Strong at Capital, Bad at Everything Else - Commoncog

Two examples of operators who were strong on the capital side of the business expertise triad, but weak in just about everything else.


This is a companion discussion topic for the original entry at https://commoncog.com/strong-at-capital-bad-at-everything-else

The flip side of these two examples I would argue is Kodak.

Kodak entered into the 2000s with several very strong legacy businesses via which had absolutely zero prospects for growth but could still be relied upon to extract monopoly rents for potentially decades, leading to an incredibly strong cashflow balance sheet. In its arrogance as a public company, the CEO Antonio Pérez thought that this could be used to pivot Kodak into new relevance and, according to ChatGPT, torched a stunning amount of capital into a bunch of ill-fated projects:

  1. Digital Cameras: Recognizing the shift from film to digital photography, Kodak entered the digital camera market. They produced a range of digital cameras for consumers and professionals.
  2. Consumer Inkjet Printers: Kodak ventured into the consumer inkjet printer market, introducing a line of printers and ink cartridges. The company aimed to compete with established players in the printing industry.
  3. Online Photo Services: Kodak invested in online photo-sharing and printing services. They launched the Kodak EasyShare Gallery (later rebranded as Kodak Gallery), allowing users to store, share, and print their digital photos online.
  4. Health Imaging Solutions: Kodak expanded its presence in the healthcare industry by offering medical imaging and healthcare IT solutions. This included digital radiography systems and picture archiving and communication systems (PACS).
  5. Commercial Printing Solutions: Kodak developed and marketed digital printing solutions for commercial and industrial applications. This included digital printing presses, workflow software, and printing plates.

All of them were flops and the company entered Ch11 in 2012.

A “good” PE firm would have taken Kodak private in 2003 and slowly bled Kodak dry using all the conventional “vulture capital” techniques where there was just enough cash left in the business to operate but not any more than that to tempt the CEO into doing something dumb (to be clear, “dumb” in this context would include things like buying employees new office chairs vs forcing them to scavenge from leftover corpses or IT modernization away from a legacy system riddled with security flaws that have already leaked user data and for which ransomware was already paid, I don’t know how you convince a CEO not to do those things except literally not have enough room in the budget for them). Kodak would have been the ultimate hateable company in America by ruthlessly taking advantage of its customers, its employees, the US Government and its legacy but it also would have unlocked a vast tranche of capital that could have been redirected to more profitable purposes.

Even if you look at Kodak in 2023:

It’s still a place full of long time employees with “good culture” that “want to do right by their customers” and “has the old Kodak culture” which is all code for transforming a bunch of cash into goodwill that can definitely never be transformed back into cash vs the “enshitification” style framework Doctorow loves to tout so much but is the objectively correct answer to how to run Kodak in this scenario.

I’ve asked experienced investors over the years whether there has ever been a public company like Kodak that has gone on to do the “right” thing and I’ve never gotten a convincing positive answer. It seems like, structurally, US capital markets need PE firms to take over firms like Kodak and run a ticketmaster business model where they absorb all the blame in exchange for a Scrooge vault full of arbitrage gold and everyone inside is aware of this devil’s bargain.

I think before you can judge whether any PE firm is good or not, you need to know what their goals are and Payless and Toys’R’Us are also plausibly examples of PE firms recognizing another Kodak and correctly stepping in and performing their job function. We can never peek into the alternate universes so we will never know for sure.

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This is a somewhat odd analysis, given that PE firms are subject to a 3x minimum return bar over a 10-15 year period, and squeezing a company for cash flow — whilst perfectly rational for the reasons you’ve mentioned — is highly unlikely to generate IRR in excess of that return bar.

PE firms do not have a mandate to just return capital to their partners. They have a mandate to generate a return above the hurdle rate of an illiquidity premium. Harvesting a declining business for cash falls far below that hurdle rate.

If you want an example of a capital allocator CEO who did this for a publicly traded business in secular decline, I’d recommend looking into Bill Anders at General Dynamics, which happens to be Chapter 3 of The Outsiders. But your overall point still stands: such rational ‘wind the company down and return the capital to the markets’ is remarkably rare, though perhaps for obvious reasons.

I found your take intriguing & wanted to explore the parameters of the needle to be threaded by Kodak, or the capital allocators of a company in a comparable situation. For ease of discussion, I’ll call your proposed course of action as “controlled decline” (I think it’s a bit more neutral than “vulture capital”), and I’ll call what Kodak management actually did as “attempted pivot”.


