couple times in my career similar to what you describe. But the piece I don't understand is the banks. The loans usually end up worthless since the future earnings evaporate, so why do bankers go along with it?

Maybe the bankers are thinking the same thing -- it's the bank that loses, not me who bagged huge bonus.

But then how does it pass banks's audit?

The bank doesn't keep the loan, they sell it off to someone else. This happens all the time with mortgages. The banks are constantly adjusting their portfolios to ensure a desired level of risk and leverage. If nothing else, they've collected the origination fee already, so even if they don't get much in the way of payments they still come out ahead.

Ah thanks, this makes a lot of sense now.

The banks know this is likely to happen, but believe (usually correctly) that they can sell the debt to someone else before it becomes worthless.

I.e. the deal for the bank is not "we're going to issue this loan and collect payments for it over the next 20 years", it's "we're going to issue $20M loans and simultaneously sell $21M of bonds backed by that loan. We skim the $1M difference for ourselves at basically no risk, and if the bonds default, they default. Not our problem."

Why do people buy the bonds?

- they think they can do the same thing - repackage the bonds as CDOs (collateralized debt obligations), skim a percentage and dump the risk on someone else. This possibly includes hiding the risk by combining multiple different kinds of debt, and then issuing different 'tranches' with different risk/reward levels. (this is what happened to a lot of mortgages in the 2008 financial crisis)

- they only plan to hold the bonds for a short time (the company will probably make the first few loan, and hence bond payments) and sell them to someone who's further removed from the original sale (who may have not done their due diligence) before things go badly

- they believe the private equity propaganda (propaganda works! at least sometimes) and actually think the bonds will be paid off.

>> by having the company take out loans

How does that work exactly though? Loans from whom? Lenders watch Goodfellas too. They know the game here. Oh, a private equity firm wants to take out loans on the future earnings of this company they just bought. That sounds like it must be very profitable! Let's call off our due diligence.

Said no lender ever.

A loan at an 11% interest rate pays for itself in around six and a half years. The general concept is that even if the PE firm runs the company into the ground, it only needs to exist (and make loan payments) for 6.5 years to get your money back.

For a company like Toys R Us, there is still value in that brand name. You can reduce the quality of the store and coast on that recognition for a little while before people change their shopping habits. Put another way, how many bad meals would you have to have at your favorite restaurant before you stopped going? I bet it's more than one or two, as long as the experience isn't super terrible.

So for a lender, the questions you ask yourself are:

1. With cost cutting and other measures, how long do I think this business can last?

2. Once this business reaches bankruptcy, how much am I likely to recover on my loan? This involves figuring out how much in assets the company has.

3. What are the chances this business is able to be turned around?

There are situations where even if the company goes bankrupt, the lenders still made money.

Lenders aren't dumb. They know the reputation of the PE performing the buyout. If that particular firm has a terrible track record money to lenders, the lender will want to be compensated for that risk.

Ultimately, the people that "pay" for this are shareholders (who get zeroed out in bankruptcy) and consumers (who get degraded product/service quality for the same price; that's how the company stays afloat in the short term).

>> Lenders aren't dumb. They know the reputation of the PE performing the buyout. If that particular firm has a terrible track record money to lenders, the lender will want to be compensated for that risk.

That's not a bust out then. If the lenders get compensated for their risk it's just a business decision.

The accusation was "The company has a bunch of loans it will never be able to pay off (sucks for the lenders)".

The accusation was that the lenders were in fact dumb.

So which is it?

It's lenders all the way down, and the ones on the bottom are the ones who lose.

I mean, the view I have is that at the time of the LBO nobody knows for sure what will happen.

The PE firm knows what they plan to do. The lenders know in a general sense what the PE firm plans to do, along with the track record of that firm's other LBO's and loans. Even if the outcome of bankruptcy is fairly certain, it's hard to predict how long it will take until that happens.

The point I'm making is that if you only look at the failures, LBO's look like a bust out. But I don't think the entire concept of an LBO is a bust out, which is why I don't think the lenders are dumb for underwriting these loans.

In this case the PE firm would have been better off not getting a loan to begin with - it would have kept the interest payments to itself.

