Quelle Surprise! New York Times Fails to Call Private Equity Looting by Its Proper Name

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.

Print Friendly
Tweet about this on TwitterDigg thisShare on Reddit0Share on StumbleUpon0Share on Facebook0Share on LinkedIn0Share on Google+0Buffer this pageEmail this to someone

46 comments

  1. CrocodileChuck

    Standard PE industry communications had it that the new financiers would modernise operations and achieve efficiencies. Note in the piece that the employee with 22 years of service stated that nothing on the shop floor had changed even after new owners…

    As Jared Diamond wrote ‘Collapse’ after ‘Guns, Germs & Steel’, someone like Jim Collins (‘Good to Great’) should do a longitudinal study of co’s emerging from PE ownership

    No prizes for guessing the obvious conclusions

    1. TraderMark

      I call them leeches, feasting on hosts body but the German “locusts” works just as well.

      And don’t you dare question it, because you will be called out as a socialist! Its free market capitalism – i.e. we will do what we do until we take it to excess and then the Fed will bail us out. Or the whole system out if need be. Just as a free market should work.

    2. Charles Swann

      Crocodile Chuck

      Steve Kaplan has done a report “The Effects of Management Buyouts on Operations and Value,” which explored how PE firms in the 1980s and 1990s added value and forced public companies’ management teams to focus more on creating value than building fiefs in their respective conglomerates.

      Here is the latest academic report about the job loss at private equity firms.

      http://www.google.com/url?sa=t&source=web&ct=res&cd=3&url=http%3A%2F%2Fwww.scribd.com%2Fdoc%2F6310387%2FThe-Global-Economic-Impact-of-Private-Equity-Report-2008&ei=IMTLSvmnH4HJlAeJpZ3NBQ&usg=AFQjCNGSVZJhpNyCtj3hqJV7eh2-9aT8WA&sig2=pY8dkmJL8mhJ1Yb_gGLXEg

      If no time read the article by Andrew Sorkin of the Times describing that paper and its results here.

      http://www.nytimes.com/2008/01/25/business/worldbusiness/25davos.html

      Both find little evidence that private equity firms do more firings than is necessary to clear dead wood than any other firm. “[Portfolio companies] compared with those public companies with similar junk debt ratings, buyout [portfolio] companies defaulted at half the rate.” Tends to show that PE firms are more adept at managing a fiscal crisis than their public counter-parties with similar capital structures. This is because their debt was not securitized but instead done in face to face negotiations with the lenders. So instead of flushing the baby with the bath water the creditors were willing to adjust some of the terms so portfolio companies could survive revenue drops.

      I will agree that the behemoth pe firms can have their incentive structured skewed to earn management fees and transaction advisory fees, ahem KKR, but the majority of funds and the GPs only make money once it has been all returned to the LPs. (indeed the carried interest doesn’t start until the principal and the management fees are returned to the LPs.)

      Easier to howl (chomp?) at the moon than do research, but I have done the legwork for you, now you can just analyze the arguments and see the results for yourself.

  2. houseofcards

    Good article. The UK govt loves PE, they describe them more as venture capital firms than the asset strippers they really are. In a recession, even solid firms can have cash flow problems- exacerbated by interest payments, fee’s, etc going to the govt/bankers best buddies.

  3. houseofcards

    Also, many PE execs entered the revolving door of New Labour or were big donors- to counteract any changes to capital gains tax (PE execs paying less tax as proportion of income than their cleaners).

  4. RebelEconomist

    OK, so private equity is is rip-off, but that does not explain why anyone is willing to take on the debt. If the debt buyers are greedy for return, then don’t they deserve what they get, and if they are stupid wouldn’t they probably blow their money some other way anyway?

    I sometimes think that this blog is a little too ready to condemn the looters, without asking why the losers end up in that position – tackling this activity from either side could curtail it. But I am glad to have your concise and topical posts back Yves!

    1. anon

      Right.

      BTW, what’s the rough exposure of the banks to private equity debt? To what extent has USG/FDIC subsidized bad bank investment in private equity? Or is it mostly elsewhere in the less subsidized parts of the financial system?

    2. DownSouth

      RebelEconomist,

      Who do you think you’re fooling?

      Do you really think people are so stupid they can’t figure out how all this works?

      Take a look at this video, the latest (and by far most comprehensive) released last night by the University of Pittsburgh students:

      http://www.youtube.com/watch?v=JySzR9G5KNc

      What is one of the principal messages?:

      “NO BAILOUTS!”

