In this segment, Eileen Appelbaum and Rosemary Batt describe some of the ways that private equity firms make the companies they buy more vulnerable to bankruptcy, yet get away with it. One widely-used method is to take property owned by the company for its own operations, sell it, and require the company to lease it back. The reason that this is pernicious is that it increases what is called “operating leverage.” A company with high fixed costs has high operating leverage. This picture is even worse when you understand that companies that own their own real estate are typically ones like retailers or restaurants with a high degree of variability in their sales levels, either because they are seasonal or see big swings in revenues over an economic cycle. Owning their own real estate helps keep their expenses down and enables them to ride out bad times.
As Eileen Appelbaum explains below, not only is this sale/leaseback strategy (called “op co/propco” for “operating company/property company”) generally risky, but the way that private equity firms implement it often pure and simple asset stripping. The private equity firm sets the lease payments for the operating company at a high level. That means they can sell the real estate at a much higher price, to the detriment of the operating business.
Appelbaum and Batt also describe how private equity firms are big enough borrowing customers of bank that they are able to get the banks to agree to loan structures that put banks at a disadvantage in bankruptcy. That enables the private equity firms to restructure the company’s liabilities out of court. Normally that might seem to be a good thing, since bankruptcy is a costly and fraught process. But as Appelbaum and Batt describe in their book, these restructurings amount to a transfer from lenders to private equity investors. And that’s before you get to the fact that restructurings also provide the general partners more opportunities to charge fees. And by avoiding bankruptcy court, they also avoid the risk that they might have some of their pre-bankruptcy fees challenged as fraudulent conveyance.
By Andrew Dittmer, who recently finished his PhD in mathematics at Harvard and is currently continuing work on his thesis topic as well as teaching undergraduates. He also taught mathematics at a local elementary school. Andrew enjoys explaining the recent history of the financial sector to a popular audience
Andrew Dittmer: Could you talk a little bit about how some PE firms sell off company property and lease it back to the company (the opco/propco model: “operating company/property company” model)?
Eileen Appelbaum: The case of Red Lobster is so egregious I can barely stand it. This is how it happened.
Red Lobster is not performing all that well. It’s profitable, it still generates tremendous revenue, but Darden [Red Lobster’s parent company] now has younger restaurant companies that have faster growth potential, and it wants to concentrate on those. So it decides that it’s going to sell Red Lobster and the best deal it can get is with a private equity company called Golden Gate.
So it sells Red Lobster to Golden Gate for $2.1 billion. And on the morning of the exact same day that Red Lobster announces the sale to Golden Gate, Golden Gate announces that it has sold off the real estate of 500 Red Lobster restaurants for $1.5 billion to a real estate investment trust. What that means is that Golden Gate did this before they even had to borrow the money for the takeover, and as a result, they had to borrow much less. That means there is relatively little debt on the restaurants, but the flip side is that restaurants that were struggling to make a profit now have to pay rent on top of whatever costs they already have – cutting their net annual revenues about in half. They may or may not make it.
We saw this with Friendly’s. When Sun Capital bought Friendly’s, the workers actually welcomed Sun Capital. Sun Capital had said, “Yes we know that the menu is outmoded, and the restaurants need refurbishing. We are private equity; we are galloping to your rescue.”
But what they actually did is they sold off the real estate of the Friendly’s restaurants and then leased the restaurant properties back to the restaurants. At this point, the restaurants had to make rent payments and in short order the chain faced bankruptcy – many of the restaurants were closed, and many, many workers lost their jobs. This was one of the 363 bankruptcies we mentioned earlier, and as a result the pension obligations were thrown on to the PBGC and the costs are now borne by a quasi-public agency, and the workers will not get the full pensions that they were expecting.
The case of Sun Capital was especially egregious, but we’ve seen others. Mervyns is a major department store out on the west coast. It was the anchor of many malls and small towns. But Sun Capital used the opco/propco model, so the properties on which the stores stood were sold out from under them, forcing the stores to pay rent. When Mervyn’s went bankrupt, its unmet liabilities were less than the increase in their rent obligations. You can see from this how destructive the model can be.
When a publicly traded or a family-owned company engages in a sale/lease back arrangement, the company actually gets the benefit from the sale. You can imagine situations in which this would be a good idea. You might want to make investments in your business, and maybe the cheapest form of financing would be to sell the properties, take the bundle of cash to make the investment, and then pay rent to lease back the properties. What makes this different is that you, the company, get the money.
When Golden Gate engaged in the sale/lease back of the Red Lobster restaurants, the money went to Golden Gate. It may have used it merely to defray the cost and not take on debt. It may have used it to pay off other debts. It may have returned some of the money to its investors. It did whatever it wanted.
The important point is that it is likely that Red Lobster didn’t get much or perhaps any of the proceeds. Red Lobster didn’t get the benefit of the sale, but its restaurants are obligated to pay back the rent.
Andrew Dittmer: Another topic you discuss in your book is “amend and extend” deals, in which creditors agree to renegotiate the PE companies’ debt and typically provide them with more time in which to pay. You explain how PE typically structures companies’ debt so that they have smaller amounts of subordinated debt, and that makes creditors holding more senior debt frightened of taking a hit. So they are more willing to agree to new deals that are favorable to the PE firm.
Eileen Appelbaum: That’s right – the creditors know they are at risk.
Andrew Dittmer: In these cases, why aren’t the lenders able to press for a deal in which the equity also gets diluted so that the PE firm takes a hit and loses part of its ownership stake?
Eileen Appelbaum: I think, again, it’s the asymmetric power. I think that private equity says, “Ok, we’re on the verge of bankruptcy. You can take this deal we offer you, or you can throw yourself on the mercy of the bankruptcy courts.”
With the amend and extend agreements, banks and other creditors can act as if the asset will pay off in the end. They aren’t forced to mark it down as much. They take a haircut on the initial loan, but that’s it – they don’t have to say, “And by the way, the rest of this is probably not too stable either.”
Andrew Dittmer: Why do you think non-PE companies don’t pull off these amend and extend deals as frequently?
Eileen Appelbaum: For one thing, they don’t have as much debt. But I think a big piece of it is the relationship that the PE funds tend to have with banks. They go back to these banks every other day for more loans, and the banks can make a lot of fees from securitizing the loans used to finance the initial buyouts. A publicly traded company just doesn’t have that kind of relationship with banks and other top-tier lenders.