Private equity managers won the financial crisis. A decade since the world economy almost came apart, big banks are more heavily regulated and scrutinized. Hedge funds, which live on the volatility central banks have worked so hard to quash, have mostly lost their flair. But the firms once known as leveraged buyout shops are thriving. Almost everything that’s happened since 2008 has tilted in their favor.

Low interest rates to finance deals? Check. A friendly political climate? Check. A long line of clients? Check.

The PE industry, which runs funds that can invest outside public markets, has trillions of dollars in assets under management. In a world where bonds are paying next to nothing—and some have negative yields—many big investors are desperate for the higher returns PE managers seem to be able to squeeze from the markets.

In the best cases, PE managers can nurture failing or underperforming companies and set them up for faster growth, creating outsize returns for investors that include pension funds and universities. But having once operated on the comfortable margins of Wall Street, private equity is now facing tougher questions from politicians, regulators, and activists. One of PE’s superpowers is that it’s hard for outsiders to see and understand the industry, so we set out to shed light on some of the ways it’s changing finance and the economy itself. —Jason Kelly

The Magic Formula Is Leverage … and Fees

PE invests in a range of different assets, but the core of the business is the leveraged buyout

The basic idea is a little like house flipping: Take over a company that’s relatively cheap and spruce it up to make it more attractive to other buyers so you can sell it at a profit in a few years. The target might be a struggling public company or a small private business that can be combined—or “rolled up”—with others in the same industry.

1. A few things make PE different from other kinds of investing. First is the leverage. Acquisitions are typically financed with a lot of debt that ends up being owed by the acquired company. That means the PE firm and its investors can put in a comparatively small amount of cash, magnifying gains if they sell at a profit.

2. Second, it’s a hands-on investment. PE firms overhaul how a business is managed. Over the years, firms say they’ve shifted from brute-force cost-cutting and layoffs to McKinsey-style operational consulting and reorganization, with the aim of leaving companies better off than they found them. “When you grow businesses, you typically need more people,” said Blackstone Group Inc.’s Stephen Schwarzman at the Bloomberg Global Business Forum in September. Still, the business model has put PE at the forefront of the financialization of the economy—any business it touches is under pressure to realize value for far-flung investors. Quickly.

3. Finally, the fees are huge. Conventional money managers are lucky if they can get investors to pay them 1% of their assets a year. The traditional PE structure is “2 and 20”—a 2% annual fee, plus 20% of profits above a certain level. The 20 part, known as carried interest, is especially lucrative because it gets favorable tax treatment. —J.K.

The Returns Are Spectacular. But There Are Catches

For investors the draw of private equity is simple: Over the 25 years ended in March, PE funds returned more than 13% annualized, compared with about 9% for an equivalent investment in the S&P 500, according to an index created by investment firm Cambridge Associates LLC. Private equity fans say the funds can find value you can’t get in public markets, in part because private managers have more leeway to overhaul undervalued companies. “You cannot make transformational changes in a public company today,” said Neuberger Berman Group LLC managing director Tony Tutrone in a recent interview on Bloomberg TV. Big institutional investors such as pensions and university endowments also see a diversification benefit: PE funds don’t move in lockstep with broader markets.

But some say investors need to be more skeptical. “We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest,” said billionaire investor Warren Buffett at Berkshire Hathaway Inc.’s annual meeting earlier this year. There are three main concerns.

• The value of private investments is hard to measure

Because private company shares aren’t being constantly bought and sold, you can’t look up their price by typing in a stock ticker. So private funds have some flexibility in valuing their holdings. Andrea Auerbach, Cambridge’s head of global private investments, says a measure that PE firms often use to assess a company’s performance—earnings before interest, taxes, depreciation, and amortization, or Ebitda—is often overstated using various adjustments. “It’s not an honest number anymore,” she says. Ultimately, though, there’s a limit to how much these valuations can inflate a PE fund’s returns. When the fund sells the investment, its true value is exactly whatever buyers are willing to pay.

Another concern is that the lack of trading in private investments may mask a fund’s volatility, giving the appearance of smoother returns over time and the illusion that illiquid assets are less risky, according to a 2019 report by asset manager AQR Capital Management, which runs funds that compete with private equity.

• Returns can be gamed

Private equity funds don’t immediately take all the money their clients have committed. Instead, they wait until they find an attractive investment. The internal rate of return is calculated from the time the investor money comes in. The shorter the period the investor capital is put to work, the higher the annualized rate of return. That opens up a chance to juice the figures. Funds can borrow money to make the initial investment and ask for the clients’ money a bit later, making it look as if they produced profits at a faster rate. “Over the last several years, more private equity funds have pursued this as a way to ensure their returns keep up with the Joneses,” Auerbach says. The American Investment Council, the trade group for PE, says short-term borrowing allows fund managers to react quickly to opportunities and sophisticated investors to use a variety of measures besides internal rate of return to evaluate PE performance.

• The best returns might be in the rearview mirror

Two decades ago an investor could pick a private equity fund at random and have a better than 75% chance of beating the stock market, according to a report by financial data company PitchBook. Since 2006 those odds have dropped to worse than a coin flip. “Not only are fewer managers beating the market but their level of outperformance has shrunk, too,” the report says.

One likely reason will be familiar to investors in mutual funds and hedge funds. When strategies succeed, more people pile in—and it gets harder and harder to find the kinds of bargains that fueled the early gains. There are now 8,000-plus PE-backed companies, almost double the number of their publicly listed counterparts. The PE playbook informs activist hedge funds and has been mimicked by pensions and sovereign funds. Some of PE’s secret sauce has been shared liberally in business school seminars and management books.

