Explaining the con that is private equity

Originally published at: https://boingboing.net/2020/01/07/leveraged-buyouts.html


This has been going on for a long time.

Wasn’t that a side discussion in the movie Pretty Woman? The John that hired the sex worker was in the private equity business, and bought businesses to destroy them? His partner was angry the John was so changed that he no longer wanted to rip apart these businesses, but wanted to build really good healthy businesses?


All the easiest money has been made. The economy peaked in the mid-seventies. Ever since then, creating real wealth has gotten harder and harder, all the “smart” money is on reallocating wealth that’s already been made.


Quite right. Which is why I hated – still hate – Pretty Woman.

Fucking Hollywood. It’s a very fine line between loathsome pandering and leering feel-good formula.

PS, Down and Out in Beverly Hills can go fuck itself in the bargain. Did you know someone made a television series based on DAOIBH? And by “based on”, I mean I happened to catch the moral climax of the pilot episode, and did it exactly recapitulate the premise of the film? Yes, it did – it exactly recapitulated the premise of the film.

PSS, same deal with Nothing in Common, although I kinda liked Nothing in Common … Tom Hanks, Jackie Gleason … yeah, Hollywood tripe … but Hanks and Gleason … still, TV pilot recapitulates moral premise of film.

Ugh. It’s like I have to do all the creative thinking in this world, and Hollywood somehow cashes in on prostitutes it.

See also “high frequency trading.”

Both are schemes to extract wealth while adding ZERO value.


IIRC, this is the kind of scummy scamming that made Mitt Romney his hundreds of millions?


private equity’s No. 1 priority isn’t the long-term health of the companies it buys — it’s to make money, and as is the case in so many facets of investing today, to make money fast.

This gets to the core of the problem. Vulture capitalists are no more interested in building true value in the businesses they acquire than Paulie in Goodfellas was when he became a “partner” in the local lounge.

In addition to Pretty Woman, there’s also Wall Street. The plot is centred around a shady hostile takeover of a small airline with the intention of stripping it for parts. Naturally, Libertarians see Gordon Gecko as the hero of the piece and love quoting his “greed is good” speech.

There’s also this real-life story, featuring PE creep supreme Henry Kravis:

Correct. Dem candidate Cory Booker also worked for the same bust-out outfit, which should give as much pause to supporting him as Wall Street Pete’s time with McKinsey.


The house owes that money to the bank or creditor who lent it

This part always feels glossed over. Why do banks lend to PE if they are then reliably saddled with hundreds of millions of dollars in debt? Shouldn’t they have either caught on or gone out of business themselves by now?


Oh! I think I can explain this part!

OK, say you have a lot of money to invest. The money doesn’t belong to you, it belongs to a group of suckers that don’t really have a say in where their money goes (“clients”).

So as the bank, when you loan the money, you take a chunk of it - your commission / origination fees. While the payments on the loan are still being made, you get a chunk of that - still your commission / interest fees. When the money gets defaulted on, well, it wasn’t your money.

So the bank makes profit on the commissions and on the interest it charges, and the loss is suffered by the sucker… I mean clients.

It’s not like the bank is actually loaning their money to the PE people… it’s loaning 401(k) money and money from people who gave their money to professionals to invest.

See also: Reasons for Old Timer’s Revolt (2050).


In addition to that: the bank gets first dibs when it comes to selling off the corpse at bankruptcy, doesn’t it?


Listening to a story on Marketplace last night about Borden Dairy declaring bankruptcy due to unsustainable debt. I didn’t even have to listen, I knew how that story would end. Waited for it … and there it was, private equity, saved for the end of the story.


It’s supposed to sell the assets at auction to help recover losses for their clients (taking a hefty fee again), but in practice they tend to transfer the juicy, useful bits to other companies that happen to be owned by friends for less than the value, further reducing the redress for their clients but enriching their friends, who return the favor… it’s not like you can really say how much something would have gone for at auction.


Wouldn’t they just create the money out of thin air?

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That really doesn’t work the way that people think that it works. It’s not nearly as big of a scam as people think that it is.

It’s just another way of saying “not on a gold standard”…


Can you share some reading material on this, please and thank you?

I think the usual argument goes along the lines of “If a bank had to keep 100% of the money kept in the bank liquid all the time, then it wouldn’t be able to make any investments at all by definition, so we’re really just arguing over what amount is okay for the bank to just not have”

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Somewhere in here, I believe there is the idea of packaging up the debt with other debt, then selling that as yet another “investment” vehicle. So when something goes way south, the loss is spread so thin among so many suckers, it’s not very noticeable.

I’m not sure what it’s called, but it’s the same as when before the 2008 financial crisis, banksters bought up tons of really bad and risky robo-signed mortgages, packaged them up into a ‘mortgage back security’, got some kind of AAA rating on it, and sold them to the government or Iceland or Norway, among many others. I hope, and I’m sure that, Liz Warren has this kind of scheme in her sights, too.

Remember, the PE deals that are mentioned here are for companies that are already in trouble (Toys ‘R’ Us, hello?). Dramatic restructuring is typically necessary and that involves laying people off. PE isn’t a con or a scam but it is high risk so the people that are putting money into these companies come up with structures that pay themselves back first. The lenders are doing their own due diligence and going in with eyes open. When the turnaround fails, the returns from the successful deals hopefully are a net positive for the PE firm. The returns for those stakeholders have been good but have steadily declined in the last 20 years as the low hanging fruit is picked.

Where the fish starts to stink a bit is in the handling of pension liabilities which always were unsecured liabilities. That means the workers are in the back of the line with the owners, behind the banks and bond holders. Pensions might get fobbed off the the government insurance fund (PBGC) which blew through it’s capital in 2009 but that would happen in a bankruptcy proceeding anyway if, as some would like, private equity were “not allowed to exist.”

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One of the interesting plays in the PE playbook is to sell the physical stores to separate firm and force the taken over company into a long term lease. Which frees up capital immediately to pay back the PE people for buying the company, but saddles the company with new expenses.