My assumptions about the key elements of “controlled decline”:

  1. inelasticity of the revenue to the “controlled decline” playbook
    1a) Why I think it matters: Deep cost cuts (on the income statement) and returning unused cash to shareholders (on the balance sheet) are the key drivers to releasing a “Scrooge vault full of arbitrage gold”. I can definitely see how this helps increase the total amount of capital returned to shareholders, while reducing the relevant denominators to give you better ROA, ROE, and IRR. However, none of the benefits materialize if revenues decline faster than costs.
    1b) Why I think it’s hard to do: I imagine a great deal of operational expertise would be required to know which cuts are aimed at excess fat and which cuts might hit an artery. If you’re cutting staff who have been around for decades, I think it’s unlikely they’ll willingly provide you with the right information to know the difference.
    At the same time, if publicly listed, these actions will correlate with a drop in share prices. While I’m aware that in the (current) timeline, share prices dropped anyway, in the counterfactual timeline I suspect the overall drop in share prices will exceed the capital returned to shareholders.
    “I know our share price dropped by 10 dollars, but at least you got 7 dollars in dividends” is going to be a tough sell for investor relations, especially if you need to hold the course for many quarters.

  2. access to debt capital at a cost below the return on assets, for an industry visibly in decline
    2a) Why I think it matters: Actually, it matters a little less for management; I think the net amount of capital returned to shareholders would be about the same for an unlevered company. However, for any PE firm, as Cedric pointed out, there are strong expectations to deliver the kind of returns that can only be attained by funding the 60-80% of the purchase price with debt.
    As for the relationship between cost of debt and return on assets, any delta between the ROA and interest cost is additional profit to the PE firm; any time the ROA drops below the interest cost, financial leverage starts working against the owners.
    2b) Why I think it’s hard to do: Assuming that a zero sum transfer of wealth from lenders to PE operators isn’t the goal of this entire exercise, you would have a relatively accelerated repayment profile, to match diminishing revenues. I don’t know what kind of covenants are typical for these arrangements, but some very precise forecasting is going to be needed to ensure debt service ratios and debt to book value ratios don’t tie your hands too much. Plus, the entire enterprise becomes vastly more fragile as the debt load grows as a proportion of balance sheet.

  3. (in the instance of a PE firm stepping in) a cooperative shareholder base which is willing to accept a fair offer, instead of anchoring on the substantially higher prices that they paid in the past
    3a) Why I think it matters: Change of control is a necessary condition in the PE driven scenario.
    3b) Why I think it’s hard to do: The board, management, and shareholders have spent many years, if not decades, of thinking of their stock as a blue chip. While it’s clear that a storm is coming over the horizon, the board and management are telling the shareholders (and themselves) the “attempted pivot” narrative. To take some liberties on my end, if they engage an impartial third party such as a top tier consulting firm for advice, they’re also likely to hear about how they can transform their company, disrupt & reinvent themselves, use their cash cow to invest in more promising adjacent segments, etc.
    In our present time (their future), we happen to know that these efforts represent tossing “a stunning amount of capital into ill-fated projects”, but in that moment the shareholders and management only see the flop, and the turn & river are yet to come.
    Enter “good” PE firm, who has crunched the numbers and secured financing at a decent rate. They make a fair offer, at a slight premium to current market cap while still leaving some gains on the table for themselves. This fair offer, though, is a huge discount from the entry price for nearly all shareholders. Will they take it?


In the case of management willing to make the hard choices, they will have to hurdle the first element and simultaneously placate investors; in the case of a PE firm, they might have an easier time with the first element but a harder time with the second and third.

It’s possible that these elements were present in the Payless and Toys’R’Us scenarios, too; I’m not intimately familiar with the details.

All things considered though, it seems to me that the “controlled decline” playbook seems to rely on just as much optimism and guesswork as the choice to throw money at adjacent lines of business with some unknown chance of redemption.
The key difference is that in the controlled decline scenario, you experience a huge gush of cash upfront (offset, if not exceeded, by declines in market cap), and the uncertainty is around how long before revenue shrinks to nothing; in the attempted pivot scenario, you burn a huge amount of cash upfront, with (hopefully) positive expected returns, and the uncertainty is presumably mitigated to the extent that you possess Operations and Market expertise.

With these two uncertain options at hand, it’s unclear to me that framing controlled decline as “doing the right thing” is completely justified.

I’d like to know if you think I’ve missed any key elements that are salient to analyzing such scenarios, or if the three I’ve proposed are flawed in some way!

