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)
- The Key Question: PE can generate a return by cash extraction alone, and without improving the underlying business.
- 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:
- The PE firm puts up a relatively small amount of equity capital and uses a huge amount of debt.
- It extracts as much cash as quickly as possible, generating a return above their equity capital.
- The remaining company with its crushing debt burden is of little concern to the PE firm.
- 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.
- 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.
- One way of looking at this is that this is a transfer of wealth from private lenders to PE firm partners.
- 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:
- You have incredibly cheap debt across the market, as a result of perpetually low interest rates.
- 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.
- Why are there so many
suckersplayers 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.
- 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.
- 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:
- 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.
- You could say this is capital expertise put to morally bad means.
- 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:
- The cost of debt has been low for the past 15 years, and is only beginning to change this year (2023)
- A zero sum transfer of wealth from lenders to PE operators is the goal of this entire exercise
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:
- I don’t think so. And
- 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.