The New York Times tonight features a generally very good piece, “Buyout Firms Profited as a Company’s Debt Soared,” by Julie Creswell that falls short in one important respect: it fails to call a prevalent and destructive practice of private equity firms by its proper name.
PE firms in the risk-blind environment preceding the credit crunch got into the habit of producing good to stellar returns by modifying their usual formula. The traditional model was to buy companies with a ton of debt, then improving their bottom line by a combination of partial asset stripping (selling off ancillary operations), cost cutting, and once a blue moon, actually doing something to improve operational performance. Then the company would be sold, either privately, usually to a corporation, or taken public.
But the PE firms found a much easier approach: just pile on more and more debt, and pay themselves a special dividend. No need to do any work, just keep borrowing until you had recouped your investment and then some. And that way you did not need to care how the company fared. If you destroyed the business, it was of no mind to you and your investors. Other saps were left holding the carcass.
George Akerlof and Paul Romer called that activity looting in a famous 1993 paper and depicted it as criminal:
Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations….
Our description of a looting strategy amounts to a sophisticated version of having a limited liability corporation borrow money, pay it into the private account of the owner, and then default on its debt…
First, limited liability gives the owners of a corporation the potential to exploit lenders. Second, if debt contracts let this happen, owners will intentionally drive a solvent firm bankrupt. Third, when the owners of a firm drive it bankrupt, they can cause great social harm, just as looters in a riot cause total losses that are far greater than the private gains they capture.
This version wasn’t sophisticated. It was done in broad daylight. The Akerlof/Romer article describes how looting occurred (among other places) in Chile and in the US during the savings and loan crisis. But the New York Times article is robbed of its punch by its inability (due to Grey Lady conventions) or reluctance to call this form of chicanery what it is, a fraud perpetrated on society as a whole.
From the New York Times:
For most of the 133 years since its founding in a small city in Wisconsin, the Simmons Bedding Company enjoyed an illustrious history….
Simmons says it will soon file for bankruptcy protection, as part of an agreement by its current owners to sell the company — the seventh time it has been sold in a little more than two decades — all after being owned for short periods by a parade of different investment groups, known as private equity firms, which try to buy undervalued companies, mostly with borrowed money.
For many of the company’s investors, the sale will be a disaster. Its bondholders alone stand to lose more than $575 million. The company’s downfall has also devastated employees like Noble Rogers, who worked for 22 years at Simmons, most of that time at a factory outside Atlanta. He is one of 1,000 employees — more than one-quarter of the work force — laid off last year.
But Thomas H. Lee Partners of Boston has not only escaped unscathed, it has made a profit. The investment firm, which bought Simmons in 2003, has pocketed around $77 million in profit, even as the company’s fortunes have declined. THL collected hundreds of millions of dollars from the company in the form of special dividends. It also paid itself millions more in fees, first for buying the company, then for helping run it. Last year, the firm even gave itself a small raise.
Wall Street investment banks also cashed in. They collected millions for helping to arrange the takeovers and for selling the bonds that made those deals possible. All told, the various private equity owners have made around $750 million in profits from Simmons over the years.
A result: THL was guaranteed a profit regardless of how Simmons performed. It did not matter that the company was left owing far more than it was worth, just as many people profited from the mortgage business while many homeowners found themselves underwater.
Yves here. While the NYT does not use our preferred terminology, it does correctly connect the dots between this sort of looting and the mortgage industry variant. Back to the story:
From my experience, none of the private equity firms were building a brand for the future,” said Robert Hellyer, Simmons’s former president, who worked for several of the private equity buyers before being asked to leave the company in 2005. “Plus, the mind-set was, since the money was practically free, why not leverage the company to the maximum?”…
A disproportionate number of the companies that were acquired during that frenzy are now struggling with the enormous debts. More than half the roughly 220 companies that have defaulted on their debt in some form this year were either owned at one time or are still controlled by private equity firms, according to analysts at Standard & Poor’s.
Yves again. Of course, the article offers the hollow defenses of Thomas Lee, that the company was a casualty of the downturn. But that reasoning is spurious. Companies need reserves for bad times, in the form of cash on hand and spare borrowing capacity. PE firms, by contrast, hollowed out their charges, assuring failure if not very much went wrong. And in the real world of commerce, things go wrong all the time.
Expect more wreckage, and expect the perps to get off scot free.