      Why don’t we drop the facade and call you for what you really are, RebelEconomist? You’re not an advocate of capitalism, you’re an advocate of state capitalism. You’re not an advocate of a free economy, you’re an advocate of fascism.

      Why can’t you just come out and admit what you are? Do you really believe people buy into your coy little ruse that you’re so ignorant that you don’t understand what is going on?

      Of course I suppose there is a possibility you are so blinded by your own ideology and your self-interest that you can’t see the obvious. It certainly wouldn’t be the first time:

      When one thinks of all the people who support or have supported fascism, one stands amazed at their diversity. What a crew! Think of a programme which at any rate for a while could bring Hitler, Petain, Montague, Norman, Pavelitch, William Randolph Hearst, Streicher, Buchman, Ezra Pound, Juan March, Cocteau, Thyssen, Father Coughlin, The Mufti of Jerusalem, Arnold Lunn, Antonescu, Spengler, Beverly Nichols, Lady Houston and Marinetti all into the same boat! But the clue is really very simple. They are all people with something to lose, or people who long for a hierarchal society and dread the prospect of a world of free and equal human beings.
      –George Orwell, “Looking Back on the Spanish War”

      Even when they had begun to grasp that fascism was dangerous, its essentially revolutionary nature, the huge military effort it was capable of making, the sort of tactics it would use, were quite beyond their comprehension.
      –George Orwell, “England Your England”

      1. DownSouth

        And while you’re at it, make sure you don’t miss the companion piece to the article Yves posted. It gives a nice snapshot of what “the best and the brightest” look like up close:

        …many former Simmons executives said that he ruled from afar — that he rarely appeared at the Atlanta headquarters. Instead, he spent much of his time in Naples, Fla., where he and his wife built an opulent home with a 1,000-bottle wine room and a multitier cascading pool featuring glass mosaic tiles. The home was listed this spring for $16 million.

        Mr. Eitel also spent a great deal of time wooing clients from his 80-foot yacht, Eitel Time. With his boat, which had 11 televisions, a hot tub on the flybridge and a sunken granite-topped bar in the salon, Mr. Eitel took customers out for cocktail cruises and junkets to Martha’s Vineyard.

        http://www.nytimes.com/2009/10/05/business/economy/05simmons-side.html

      2. Dan Duncan

        What an odd response.

        Rebel Economist–while stating that “PE is a ripoff”— has the temerity to ask why anyone would take on the debt…

        And he’s hit with Fascist accusations, while being told that “we’re all on to your coy ruse”…only to be followed up with the all too perfunctory Orwell quotations????

        And here I thought RebelEconomist was simply saying that these PE deals stink and it would also help if the Enablers of the deals would quit enabling. I had no idea that I was a victim of his coy ruse and that I was being indoctrinated into a fascist ideology.

        Thank you DownSouth for clearing that up!

        Hey Rebel Economist: Why don’t you take your crap fascism–all dressed up in the form of a simple and reasonable question–and stick it?! We’re on to your coy ruses. We even have Orwell on our side!

        1. DownSouth

          It’s a shock when someone rips your mask off and exposes you for what you really are, isn’t it?

          And funny how you managed to say all that and still can’t bring yourself to say what’s really ailing America. For the “Enablers of the deals” has a name. It’s called the United States government. And the enabling mechanism used by the United States government also has a name. It’s called bailout.

          The post-Vietnam right has almost nothing to do with traditional conservatism. “The conception of politics to which neoconservatives paid allegiance owed more to the ethos of the Left than to the orthodoxies of the Right,” Andrew Bacevich writes in The New American Militarism. “Their ultimate ideological objective was not to preserve but to transform. They viewed state power not as a necessary evil but as a positive good to be cultivated and then deployed in pursuit of large objectives.”

          Neoconservative. Fascist. Neo-fascist. State capitalist. Capitalist. Neo-capitalist. National Socialist. Neo-national socialist. Socialist. Neo-socialist. Communist.

          Call yourself whatever you want. It’s all the same to me. But I’ll call things the way I see them.

          All of this goes to confirm the amazing prescience of Hannah Arendt. As she so clairvoyantly augured in Crises of the Republic, “the alternative between capitalism and socialism is false—not only because neither exists anywhere in its pure state anyhow, but because we have here twins, each wearing a different hat.”

    3. Reino Ruusu

      RebelEconomist, the answer is simple. The lenders are also playing with other people’s money. They are paid huge bonuses for making those deals, until they blow up. But then those bonuses are already paid out. It’s a second layer of the same looting.

