How do Private Equity funds make money by closing businesses? You hear all this stuff about Bain capital buying and raiding businesses and closing them down. How does this business tactic make money?
I would think holding a losing business is not a money-making proposition, otherwise, why would the owner have sold it?
As always, no political comments. I am looking for reasoned informed answers here.
The assets (machinery, buildings etc) can be sold profitably. Intellectual property can be a very significant asset. The company Interplay, for example, is worth nothing except for its IP over games like Fallout.
Also, “a business” can refer to a particular business or a group of them.
Let’s say I buy Company 1. Company 1 owns company A, company B and company C. A and B are profitable while C is losing money fast.
I close C, leaving A and B. Company 1 is now doing better.
Note that “raiding” refers to more than closing. It can mean restructuring a company without closing it down althoug it can involve closing down significant parts of the business.
A lot of companies have assets that are collectively worth more than its market capitalization, because the market has overreacted to the company reporting bad numbers or decreasing revenue or high losses. So if you can raise enough money to buy a controlling interest in the company, then shut down the business and sell off all the assets (which in some cases may just be a collection of subsidiary companies) then you make a profit.
Back in the day, a number of people got famous for financing such adventures by selling massive amounts of junk bonds.
More generally, this is an important piece of it. You borrow the money to do the takeover. Sell whatever is valuable at a profit. Then pay back the loan. Your out-of-pocket costs are minimal so any profit is enormous. That’s the really rich way of making money. It works for all types of investments, not just takeovers.
(friedo’s post in cinema) Pretty Woman was on TV last night, same concept. The sum of the parts can be worth more than the whole, and owners sometimes have emotional attachments that impair their ability to make purely financial maximizing decisions.
Many of these companies have assets on the books (land, building) that are worth far more than they account for. Frequently, these firms are bought for the land-building is razed, and turned into a multi-million$$ shopping mall or condo complex.
Are there really a “lot” of such companies? It’s hard to imagine that there are, as they would be snatched up pretty quickly and liquidated. No?
I mean, a person might be able to make more money by looking at the long term and trying to make the company profitable, but as the saying goes, a bird in the hand is worth 2 in the bush.
In some cases, they don’t dismantle the company, but restructure it. They cut redundant positions and underperforming departments and then resell the company. IIt’s just like flipping a house, in order for it to to work, the buyers have to get in and out quickly so that they don’t eat up their profits making loan payments.
Well, maybe not “a lot” in comparison to the total number of publicly traded companies, but there’s enough to keep the small number of professional corporate raiders in business, especially during a recession.
Some companies which may be undervalued are also a lot more difficult to take over, due to clever structuring or poison-pill plans designed to prevent hostile takeovers.
So these places are not doing anything that the business’ owner could not do. They just are better at it because they can handle it with objectivity?
Sometimes it is because they can handle it with objectivity, sometimes it is because they come in with more capital than the owners can generate, and sometimes the raiders have different goals than the current owners (that is the raiders are more interested in making a quick buck, rather than longer term goals).
They may also have acquired skills in how to restructure; what not to cut, what to cut and how to cut it. A bit like a surgeon I suppose.
They may also pay more attention than most shareholders. When the shares of a company are chiefly owned by people for whom this is a small investment, they may not have enough incentive to take a close look at the company and effect changes. Look up “principal agent problem”: Principal–agent problem - Wikipedia
When a raider comes in, he has a controlling share and this is major investment for the raider. He therefore has both the ability and the incentive to take a close look at the company, its policies and employees and change them. The employees include the executives and the directors, who may not like the scrutiny and may have been happy to run the company with uninformed and uncommitted shareholders.
Actually selling off everything and intentionally closing down the business is pretty rare. Usually the private equity investor very much wants the business to succeed. However, an increased likelihood of business failures is a predictable result of private equity investment.
Let’s say that Oldco has been making widgets for a long time. It’s a boring company and steadily produces modest profits. A private equity investor decides to buy the company for $1 billion. Most of the money to buy the company, say $850 million, will come from Oldco itself, which will raise it by borrowing to the hilt. The private equity fund puts up the other $150 million and gets 100% of the common stock, except for some stock and large stock options that will go to management, to ensure that management is focused on the private equity fund’s interests and not on other considerations, such as preserving the existence of Oldco.
Following the buyout, management will relentlessly work to maximize the private equity fund’s returns. Inefficient factories will be closed and their workers laid off. Assets that are not part of Oldco’s core strategy will be sold off to retire debt. But it’s not entirely a matter of paring back and shutting things down; there will be large investments in new factories and equipment that are expected to produce high returns. In general, this stodgy company will become a risk maximizer, willing to roll the dice for a big win.