This looks a lot like selling some bad assets to some sucker investors. But the question a lot of people seem to ask in this thread is: when will the world run out of suckers? (Maybe this question shows how naive I am? Maybe some people know how to find these suckers one after the other?)

There are a lot of suckers, including:

- Folks trying to ‘get a better retirement’ by buying riskier products.

- folks targeted by Wolf of Wallstreet types (or their more ethical brethren)

- folks trying to ‘get rich quick’

- folks trying to ‘double or nothing’ after a bad decision.

Etc, etc.

‘There is a sucker born every minute’ and all.

>In this case the PE firm would have been better off not getting a loan to begin with - it would have kept the interest payments to itself.

That assumes the PE company can predict exactly how long the expect the business to survive after takeover. They can't.

Both sides (the lender and the PE firm) are evaluating the company being purchased and the plan set out by the PE firm. The loan terms are set such that both sides feel they can make money on the deal.

The fact that PE doesn't make money on every deal indicates that they can be wrong.

I vaguely recall they did a few rounds of this at bed, bath and beyond.

Also Sears

So, some PEs do try to run businesses sustainably. But we mostly hear about the PEs that turn a business that's slowly dying to one that will operate "as normal" until it suddenly dies, usually somewhere around 5-7 years later.

The first thing is that, if at all possible, the PE wants to do a leveraged buyout where the acquired company itself has borrowed most of the funds to buy itself. This cashes out the previous investors, but leaves most of the risk with lenders rather than the PE firm. Sometimes the PE may get a cut of the financing revenue. Most of the loan will be sold on the bond market, typically as junk bonds. Junk bonds have high interest rates, because there's a good chance the loan won't be repaid, but maybe you'll collect enough between interest and the bankruptcy settlement.

While the company operates under the PE's management, it's getting paid management fees.

It's also likely to move valuable assets out of the company; for real estate, sale and leaseback is common; when the company implodes, the PE keeps the land and can sell or lease it to someone else. The sale price was probably under market and the lease over market, so the PE earns money here. Having a high lease payment helps the PE finance the purchase, and may help it finance similar property as well.

Question is, why do lenders lend money to them? Maybe they can get the principles back somehow?

They got 13 years of payments which might have been enough to make it worth it for the lenders depending on the premium they were getting on loaning the money. Sears and Joann's also took about 13 years from buyout to bankruptcy. Party City only took 6 years.

The interest rates are high, and the lenders likely will sell off the loans in a few years. If the company sticks around for a few years and looks ok, they might even be able to sell the loan for more than they lent out. Especially if the corporate numbers look good because of short-term changes, they may be able to get out.

When the company goes bankrupt, the lenders have first priority for remaining assets, sometimes lenders will takeover a business and run it away from the shore and earn a profit that way, too.

Thanks, looks like interesting cases to study.

Stick the junk bonds in. With solid bonds and hide that they exist. Sell to a greater fool.

Thanks, I remember reading about those LBOs many years ago when they were kinda new to the public. Should have thought about that.

Guess the key is:

1) Find a suitable monetary situation

2) Find companies that still have long term value but are struggling

3) Find a loan

4) Execute

the PE wants to do a leveraged buyout where the acquired company itself has borrowed most of the funds to buy itself.

Planet Money did an excellent podcast back in 2012 about Bain Capital buying and effectively destroying an iconic American manufacturer of legal pads. It's a great example of exactly this behavior:

https://www.npr.org/transcripts/147590440

Compare this to the other trend I noticed the other day, JIT delivery beyond excess.

Was in Walgreens, and a woman was restocking the shelves. She had a series of reusable plastic boxes, but they were all labelled by isle. So she'd take the box to isle 5 or whatnot, and there'd be 5 products in it. Literally the products sold the day before. EG, one box of toothpaste, one brush, that sort of thing.

Asked her about it, and she loved it. Said before, she had to walk all over the store to restock, but not now. Later that week, I was in again and noticed a van unloading about 10 of the same reusable boxes.

Definitely a powerful way to keep stock levels down, even if not working towards a squeeze to close-out path. I wonder on the comparative on daily van delivery costs vs say.. a larger truck once a week, along with stock levels. Some very interesting math there, including regional supply depots stock levels, maintenance costs of larger trucks versus a van, and so on.

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