      There are millions of losers here. The target company employees lose, the owners and depositors of the lenders lose. And now the whole society loses, when the lenders are bailed out with tax funds.

      The credit bubble has been built on separating the decision making from the ultimate liability. The same was ongoing in mortgage securitization. A broker of other people’s funds with no personal liability, coupled with bad actors on the receiving side.

  5. fresno dan

    i think “Rebel Economist” has a good question. And I would bring up my own maxim, “debt is not wealth, and borrowing is not income.” Owned by 7 owners in 20 years? Who kept financing all that debt? Shouldn’t it have been obvious that, just like the internet, mattress sales are not unlimited? Could it be that the most insightful critique of capitalism is that bondholders are all idiots?

  6. Marinbelge

    “OK, so private equity is is rip-off, but that does not explain why anyone is willing to take on the debt. If the debt buyers are greedy for return, then don’t they deserve what they get, and if they are stupid wouldn’t they probably blow their money some other way anyway?”

    Ain’t any real power left for the loony saver anymore in the current monetary scheme.

    The grand manipulation of the fiat currency system by Greenspan, Bernanke and the BoC via REAL interest rates manipulation has to be exposed for what it is. A looting scheme on a much grander scale than anything devised by Wall Street or London in the field of PE or security market manipulations of all kinds. From CDO to CDS. The current monetary practices by key central bankers has changed aka perverted base saving/consuming patterns on a wide and durable basis.

    That should not prevent Yves and al from denounce those practices. But one has to tell the basic truth. It does not originate in the banking sphere. Nor is it contained into it. Consumers, and corporations (look at the Spanish ones…), as well have their part in the game.

  7. bob

    PE in nursing homes and elderly living situations is a prefect example of this too. They borrow so heavily against the enterprise that when a judgement is finally leveled for them killing someone there is nothing left to take. The current residents get in line behind the lenders during BK, and the whole thing is recycled into another leverage vehicle for another PE firm after all claims are released.

    The real “owners” are never brought to task, and their anonymity is preserved.

    There is an old saying in the car rental business, the car with a dent in the fender is worth more than one in perfect condition. This is pre-supposing that a few people will rent the car without realizing that the dent is there, and then pay for fixing that it when it is returned. Of course the dent never gets fixed, its worth way too much….

  8. Siggy

    Freson Dan raises the critical question, who is providing the financing? The applied debt is the instrument of the theft.

    1. DownSouth

      Who is providing the financing?

      After 25 years of the government bailing out the “too-big-to-fail” financiers for their bad loans, isn’t the answer to that question rather obvious by now?

      Why it’s the taxpayers of course! They’re the ones who ultimately get stuck with the bill.

      1. j h woodyatt

        …isn’t the answer to that question rather obvious by now?

        “The plainest print cannot be read through a solid gold sovereign, a ruble or a golden eagle.” —Samuel Cummings, weapons dealer.

      2. Siggy

        Perhaps I should have said another way. Why do we permit the government and its agents to rob us?

        Why bailout AIG when it is obvious that AIG perpretated a massive fraud? Big domino effect? Who would it have impacted? The primary dealers? Who benefited from the bailout?

        Bang the drum slowly, the fiat currency is dead, long live the fiat currency! Bang the drum slowly, the regulators are not doing their job!

        The corruption is so vast it is beyond description let alone establishing accountability.

  9. Thurston Howell

    LBO dudes are the scum of the universe. My neighbor is a PE dude. He makes improvements to his house and damages my property. He lets his children make obtrusive noise and destroy our landscaping. I’m a bad neighbor in his eyes. The world is his doormat. Hope his plane crashe on the next flight to Asia.

  10. Peter Principle

    The PE firms clearly watched their Mafia movies. What Yves calls “looting” is commonly known as a “bust out” — as depicted in “Goodfellas” and “The Sopranos.”

    Wall Street is always open to good ideas, no matter where they come from.

  11. Eric

    They did this on the Sopranos. A guy that owned a sporting goods store owed Tony a lot of money. To pay off the debt the owner let Tony and his boys buys lots of items that they could re-sell easily, and ran the store into bankruptcy. Same basic philosophy.

  12. tekel

    ok, I’ll admit up front I haven’t read the piece, and I’m just here from my eschaton RSS feed. But i have a question for all you smart guys here:

    Isn’t it clearly securities fraud for the owners to pay any kind of dividend while the company is insolvent, or to pay a dividend that results in insolvency? I realize that the specifics probably matter, i.e. where is the entity organized, is it a C-corp vs. an LLP vs. an LLC, but I’m also pretty sure that the ’33 Act doesn’t give a damn about any of the details.