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What evidence do we have that these PE firms were even strong at capital? It sounds like they were bad at everything.

And even if you look at capital allocation as a skill, allocating the profits to rewarding the PE firms while driving the companies bankrupt doesn’t feel like a good capital allocator, unless we define that as one that primarily uses capital to enrich oneself, rather than using capital to create more capital flows, as the rest of the Capital series seemed to indicate. It’s not even clear they had special access to capital to fund their acquisitions, as it was primarily funded by debt.

Just curious about the article title, and what you’re seeing that I’m not.

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I burst out laughing at this!

I was mostly talking about the deal-making and the capital raising aspect of Capital Expertise, not the capital allocation aspect. These PE firms could negotiate the deal, recap the company, figure out a mixture of debt that (in the case of Payless’s first transaction — seemed perfectly reasonable) and set it on a path for recovery … and then botched up said recovery. The Toys “R” Us story seems less defensible, I agree.

I will say that I can’t do any of these things, even if you held a gun to my head.

You know, I was thinking about your response today, and I realise that ‘controlled decline’ can really only be done in the context of a long term holding structure. Or, to invert that:

  1. Using too much/too expensive debt makes controlled decline more tricky.
  2. Controlled decline within a < 10 year period is even more unlikely.
  3. Controlled decline with debt and a < 10 year period and attempting to clear a PE hurdle rate is nigh on impossible.

But using debt in the context of a holding company actually makes it possible, because you no longer have the time limit. I’m also assuming that such a holding structure would be ok with a lower than PE rate of return, but this is certainly no recipe for passing Buffett’s test.

The other thing I was thinking about was just how damn hard it is to be in retail. No wonder Buffett seems to be biased against it!

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I can’t do these things either but I guess I understood “Strong at Capital” to be strong at the skill relative to other capital allocators, not compared to the general business population. The comparison population matters - a terrible NBA player is still among the top 500 basketball players in the world. But I get what you mean now - they had enough of the skill of capital to make the deals, which you and I couldn’t. Thanks!

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If I’m not misremembering, this isn’t quite the example you’re intending to make. Kodak invented digital cameras, back in the 70s. But they got worried that digital photography would eat into the extremely profitable film and chemical business, and self-sabotaged. By the time they realized that digital would kill film for all but niche markets, competitors had already cornered the market. This reads like a rhyme for Bell Labs and Xerox PARC. Eventually, they sold their digital sensor business to a PE firm and after Ch11 bankruptcy, shifted to leveraging their chemical operations.

Similarly, EasyShare was launched in 2001, 3 years before Flickr was founded.

And the medical imaging operations isnt as farfetched or a brand extension: Konica Minolta (RIP) and Leica were/are both lens/sensor companies that get a lot of mileage from healthcare technology. Similar to how Phillips and GE have very robust healthcare operations, or how Rolls Royce makes jet engines. These moves make a lot of sense because enterprise sales have a lot more price insensitivity and maintenance or use-based contracts (thinking of the case study on Invisalign now). Those areas of the business end up being the workhorses that subsidize the more well known consumer brands. (Speaking from personal experience in healthcare, seeing a lot of DTC competitors expand into insurance and B2B contracts because they cant make the DTC unit economics work out, without publicizing it too much as a brand).

I’d argue that Kodak was repeatedly both ahead of its time and self-sabatoging when it came to making the “demand” side of the house work.

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tldr: PE is only good at capital/financial engineering, and almost never in operations.

PE relies on levering up companies with as much debt as possible & taking cash out of the company via fees & dividends i.e. recapitalization. If they take on too much leverage, the PE firm can simply walk away.

There is no evidence that PE improves operations. Private Equity Operational Improvements – Measuring Value Creation in LBOs

PE, as an asset class, is a levered small cap strategy without the daily liquidity.
Its Sharpe Ratio looks great because of volatility smoothing / volatility masking /volatility laundering via its mark-to-model tricks. RE, VC, and other illiquid asset classes have the same performance measurement issues.
I would contend that is a feature not a bug to GPs & LPs/capital allocators because capital allocators get to sleep better, report a higher Sharpe to their own beneficiaries, and get paid better, so a win-win-lose for GP-LP-beneficaries respectively. See: The volatility laundering, return manipulation and ‘phoney happiness’ of private equity

