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Part of the most egregious element of the whole thing is that the Sear’s pension fund was apparently (if the newspaper I read is correct) underfunded at the same time as the stock buy-backs were happening.
I’d have very little difficulty with a law preventing dividends and stock buy-backs while the pension fund remains underfunded.
(And yes, I can imagine it destroying some companies who might have eventually paid up the pension, but died because they could no longer attract investment to get out of a slump - every policy has its costs.)
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At least the management companies put it right there in their name that they are about death and distruction: Ares management owns Nieman, Cerberus Capital Management sold off all of Mervyn’s real estate dooming it to Chapter 7.
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So the creditors are suckers who end up holding the bag every time. This makes so sense either. Why would anyone lend to a company owned by private equity if that’s the model?
I’m not sure, my knowledge drops off here. Possible reasons: the credit system is easy to game and these are old companies with plenty of good credit, so no reason not to lend to them; people haven’t become wise to the private equity game yet so don’t downgrade your credit rating automatically if you are owned by a PE firm; PE firms don’t always or even mostly do this, so the firms they own are not necessarily an automatic bad credit risk.
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That is actually a very good question. I think that the answer is simply that the fund provides a service to the end buyers that the end buyers cannot do themselves.
Let us suppose that in a line of companies more or less doing the same thing, you have companies A, B, C and D. The business is not important, what is important is that they do about the same. They all have assets for doing their.business: factories, buildings, brand names, etc… The assets are somewhat specific, if the business is to produce cars, they will not need the same things than if they produce electronics, for example. As a consequence, the only buyers for, say, company D will be the other 3.
D is the one not doing so well. As a consequence, it will have part of its assets which are outdated, not adapted to the present market, etc… It will have some more valuable parts. The rational thing to do for a buyer (any of the other 3) will be to close these older parts, fire the workers, etc…
Régulation or public outrage may prevent that. Anti-trust regulation may event prohibit the other 3 to buy their competitor.
The fund provides that service. They buy D, run it to the ground, sell the unuseful real estate to real estate developers, fire the unneeded workers and, when D is bankrupt, there is little choice but selling the remaining parts to one of the other 3. Then you repeat till you have a monopoly.
For this to work, it helps that the people running companies A, B, C and D and the people owning the fund are usually about the same people.
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And they would have gotten away with it if it wasn’t for those meddling…
no, wait - they did get away with it, didn’t they.
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Of course, we could go back a bit further and look at the original decision to make these companies public. Sure, there’s the possibility of increased cash flow due to public investment but with that comes risks as well. One of those risks is that your company will be destroyed by investors with no interest in your business.
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Yeah, like the other newspaper-related post, this is dumb. It’s like when you get old or have an immune disorder, you are more vulnerable to attacks that you would have previously been able to defend against. The cold may be what technically what kills you, but it was the underlying disorder that was responsible for your demise. In this case, private equity is the attack, but the overall disorder is that department-store style retail doesn’t make much sense in a world where home shipping is near-frictionless (notwithstanding seasonal package theft issues).
Part of the reason is that a huge portion of the market is being manipulated this way and they are rarely a straight smash and grab. Almost every retail shopping center you’ve ever seen funds the developer through a complex series of debt manipulations. Basically they are creating a debt load that is too large to react to the next cyclical shock. They make money as the business declines by leveraging future earnings and then another group of vultures makes the money as the business collapses by buying the assets at below market rates because they are on a schedule to meet the debt burden. The whole system works until there is an exogenous shock, then it fails catastrophically.
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Leveraged buyouts are routinely used to purchase firms large and small. The lender receives interest on the loan which is paid for with the net profits of the firm. The firm’s assets are collateral. The loan agreement limits which assets the buyer can legally sell off.
Corporate raiders like Bain Capital (the private equity firm Mitt Romney use to work for) have perverted this model. Instead of buying healthy firms with the intent of operating them or consolidating them into another firm, raiders gut distressed firms that are quite literally worth more dead than alive. The loan is paid back with a single fixed interest payment, or it’s rolled into a larger debt vehicle with other obligations, and the lender makes a tidy sum while the borrower deducts the interest. The reason raiders are so reviled is because instead of making a steady income from a healthy firm over a long time, they make a lump sum from liquidating distressed firms. A healthy LBO is normally facilitated by a lending bank requiring the borrower to show the firm is viable. Raiders rely on private equity firms with whom they openly conspire to strip companies of their assets.
The entire thing works because interest on corporate loans is tax deductible. Which is good policy if the firm is healthy because the firm will keep keep making a taxable profit. Yet another aspect that raiders have perverted.
An apologist for the practice will say it enables a profit to be turned from distressed firms that are or would become insolvent anyway. The problem is that distressed is a relative concept. A private equity firm might work with client to liquidate otherwise healthy competition. With a private firm in good standing with its creditors, they can’t do that without the consent to sell of the firm’s owners (though non-owner workers are out of luck). But with publicly traded companies they can just buy up enough voting stock to force the sale. Then, as Cory noted, the raiders can take it private and then public again until the stock is drained of all value and becomes worthless, and the raiders make a killing on the IPO, then sell off the remaining assets to pay off the debt they borrowed to buy the original stock. This works great for them because they only need to borrow enough to buy a controlling share, not the entire firm they’re trying to bleed dry.
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