Private Equity? Where's the equity?

credit: African Safari Pictures

eq·ui·ty  (kw-t)

n. pl. eq·ui·ties

1. The state, quality, or ideal of being just, impartial, and fair.

2. Something that is just, impartial, and fair.

3. Law

a. Justice applied in circumstances covered by law yet influenced by principles of ethics and fairness.

b. A system of jurisprudence supplementing and serving to modify the rigor of common law.

c. An equitable right or claim.

d. Equity of redemption.

4. The residual value of a business or property beyond any mortgage thereon and liability therein.

5.

a. The market value of securities less any debt incurred.

b. Common stock and preferred stock.

6. Funds provided to a business by the sale of stock.

via freedictionary.com

Private equity funds inflict injury on the companies they acquire.

Why? Because private equity funds (launched by private equity firms) finance their buyouts with money borrowed from investors. Then, the purchased company must pay back that debt to investors, plus interest. So, a company finds itself unnecessarily burdened with debt that serves no purpose but to pay off vultures who acquired the company. The payoff to investors -- the borrowed money plus about 8% interest -- imposes drag on the growth of the company: the debt limits opportunity to invest in productivity improvements; to purchase new equipment; to offer healthcare and pensions to employees; to hire more employees. And all of that 8% interest expense -- plus a 2% "management fee" paid to the private equity firm -- is deducted from the company's tax liability, forcing taxpayers to subsidize the profits to investors.

By the above definition, there is no equity -- fairness -- for employees of companies that endure a private equity fund leveraged buyout. Instantly, the company finds itself at a disadvantage relative to its competitors. And if it was not in good shape to begin with, it must then sell off assets or fire employees to pay down its debt. This puts the company at further disadvantage; hurls it into a spiral of diminishing returns. Either way, whether the company was solvent and debt-free prior to the leverage buyout, or on the ropes, after the leveraged buyout, the company is at a disadvantage relative to its competitors due to the unproductive debt imposed on it -- debt that does nothing but pad bank accounts of investors. And taxpayers subsidize all of this bad karma when the company writes off the interest paid to investors.

But the vultures don't care. Through the magic of carried interest (also called, ironically, "performance fees"), private equity fund managers suck their pound of flesh out of the company -- about 20% of the gain in "value" realized by the company as a result of the buyout -- and move on to the next victim. (The value is increased because the vultures cut operating expenses [number of employees, investment in new equipment, etc.], crippling the company in the long-term, but increasing short-term profits.) The private equity fund managers walk away with millions in profit, and pay only 15% long-term capital-gains tax on those profits. The magic of carried interest. But it is not magic. It is more like voodoo. It turns the victims of private equity funds into zombies. Sometimes they recover, sometimes they don't.

Private equity fund managers will argue that their "investment" in the company, and subsequent takeover of its management, allows it to trim away the "fat" and "dead wood" and force the company to focus on its core competency. But most companies don't have all that much fat and dead wood. They do have capital assets and employees. Most are vital to productivity, of course. But these assets and employees are what the fund managers -- and new owners of the company -- will respectively sell off and lay off to repay their investors -- including 8% interest, plus the private equity fund management fee, another couple of percent. And once they've done that, once they meet the "hurdle rate" -- that 8% paid to investors -- they suck out their "performance" fee: usually 20% of the increase in "value" of the company -- remember, this short-term gain in value generally comes at the expense of long-term viability. All told, these buyouts usually yield about 28% return on investment to the private equity firm. That's a lot. In fact, it's astronomical.

The fund managers will tell you they earned that money through diligent application of their hard won expertise and superior intellects; that they must be compensated for their risk; that now the purchased company is "leaner and meaner." But lean and mean are not necessarily good. If the company lacks capital, it can't grow, it can't adapt -- leaner -- and it can't take very good care of its employees -- meaner. So the company contracts, struggles to survive wounds inflicted by the private equity fund attack, and may or may not return to sustainable profitability. But the employees of a leaner, meaner company, the ones that aren't fired, won't be working for the same people or the same company, and they will likely look elsewhere for better opportunities -- if they can find them.

No, don't buy the private equity fund snake oil. It is the worst kind of voodoo, and it only benefits the private equity fund and its investors, and it burdens taxpayers who pick up the tab for those interest expense write offs.

Here's one story (among many) of a colossal failure of a private equity fund buyout (failure for the victim, the fund and its investors got their money, of course). Give it a read, it will deflate the over-inflated rhetoric you've been hearing about the benefits sown by private equity funds:

Profits for Buyout Firms as Company Debt Soared

And then, visit the NY Times Topic: Private Equity
to find out whats going on right now, and see interviews with the self-serving purveyors of doom.

And don't confuse venture capitalists with vulture capitalists -- two very different animals.