Other good reads on PE

  1. Private Equity: Overvalued and Overrated?

  2. Private Equity: Still Overrated and Overvalued?

  3. Private equity’s mark-to-make-believe problem

  4. Why Does Private Equity Get to Play Make-Believe With Prices?

Re: Kodak, what a ‘good PE firm’ could have done:

  1. After acquisition, immediately sell multiple biz units to…
  2. Pay yourself large dividends to extract cash & pay down debt †
  3. Sell non-core assets such as real estate and lease it back from new owners, or use the property to spin-off into a REIT (many hotel cos. Have done this because of activist HFs) †
  4. Cut jobs, and costs to the bone & only do enough to keep the lights on & service existing customers
  5. Sell the smaller co. to another PE firm if interest rates have not gone up, or EBITDA has improved because of prior cost cutting.

† these moves boost IRR, so extracting cash early is important for PE.

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The nature of PE transactions is that they are highly leveraged with very small amounts of PE cash inputted relative to deal sizer so a 3X return is actually less difficult than it seems from the outset.

One way to think about it is that PE buys a box full of future cashflows for a present day price and then, similar to a CDO, tranches those cashflows out and sells senior claims to banks by “loading the company with debt” and retains the “junk bond” style assets for themselves. This allows for high risk/high reward plays from very little capital.

The nature of working in a declining industry is that all of your customers are well known and their walkaway reasons are overwhelmingly secular which means you know to a much greater degree of specificity the exact minimum requirements to keep a customer.

Share prices have already priced in expectations of future decline. In an efficient market, they only move due to genuinely novel decisions/occurrences.

I think viewing these as conventional debts (where the goal is to repay the debt) is a mistake. I think more accurate to view them as perpetual debts, where you transform a stock of cash into a flow of cash stream for an indeterminate period of time until the company is forced into Ch11.

This is why the golden age of PE was in the 80s when hostile takeovers were more easily a thing.

Yes, every option has risk involved and skill required to best manage that risk. I’m not saying this is some magic money machine that is just sitting out in the open.

I think maybe what you’re missing is just how durable some of these legacy cashflows are. We can look at Kodak, 20 years from when they should have “given up” and 10 years after they actually gave up (and filed for Ch11) and look at just how many customers they still have and why. Decades after Hollywood completed the “shift to digital”, Nolan and Tarantino are still shooting on film. Oppenheimer and Killers of the Flower Moon were both major motion pictures put out this year shot on Kodak film. Kodak is still a public company (300M market cap) so the monopoly margins they’re earning on projects like these are still being spent in public company ways and not private company ways.

One way to test this is look at the fates of the principals involved after the incident. Were they drummed out of the industry in humiliation after such a devastating failure or have they continued to have successful careers in the industry? I’m not familiar with the principals involved

This wasn’t my example, this was straight from ChatGPT (potential hallucinations and all). I remember following all the ill fated examples Kodak was trying to do at the time to try and remain a relevant company but have lost all the concrete specific memories so I’ll defer to anyone who has a more detailed recollection but the overall mood was one of doomed arrogance.

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What evidence do we have that these PE firms were even strong at capital? It sounds like they were bad at everything.

I had the same question as @eric. It seems like the skill of capital needs to be a lot more than just getting access to capital to be meaningful. Present-day Elon Musk has a ton of access to capital, while young John Malone had very little capital to access; I have no hesitation in saying which one is a better allocator of capital.

The example I would like to see is someone (maybe a PE firm) who comes up with a creative way to make the financing work for a deal, and structures the deal in a way that the company is not leveraged to the point of fragility, and has a good strategic direction, but fails to execute on the strategy and thus gets out-competed.

For instance, the Payless story would have been a lot more convincing if the new ownership structure resulted in a significant increase in capital expenditure on technology, but they failed to manage the implementation of their new e.g. ecommerce system.

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I have an on-topic response that I’ll write in a bit, but I’ve added a staff notice to your original post.

I’d like discussions in this forum to be educational, informed, and biased towards usefulness + action. Using ChatGPT to make up an example in support of a point goes against this spirit. If you want to make an argument, do the work to back it up.

I’m making this a public call out to set the tone for the rest of the forum.

Consider this an unofficial warning. (Unofficial here means no consequences, so don’t worry about it, just don’t do it again).

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This is going to be a long reply, but I think it’s going to be worth it. At some point I’m going to extract this and turn it into a synthesis piece for the Capital Expertise concept sequence.