The company’s large debt burden will leave it ill-prepared to respond to negative developments, so many companies fail after their buyouts. When there is a win, though, the private equity fund wins big. Suppose that Oldco has a 50% chance of failing and a 50% chance of doubling in value. If it doubles in value, to $2 billion, and still has $850 million in debt, then its common stock, for which the private equity fund paid $150 million, is now worth $1.15 billion. Score!
For the nonmanagement employees, who went from having a steady job to a more than 50% chance of being laid off, with no opportunity to share in the upside, it is not as positive a development.
In my day the term private equity wouldn’t have been used for Bain Capital. Bain was an LBO operation, which technically means it was a private equity but LBO operations are generally seen a bit sleazy because of what jbaker just described.
Not all private equities do what an LBO operation does, private equities are often involved at the genesis of many of today’s larger, profitable companies. So private equity is not anywhere close to being synonymous with “corporate raiders that destroy companies and cash out.” LBO operations on the other hand…
As jbaker points out, they essentially leverage their buyout using the buyout target’s own assets. They do this buy getting a controlling stake in the equity of the target firm. This means they have very little of their own skin in the deal and are able to put the target company deep into debt without themselves having to go deep into debt. Then if things go as planned the LBO operation later will cash out in a manner profitable to them. Sometimes the cash out destroys the company because it will be in the form of making the company issue tons of new debt to buyout the LBO operation (but to be able to do that the target will often need to enter a period of post-leveraged buyout profitability so that it has the ability to issue new debt.)
When a deal works, the profit margins are massive for little risk. Most of an LBO outfits deals fall through and do not profit, but because of the nature of their activities they risk far less than the actual cost of the interest they are buying in a company, so they can lose on many deals and succeed on only a few and still come out massively ahead. Basically it’s a way to “gamble” such that the 1 time out of 10 you win, it pays for the losses of the 9 times you lose and then some.
It is my understanding that the money for acquisition in a leverage buyout such as JBacker describes may come via a loan and then assets of OldCo are used as collateral for the loan the actual money does not come from OldCO but from the loan.
There is a way to get money from a failing business in that after you buy all of the stock you can start paying yourself dividends. However, the dividends will not be as much as you paid in, so they just mean you lose less money when the business ultimately fails. Ultimately, the only way to make money in private equity is the same as elsewhere, you have to be lucky or good.
Generally Accepted Accounting Principles (IANAA) require you to keep assets on the books for what you paid for them - i.e. land, factory, etc. The only exception is if it’s material you habitually trade, etc. This way, your numbers are dependent on your real business, more meaningful and not bouncing with the ups and downs of the real estate market where your factory is. Besides, until you actually sell it, any new evaluation is just a guess.
So companies like A&P and Greyhound, IIRC, were famous for having acquired their downtown properties at pre-1950’s prices. By the 1980’s the price difference between book value and real world value was pretty high; if investors were not paying attention, they were easy targets for the buy and dump it all strategy.
That’s what we mean when we say they fund the acquisition by leveraging the target company’s assets.
Actually, they don’t always pay back the loan. They just have the target company take on the obligation. They suck out every bit of revenue they can, leave the target burdened with debt and sell it off to some sucker who then has no choice but to liquidate it.
Sometimes they are just crippling the company with debt and selling on to investors who don’t know that the company is not as strong as it looks on the books.
This American Life did an excellent show on private equity buyouts. One of the stories was about a mattress maker – Sealy or Simmons. Before the takeover, they were a profitable company that might have been mistakenly valued or slightly inefficient. By the time the private equity company was done with them, it was a crippled hulk.
The game can get complex. Here’s another example:
Corp A and Corp B are competing businesses producing similar products of similar quality. They are the two top players in their niches, and are regularly price-cutting and innovating to try and take the top spot. They are bitter rivals who would never consider a merger.
You come along and enter private negotiations with both companies simultaneously, keeping it secret. Buy both companies.
Step 1: Eliminate redundancy. Cut back to just one accounting department, one sales force, one development team. Clear out equipment not operating at 100% capacity (e.g., each company owns an expensive piece of gear that’s used a few hours a day. Sell one and use the other for both product lines).
Step 2: Now that you own both companies, stop with the price-cutting competitions. Raise prices (or hold to list prices) on both lines. Less competition means less advertising required, too. With equal resources, the weaker product line will start to falter on its own.
Step 3: Kill the weaker product line entirely and gut the remains of the company that produced it.
If these are small or medium-sized business that won’t attract FTC attention as a monopoly problem, you end up with one business owning its niche and controlling pricing.
And, of course, you’ve now lost all the benefits of competition (price competition and innovation/quality competition), you have monopoly pricing, and you have half as many people earning their livings in the industry. And you also have an intellectual property asset (trademark, etc.) that has built up decades of goodwill and name recognition, but no longer has a product that it can be applied to.