    If this is really how these deals are going down, why aren’t the directors of these little debt factories being prosecuted and convicted? I know, i know, like everything else he touched turned to shit, GWB ruined the SEC too. But there’s a new sheriff in town, right?

  13. Bas-O-Matic

    Sounds very familiar.

    Now the guy’s got Paulie as a partner. Any problems, he goes to Paulie. Trouble with a bill, he can go to Paulie. Trouble with the cops, deliveries, Tommy, he can call Paulie. But now the guy’s got to come up with Paulie’s money every week. No matter what. Business bad? F–k you, pay me. Oh, you had a fire? F–k you, pay me. The place got hit by lightning, huh? F–k you, pay me. Also, Paulie could do anything. Especially run up bills on the joint’s credit. And why not? Nobody’s gonna pay for it anyway. And as soon as the deliveries are made in the front door, you move the stuff out the back and sell it at a discount. You take a two hundred dollar case of booze and you sell it for a hundred. It doesn’t matter. It’s all profit. And then finally, when there’s nothing left, when you can’t borrow another buck from the bank or buy another case of booze, you bust the joint out. You light a match.

  14. Yves Smith Post author

    The debt for most large transactions was recombined into collateralized loan obligations. These in turn were tranched into securities that received ratings ranging from AAA to equity (non-rated) but the bulk of the deal (well over 70%) was in AAA rated securities. The AAA rating was based on the protection afforded by the lower tranches, plus the belief that the pools were diversified (use of now discredited correlation models played a major role).

    A further layer is that some banks (European) had great latitude under Basel II rules as to how much equity they had to hold against AAA tranches. Many engaged in a so-called negative basis trade, in which they bought CDS against the AAA tranche, further reducing the equity that the bank was required to hold. Other investors engaged in neg basis trades against lesser rated tranches (the cost of the CDS guarantee was less than the interest on the tranche, so they have positive carry). Some prime brokers would allow traders to lever up these hedged positions considerably.

    So no one was doing old fashioned credit scoring. Loans were made on the assumption they would be sold. Buyers depended on ratings and hedging.

    Now IBs were a bit hoist on their own petard, they wound up holding a ton of CLO inventory when the music stopped, but that’s another story.

    1. Siggy

      It is indeed another story. But then, will we let them fail as they rightly deserve? That’s the stuff that might have legs, that’s the stuff that might raise hell at the coming mid-term election.

      Is there the threat that the electorate will determine that it’s time for them to execise their right to a revolution, and if so, what shall we get?

  15. NTB

    Reluctant to post a comment given the loony-ness of some of the other posts, but in response to tekel …

    As to the fraud question – timing is everything. Payments done when a company is in the zone of insolvency are scrutinized for fraudulent conveyance and are subject to clawback during the BK process. Secured creditors can sue to recover pretty much any payment to an unsecured creditor (such as a vendor) or insider (employee or shareholder). However, the dividends were paid through the issuance of new debt, and no one can make the argument that a company is insolvent when there are a bunch of investors lining up to buy debt that they know will be used to pay a dividend.

    And as for the mafia analogies, the folks making them give the PE guys too much credit. PE was living in a world where “acceptable” debt levels shot up from 3x to 6x EBITDA in just a couple years. The amount of equity required for deals dropped at the same time, further reducing the PE skin in the game. Those levels were determined by the banks lending the money, not the PE guys. Just like subprime borrowers, PE firms just took the money that banks were offering them.

    In the case of Simmons specifically, here’s a deal where THL paid too much for a company and failed to make the quick flip in an IPO they had hoped for. Even at a little over a 1x, this investment was still a dog for THL. But if they had not taken the dividend banks were begging to give them, THL would not have been acting in the fiduciary interests of their LPs (including pension funds, endowments and the like).

    Now if you want to talk about how that fiduciary duty is in conflict with the one the PE firm has as an owner (and often director) of the portfolio company, then that’s absolutely a valid area of debate.

    1. DownSouth

      Oh give me a break, NTB!

      You’re another one of these people who thinks the whole world is stupid, minus you.

      “Just like subprime borrowers, PE firms just took the money that banks were offering them,” you tell us.

      So all of a sudden we’re to believe that “the best and the brightest,” the “Masters of the Universe” have no more economic sophistication than the average retail home buyer?

      And just because some of the sub-prime borrowers engaged in morally questionable practices, that somehow justifies the PE guys doing the same?