A few notes:

  • This is not going to be structured as a reply, partly because the original comment that inspired it is just so fundamentally unserious that it’s not worth taking on.
  • It turns out that there is higher-level Capital Expertise present in both the Payless and Toys ‘R’ Us cases, I just couldn’t see it.
  • This form of Capital Expertise is going to be interesting to discuss, because I think many in this forum will feel that it is morally wrong.
  • This piece is long because I’m going to have to catch you up on the current state of play in private equity, something that I wasn’t aware of when publishing the Payless and Toys ‘R’ Us cases. I actually do think this is important to grok if you live in the US — over the past 15 years, private equity has grown to own more businesses than all those listed on the US stock exchanges combined (source). KKR’s portco companies employ > 800,000 people; Carlyle’s employ 650,000, Blackstone employs ~500,000 (source). If for illustration you treat these portcos each as a single entity, these would be the third, fourth and fifth largest employers in America, behind Walmart and Amazon.
    • (Of course, these portfolio companies have nothing to do with each other, but the aggregate numbers represent the number of livelihoods impacted by a single business model. This is why this matters.)
    • Unlike a throwaway assertion in this thread, the golden era of PE lies not in the past; the current numbers make the takeover industry of the 80s look like a cottage industry. This is a little surprising, perhaps, because it doesn’t get as much press, but it is worrying for reasons we’ll get into in a bit.

One last note: I was helped in this analysis by @johannoh and @Drayton — I’ve asked them to post corrections if they find any after I post this reply. Both have Capital Expertise; I assure you that they don’t back up their arguments with ChatGPT. Any mistakes in this reply are mine alone.


Bottom Line Up Front (BLUF)

  1. The Key Question: PE can generate a return by cash extraction alone, and without improving the underlying business.
  2. The Mechanism: We can’t just wave our hands around and say this is the case, we need to provide a mechanism. Details matter. The mechanism is as follows:
    1. The PE firm puts up a relatively small amount of equity capital and uses a huge amount of debt.
    2. It extracts as much cash as quickly as possible, generating a return above their equity capital.
    3. The remaining company with its crushing debt burden is of little concern to the PE firm.
    4. Of course, the PE firm is incentivised to make a bigger return by improving the business. But the key thing to understand here is that they do not care if they fail — so long as they’ve already extracted some multiple of the equity capital they put up. In this manner, each company in a PE fund may be considered a call option. Heads they win big, tails they hit their minimum return target anyway.
    5. The people who lose are a) the lenders who provided that debt, and b) the employees, suppliers, and other stakeholders of the company. There is a societal cost involved with having so many employers in an economy suddenly becoming more fragile.
    6. One way of looking at this is that this is a transfer of wealth from private lenders to PE firm partners.
  3. The Rise of Private Credit: It’s important to note that this was not the case in the past. If your cost of debt is above the return on assets, you can’t easily make out like a bandit. But the cost of debt has been unreasonably cheap for the past 15 years. So:
    1. You have incredibly cheap debt across the market, as a result of perpetually low interest rates.
    2. And you have the rise of private credit, powered by a shadow banking system that emerged in response to strict banking regulations that were introduced in the wake of the 2007 financial crisis. As banks removed themselves from lending, new unregulated institutions sprung up in response. As of last year, the private credit market was $1.4-1.5 trillion, meaning that over a 15 year period it has caught up and is now equivalent in size with the high yield bond market. PE firms today prefer to fund their transactions with private credit, not high yield bonds.
    3. Why are there so many suckers players in private credit? The glib answer is: well, this is what the credit cycle looks like. One implication here is that lenders in the private credit market are really the ones holding the bag when this current boom goes south. So far this has not happened yet, and in fact private credit is still expanding. But famous credit investors Oaktree seem to be salivating for the correction.
  4. Is this capital expertise? Yes, I believe so! It may not be good for society or for the world (a private credit blowup might be bad?), but the PE firms, their principals and their limited partners have exploited this current system to their advantage — and they’re basically in a no-lose proposition … at least so far. Their expertise here is their ability to do financial shenanigans with the acquired company in order to hit their required return profiles.
    1. I couldn’t see it because I didn’t have the capital expertise necessary. Whilst Johann used to work at a fixed income desk, he dealt only in investment grade debt. Drayton provided us with most of the details. For instance:
    2. The PE firms also have plenty of options when the debt comes due:
      • They can renegotiate the terms to extend credit until rates are down again, IPO market reopens, good times are back etc. To sweeten the deal, they can make up the lower rate/longer maturity terms by giving lenders an equity kicker/warrants, or promise a greater payment at the end (‘balloon payment’) to make the math work
      • If they want to close out a fund, they can sell their bad deals to PE firms that specialise in ‘secondaries’ (meaning they buy washed up companies from other PE firms), using ‘mark-to-model’ valuations to keep the game going. Secondaries are 16% of the PE market.
      • Or they can even transfer the company to their next PE fund, again using ‘mark-to-model’ valuations to keep the game going.
    3. You could say this is capital expertise put to morally bad means.
  5. Is this ‘good for capitalism in general’? When you don’t know the precise mechanism you can wave your hands and say “yes so good for capitalism, hurrah PE, reallocate capital from dying companies to put elsewhere”, but then you’re leaving a lot of private lenders in the lurch. This may blow up in your face (debt crises tend to not be very good, ahem). Whether this is a net good for capitalism is left as an exercise for the alert reader.