A deeper problem could be that the first generation of buyout managers wrung out the easiest profits. PE thinking pervades the corporate suite—few chief executive officers are now sitting around waiting for PE managers to tell them to sell underperforming divisions and cut costs. Auerbach says there are still good PE managers out there and all these changes have “forced evolution and innovation.” But it’s possible that a cosmic alignment of lax corporate management, cheap debt, and desperate-for-yield pensions created a moment that won’t be repeated soon. —Hema Parmar and Jason Kelly

Buyouts Push Companies to the Limit. Or Over It

If your company finds itself part of a PE portfolio, what should you expect? Research has shown that companies acquired through leveraged buyouts (LBOs) are more likely to depress worker wages and cut investments, not to mention have a higher risk of bankruptcy. Private equity owners benefit through fees and dividends, critics say, while the company is left to grapple with often debilitating debt.

Kristi Van Beckum worked as an assistant manager for Shopko Stores Inc. in Wisconsin when the chain of rural department stores was bought by PE firm Sun Capital Partners Inc. in a 2005 LBO. “When they took over, our payroll got drastically cut, our retirement plan got cut, and we saw a lot of turnover among executives,” she says.

In 2019, Shopko said it could no longer service its debt and filed for bankruptcy, ultimately shuttering all of its more than 360 stores. Van Beckum was asked to stay on as a manager during her store’s liquidation and was promised severance and a closing bonus in return, she says. Weeks later, she received an email telling her that her severance claim wouldn’t be paid. Sun Capital has said money has been contributed to the bankruptcy plan that can pay such claims.

Private equity and hedge funds gained control of more than 80 retailers in the past decade, according to a July report by a group of progressive organizations including Americans for Financial Reform and United for Respect. And PE-owned merchants account for most of the biggest recent retail bankruptcies, including those of Gymboree, Payless, and Shopko in the past year alone. Those bankruptcies wiped out 1.3 million jobs—including positions at retailers and related jobs, such as at vendors—according to the report, which estimates that “Wall Street firms have destroyed eight times as many retail jobs as they have created in the past decade.”

Whether LBOs perform poorly because of debt, business strategy, or competition from Amazon.com Inc., research shows they fare worse than their public counterparts. A July paper by Brian Ayash and Mahdi Rastad of California Polytechnic State University examined almost 500 companiestaken private from 1980 to 2006. It followed both the LBOs and a similar number of companies that stayed public for a period of 10 years. They found about 20% of the PE-owned companies filed for bankruptcy—10 times the rate of those that stayed public. Pile on debt, and employees lose, Ayash says. “The community loses. The government loses because it has to support the employees.” Who wins? “The funds do.”

Research by Eileen Appelbaum, co-director of the Center for Economic and Policy Research, says the problem isn’t leverage per se but too much of it. She points to guidance issued by the Federal Deposit Insurance Corp. in 2013 saying debt levels of more than six times earnings before interest, taxes, depreciation, and amortization, or Ebitda, “raises concerns for most industries.” A 2019 McKinsey report shows that median debt in private equity deals last year was just under the six times Ebitda threshold at 5.5, up from five in 2016.

Of course, by the time private equity acquires some of these companies, they’re already in deep trouble. Defenders say PE fills a crucial role in the market. The firms have the resources and expertise to turn companies around and an incentive to invest in them to make sure there’s a healthy gain when they sell or take them public, says Derek Pitts, head of restructuring at investment bank PJ Solomon. “You have to make investments to grow a smaller company,” he says, and some require the kind of check that only a major PE shop can write. Being shielded from the quarter-by-quarter glare of public reporting requirements may allow PE companies to experiment and focus on more than short-term results.

The retail industry was long a prime target for buyouts because of its reliable cash flow and the value of the real estate it owned. But the sector is no longer as suited to PE ownership amid ever-changing customer whims and the massive upheaval brought by Amazon, says Perry Mandarino, head of restructuring and co-head of investment banking at B. Riley FBR. “Private equity has successfully preserved companies across a number of sectors,” he says, “but the disruption in retail has proven difficult for even some of the most savvy investors to navigate. High leverage, especially in this difficult environment, can be fatal.”

The most notable recent example of that is Toys “R” Us Inc.When the children’s toy retailer filed for bankruptcy in 2017, it was paying almost $500 million a year to service the debt from its 2005 takeover by Bain Capital LP, Vornado Realty Trust, and Kohlberg Kravis Roberts & Co. After it was liquidated in March following poor holiday season sales, its owners became the target of protests by laid-off workers, as well as scrutiny from investors and criticism from elected officials. Later that year, KKR and Bain said they’d each contribute $10 million to a fund for workers who lost their jobs when the retailer collapsed. Senator Elizabeth Warren (D-Mass.) introduced a bill in July that would limit payoutsprivate equity owners could receive from troubled companies.

That kind of impact isn’t unique to retail, says Heather Slavkin Corzo, senior fellow at Americans for Financial Reform and director of capital market policies at the union federation AFL-CIO. “The massive growth of private equity over the past decade means that this industry’s influence, economic and political, has mushroomed,” she says. “It’s hardly an exaggeration to say that we are all stakeholders in private equity these days, one way or another.” —Lauren Coleman-Lochner and Eliza Ronalds-Hannon.

Source: Bloomberg

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