      And how about those lavishly paid Washington lobbyists and law firms that the PE firms have on their payroll? How many of those do you reckon the average homeowner has at his disposal? And we’re to believe that the PE firms get nothing in return for all the largesse they bestow on K Street?

      None of this, of course, speaks to the difference in outcomes. In the case of the homeowner, what exactly did he profit from his deal? How does that compares to the millions or even billions of dollars the PE guys skimmed off their deals before they went belly up?

      1. NTB

        Glad to know that DownSouth just considers me arrogant and not a fascist. I guess Orwell didn’t have any notable quotes about arrogance.

    2. Charles Swann

      I concur with NTB, here is my take on the story.

      Nobody likes Private Equity, never have and never will. The hedge funds hate them because they make similar amounts but their structure prevents investor runs on the funds, unlike the ones that occur to a hedge fund. The i-bankers hate them because they have more freedom and make more money than they do. The regulators hate them because they operate outside their grasp. People hate them because the tippy-top make more money than Peru in a given year and almost everyone in the industry, at minimum, makes more than 3x what a median American household makes. For these reasons, and many, many more PE tries to keep a low profile. However, if you want to do the research you can find out about them their deal history, their portfolio companies, and anything else you might ponder. Dartmouth’s Tuck School of Business has a dedicated unit writing up case studies and training talent for these firms. Of course, Harvard, Stanford and Chicago train plenty of MBAs who end up in PE, either by starting a firm or joining one. Still, the only thing that ends up in main stream media are the giant takeovers and the blow ups, which represent a very small and an even smaller proportion of the deals done.

      The latest missive continues the trend of large takeovers and blow ups to again portray the industry in poor light. To help, I will refute some of the misunderstandings and bring about the industry in lay terms.

      Imagine a house. Now imagine you want to buy that house. If you are unlike Bill Gates, you will more than likely require financing. Now the current owner’s financing may be completely different from your idea of what an ideal capital structure may be. The mortgage may have already been paid off, or they may only own 25% equity if the had recently purchased it. This does not matter because you will pay them the agreed sales price and then can institute your own capital structure. For instance, once the sales agreement is negotiated stating you would pay 100,000 for the house. If it was the latter situation (25% equity), 75,000 would go to pay down the mortgage lender and 25,000 of equity would go to the former owners. Now your financing may be something like 50% cash and 50% mortgage from your local bank. The bank lends you money because it knows if you do not pay than it can reclaim the house from you, that is the mortgage is collateralized.

      Most LBOs are like mortgages where the new owners put down 20% equity and borrow the last 80% from banks, or shadow banks (sophisticated debt investors) using the assets of the firm as collateral. After the mortgage is paid down, does not have to be all the way, you can sell it. The purchaser (PE firm) will make money in several ways: the equity appreciation (less debt in the capital structure), multiple expansion ( the next buyer will pay you more than you paid for the home.) That’s basically all there is to private equity. Just like a 68% of Americans have done when purchasing their home, Private equity firms use collateralized loans.

      Of course just like Americans found out, PE firms’ portfolio companies can still end up underwater trying to live the American dream.

      1st let me flesh out an idea about how the cycle of a portfolio company works. Ever see the movie Ronin. Well, Robert DeNiro’s character never walked into a place he couldn’t get out of. That’s exactly how PE firms think. From day one they are thinking about the exit. (plenty of good work here.) Basically, there are a few ways PE firms will end their involvement with one of their portfolio companies.

      * Merger with a public company, including a reverse merger where the public entity merges into the private entity
      * Acquisition, this can be from a conglomerate, a competitor, or to another PE firm
      * IPO, sell the shares to the public
      * private placement, where a few large institutions purchase the company or a portion of it

      So instead of this paragraph sounding ominous “… 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.” You can see that this is just one of the ways that a PE firm exits. It just so happens that each time it was to a financial buyer instead of a strategic purchase from a firm like Sealy or Tempurpedic.

      The article then speaks about dividend recapitalization. Here I can agree with the article’s thrust that this action is a very dangerous game to play. However, the General Partner of the PE firm, may be at a time where his investors are looking for a return. What this action does is bring money back immediately to the LPs (investors of the PE firm) but also gives them a call option should the firm continue to shed its debt with its operational cash flow. The new debt though has to be sold to someone and that entity or entities may require some agreements, or covenants, that restrict the flexibility of the firm. This is, as the article insinuates, akin to taking out a second mortgage. Plus, as in the case of Simmons, the company can become over-levered in an economic environment that is unfavorable thus tipping the portfolio company into bankruptcy. With no recourse to follow back up to the PE firm, this leaves a bad taste in the mouths of all the people mentioned in paragraph one.