More details and sources below. Sections match the numbers in the BLUF above.


1) The Key Question

There’s a key question that’s underpins this thread:

  • Can PE firms generate a return above their hurdle rate by cash extraction alone, and without improving the underlying business?

I was clearly wrong. They can. I thought that PE firms really only made money when the acquired company succeeds because:

  • I bought the industry’s marketing narrative of “PE management takes over companies for the short term and through focus, expertise, and board discipline, improves operations, eventually selling it off and pocketing the profits.”
  • To be fair, this narrative is sometimes real (see: J. Crew’s first PE deal, which brought in industry legend Mickey Drexler, and was a home run)
  • On the flip side, the single most famous PE deal — RJR Nabisco — written up in the bestseller Barbarians at the Gate, was a loss for KKR. KKR invested 3.5 billion of equity capital, along with $25 billion in debt, and exited RJR Nabisco 15 years later at a loss of $730 million. (Source)
    • If PE firms could generate a return above their hurdle rate by cash extraction alone, why didn’t KKR succeed with RJR Nabisco — the most prominent deal of the 80s PE boom?
    • The answer: that was a different time, and their cost of debt was substantial.

Johann’s response also provides a first principles explanation of why this seems unlikely:

And he made one big assumpton:

Of course, as @Drayton soon corrected us:

  1. The cost of debt has been low for the past 15 years, and is only beginning to change this year (2023)
  2. A zero sum transfer of wealth from lenders to PE operators is the goal of this entire exercise :sweat_smile:

2) The Mechanism

I highly recommend this link that Drayton provided above: Private Equity Operational Improvements – Measuring Value Creation in LBOs.

The entire argument is excellent, but to just quote two bits:

In the year the transaction is completed, both metrics drop sharply, creating a V shape in both charts. We hypothesize that major LBO transactions are distracting to management and lead to suboptimal outcomes from a sales and margin perspective during the deal year.

Once the deal has been completed, growth and margins recover, but do not on average return to pre-deal levels. In the three years after the deal, revenue growth is on average 1.1% above industry standard, 60bps lower than pre-acquisition. EBITDA margin averages out to exactly the industry standard, 50bps lower than pre-acquisition. While PE firms are typically praised for their efficiency and cost-control, the graph on EBITDA margins shows a negligible difference in actual profitability. The supposed efficiency and cost-cutting isn’t showing up in the numbers.

The industry mythology of savvy and efficient operators streamlining operations and directing strategy to increase growth just isn’t supported by data. Instead, there is a new paradigm to understand the PE model, and it’s very, very simple.

By and large, as an industry, PE firms take control of businesses to increase debt. As a result, or in tandem, the growth of the business and the rate of spending on capex slows. That’s a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management.

There’s also the following bit:

I cited Plunder: Private Equity’s Plan to Pillage America as a source in both the Payless and Toys ‘R’ Us cases. In fact this playbook is 100% covered in the book, though the author picks the most heart-wrenching story possible to illustrate this:

Carlyle’s a large private equity firm. It bought HCR ManorCare, which was once the second-largest nursing home chain in America and then executed a number of tactics that are pretty playbook in private equity land. They executed a sale-leaseback, which means they sold the underlying assets of the nursing home chain and had the chain lease it back for a quick hit of money, but now they’ve got a long-term obligation. They executed what’s called a dividend recapitalization, so ManorCare had to borrow money to pay Carlyle and the other investors a profit. Ultimately, staff needed to be laid off, complaints and health code violations spiked. Unsurprisingly, a resident of one of these facilities dies. Without sufficient staff, she has to go to the bathroom by herself. As alleged, she slips, hits her head, and ultimately dies. But when her family sues for wrongful death, Carlyle gets the case against it dismissed.

PE defenders might say that such cases are rare, but the overarching point is not rare: PE owned companies that are treated in this manner are more fragile. You have optionality and resilience if you actually own your own real estate (you may sell it later, or you may borrow against it, etc). But resilience isn’t the point, is it?

3) The Rise of Private Credit

This has been a huge story for a few years now. Drayton and I are financial history nerds; we were talking about how the 80s takeover boom was driven by the rise of high yield bonds (aka junk bonds). In that particular case, there were a lot of conglomerates that could be taken over, and then sold for parts — thus creating instant profits (since conglomerates tend to be valued at lower than the sum of its parts, so selling off each part one by one usually nets you a windfall).

But our current PE boom is powered by private credit, not junk bonds. The rise has been an uncanny parallel.

The following Odd Lots podcast is an excellent primer: Why Private Credit’s Been Booming Even as Interest Rates Go Up.

And I found the Oaktree podcast I linked to above quite revealing (all emphasis mine):

Armen Panossian: Yeah, in private credit, it’s been a huge growth industry for the last 10, 15 years. A lot of private credit managers that are large today didn’t exist before the Global Financial Crisis. They have grown with the growth of the private equity universe and an expansion of their lending practices and capabilities and assets under management have helped fuel private equity returns as well. Now, I think private equity will experience more of a challenge in the next few years than private credit will, but I think private credit transactions that were highly levered may have some problems in old vintages because when base rates were at 25 basis points and the spreads were at 550, that cost of that leverage was 6 to 7%. Today, that same loan, even without a refinancing, is now costing the borrower 11%.

And so, what is going to happen with that company? Can it make its principal and interest payments when it comes due? If it cannot, where will the incremental capital come in to de-lever the business? There is risk in the rearview mirror in private credit, but with that risk creates opportunity out the front window, which for fresh capital, for experienced investors having invested through cycles, there will be some great buys. There are some great buys even now, but I think it’s going to accelerate in terms of private capital being deployed into a dislocated environment where there are banks and other private credit funds that were probably a little too long in their pro-cyclical lending and investment behavior. And now that’s going to need to be retracted a bit.

Howard Marks: I think the point is the tide has never gone out on private lending. It’s never been tested. Credit analysis may seem like a pedestrian activity, but the truth is there is such a thing as superior credit analysis, average credit analysis, inferior credit analysis. And the people who did inferior credit analysis in the last 15 years and maybe who scooped up too many assets to invest in, in the interest of asset growth, we’ll find out who they were, I think, and maybe the list will be winnowed.

I’m not 100% sure what Panossian is talking about when he says “Now, I think private equity will experience more of a challenge in the next few years than private credit will” — but perhaps someone with more capital expertise than I have can chime in.

The key thing is that lending discipline in this market is questionable. It’s easy to make money when you can borrow lots of it.

4) Is This Capital Expertise?

Yes. At least I think so. Drayton put it to me like this:

PE is a high leverage small-cap/mid-cap portfolio strategy, where the downside risk is masked by mark-to-model accounting, & negative returns on individual investments do not trigger a margin call on the rest of the portfolio (individual investments are siloed)

The bit about the ‘mark-to-model’ accounting is important to expand upon. Unlike investors in the public markets, private equity (and VC, and real estate), can make up the valuations of the assets that they own. (To make this more polite they call this ‘mark-to-model’, which means they come up with some valuation model and then say that their companies are valued at whatever the model says.) Contrast that with public investors, who are ‘marked-to-market’.

This is valuable if you run a pension fund or a university endowment. Over the past 30 years, pension funds and endowments alike have increasingly run their portfolios according to something called the ‘Yale model’ — that is, a large chunk of their portfolios in ‘alternative’ investments like VC, PE, hedge funds, and so on. The idea is that these investments would hopefully be uncorrelated to returns in the public equity and bond markets.

But the nice thing with these alts is that they don’t have to update the valuations of their portfolios that often, which means the ‘returns’ look smoother, or at least less volatile. You could say that PE and VC has benefited from this tailwind over the past 15 years, in addition to cheap credit.