      As always, the financial intermediaries will make money as long as transactions are going on. So of course investment banks made money as underwriters of debt and of IPOs. Articles like these love to point this out when the company fails but the i-banks also make money when these firms succeed as well.

      The rest of the article could be about any firm, any where in the current economic environment. The cheap debt era ended, consumers have cut back and employees who were looking for a lifetime commitment are in the best of cases receiving a severance on their way out the door.

      From the article, “because they pile debt onto the companies they buy, the firms free up their own cash, allowing them to make additional investments and increase their potential profits.”

      This is in so many ways wrong. The PE firms do not hold cash, they hold commitments from their limited partners (LPs/investors.) When they find a firm to purchase they hold a capital call and the LPs are supposed to provide the cash necessary to support the capital structure the GP (general partner) thinks is best suited for the targeted firm given its micro- and macro-economic environment. So never will a PE firm pony up 100% of the cash to buy a firm, just to then lard it down with debt, given the new acquisition its best shot but just playing the coin flip of heads I win, tails you lose. Intense projections, which are corroborated by the retained management, are devised. The capital structure is tested for revenue drops and unexpected shocks. The management is encouraged by the PE firm because they will also have a stake in the new capital structure along with the PE firm. So everyone works together to make the most amount of money for the equity holders of the new firm.

      As I stated above there are a few ways in which to make money in the PE process, the two already mentioned because they fell in with the house analogy are debt repayment and multiple expansion. The third however is the generation of cash flow. The PE firm’s staff are highly trained management, process innovators, former industry titans and financiers who know how to change a business model from one that may putter along into a well oiled machine. The business model has to be that way to ensure enough leeway to make bond coupon payments from the debt the company has taken on.

      Any cash taken out of the portfolio company is returned to the partners of the PE firm, either the General or the Limited Partners according to their agreement and how far along they are in the agreement. If this is the first cash generating investment it would more than likely all be going to the LPs. If it was the last 80% would go to the LPs and 20% to the GP. None of this money is used to make new investments.

      The remaining piece of the article tends to hone on the two points, the dividend recapitalization and the fall of Simmons market & thus the company. I would point out one more thing, the dividend recap was oversubscribed. The investors buying this “home equity loan” knew what it was being used for and thought with all the cheap debt and the solid business model that Simmons could handle it and be able to pay them back. Unfortunately they were wrong. The human interest portion of the article while touching and sad as Schumpterian creative destruction takes hold, shows how the executives were trying to save the company. Whereas the employee remarks there were no more Christmas parties, I say, well that means that the factory can make payroll for the next week instead.

      Did THL error, yes. Did employees suffer, yes. Is this what THL predicted or wanted as an outcome? No. That they may have gleaned their principal back is not what their LPs want. In fact when they raise their next fund the LPs will remember that in this investment they were returned their principal and not a return on the principal. The fact is at the end of the day the bondholders (including the ones who lent the “second mortgage,”) will try to make a new go of it. The only thing changing will be the owners of the company. I predict that consumers will still be enjoying Simmons mattresses years from now.

  16. Fresno dan

    Thank you for the clarification Yves Smith.
    But long story short, it just seems a lot of people buy a lot of financial instruments without really knowing what is going on.
    Now that my 401k is a 201k, the very premise of indiscriminate buying, (i.e., index fund) with the hope that the managers will account for profits honestly, disperse them equitably, and not skim from the cash register is kinda bizarre. Just like the bond buyers, the truth of the matter is that I have no ability to evaluate these people. Is it really rational to buy and hold an index fund?

    1. Siggy

      As a long serving investment practioner I can tell with certainty that buy and hold was never a valid strategy.

      I can also tell you with a certainty that the size of the portfolio being managed is a problem, get too big and you become the market.

      The minions of private equity are all singing from the same book. It’s a book with only a few pages, only a few strategies and a larger collection of tactics.

      Central to the strategy is the theme that every investment, every speculation has an objective return and term.

  17. VangelV

    I do not see the problem. If lenders are stupid enough to lend to companies that are bad credit risks why is it a societal problem? Why should reckless lending be protected when there are fraud laws that were not violated by the Buyout Firms?

  18. tompain

    Tough luck, bondholders. Maybe next time you will give more thought to financing a special dividend to a private equity buyer.

Comments are closed.