So, you need expertise to:

  • Recognise and then take advantage of this structure in the market
  • Do financial shenanigans on your acquired companies, so that, again, you make you and your partners are no-lose rich
  • Ensure that even if a certain % of your portfolio dies, you still get to hit your minimum return

Or, as federal prosecutor Brendan Ballou, author of Plunder puts it:

the basic issue is if you look at the biographies of the people that run private equity firms — and this is no slight against them — generally, they’re not folks with experience in engineering, product development, sales or marketing, logistics, or anything like that. They have experience in finance, and so the expertise that they bring to an acquisition is financial expertise. Just as to the extent that I would bring expertise to something, it would be legal expertise. You wouldn’t want me running the company. The challenge that we’ve got is, oftentimes, when private equity firms think that they do have operational experience, it sort of blows up in their face.

The thing that strikes me about all of this is just how much this is no-lose for the PE folks.

  • If the company dies, it doesn’t matter to them, they’ve already gotten their return
  • There isn’t that much of a reputation loss with their lenders, because the credit market is caveat emptor.
  • There are many levers to pull to kick the can down the road for bad deal
  • They do have upside if the company really does get better (PE firm partners get 20% of the returns) — but this is not 100% alignment because, again, they don’t mind if they fail.

You can say that this is morally repugnant, and I would agree with you. But I also think it’s useful to separate recognition of expertise from moral judgment — people can also do morally bad things on the Operations and Market side of the triad.

Meta Note on Expertise

As an aside, I thought this entire episode was a pretty good illustration of expertise. I come from the Operations and Market side of the triad; I have little Capital Expertise.

Johann worked at a fixed income desk circa 2016. His mandate was investment grade bonds; he wasn’t allowed to touch junk. As a result he didn’t understand what was going on in the current PE meta. Drayton worked in finance across trading, corporate development at a mining company, fintech underwriting, and now runs a hedge fund. He was more in tune with the shenanigans you can get up to with PE. But when discussing these things, Johann understood what Drayton was saying faster than I did, at a level of granularity that I didn’t, and faster also — by the way — than someone aping Matt Levine but with no actual experience of dealing with capital structures.

I think I won’t do so badly if you talked to me about capital structure on the equity side of things. I’ve negotiated a few things on that end, so at least I have my hands dirty there. But I have never dealt with the debt side of things and it shows!

Concrete example: both Drayton and Johann commented on how vastly I underestimate the impact leverage can have on returns. Drayton sent me this screenshot, (from this remarkable textbook by Stowell)

5) Is This Good for Capitalism?

I’ll leave this to you to decide. My take is:

  1. I don’t think so. And
  2. It’s funny how much details matter, yes?

I know there are a few PE folk from top-tier firms here, and I welcome any corrections. If you don’t want your comments to be tied directly to your name (or your firm) — feel free to message me and I’ll post your comments anonymously.

Special thanks again to @johannoh and @Drayton; again, feel free to chime in if I’ve made any mistakes. I thank all of you for being my continued business education vehicle.

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Wow, thanks so much for this deep dive. Helpful for me to see the capital expertise I was missing in my earlier flippant comment. I do think the Marks quote is relevant - the shenanigans of making these deals in ZIRP land are a skill, and they can extract profits by doing these deals, but the people who had no other skills of evaluation of good business opportunities and operations are going to be destroyed in the coming years. Insert Warren Buffett quote about the tide going out.

To make an analogy to personal finance, anybody that took an adjustable rate mortgage in recent years with the assumption they can always refinance when it comes due is likely to lose their house. In the short term, it may have looked like capital expertise to save on their monthly payments, but it was picking up pennies in front of a steamroller, to use the common expression. I wonder how many recent PE deals will look similarly disastrous when the debt comes due.

Actually this makes me question again whether to call this expertise. It feels like somebody can learn this skill by copying the structure of other deals, but without true expertise, they will not understand how to adapt to a changing environment. It feels like what Shane Parrish calls “chauffeur knowledge” Two Types of Knowledge: The Max Planck/Chauffeur Test where somebody can mimic the output but not actually understand what they’re talking about. Does doing these deals constitute expertise, or is it just copying what others have done?

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Great synthesis. I think the phrase ‘transfer of wealth from private lenders to PE firm partners.’ might be too loaded/strong; it’s better to say that, generally, PE firms are arbitraging the difference between cost of debt and cost of equity.

Franco Modigliani & Merton Miller of Modigliani–Miller theorem fame, had decent upper middle-class success as tenured finance academics (Miller even shared the “Nobel in Economics”).
However, each of the partners of LTCM all walked away with 9-figure fortunes. John Meriwether actually went on to start 2 more hedge funds.
What lessons to take from this is left as an exercise for the alert reader.

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