How does an investment firm buying a company and running it into the ground work

Factual Questions
1

I’ve heard this is a major factor in several retail chains I know about going under lately.

The argument is basically that a company is struggling so an investment firm buys them up. The investment firm them loads the company up with debt, money that it uses to hire the investment firm as consultants. They basically load the company down with debt, and transfer all that money to the investment firm, until the company fails and has to liquidate.

Is that a common business practice (taking over a company, driving them deep into debt, pocketing all the loaned money and letting the company fail)? How do you ensure all the money from over-leveraging goes to the investment firm, but none of the debt?

2

What happens is that a private equity firm takes on a huge debt to buy out a company, and then moves all the debt from its own books to the company’s books. Then they proceed to loot the company like a mafia operation, sucking out all the income through special dividends and having it take out more loans and taking that cash too. In the end, the company has no money to keep operating and a huge debt burden, so it goes into bankruptcy. Fuck the employees, fuck the customers, fuck the brand, fuck everything.

It happened to the Simmons mattress company.

I recall posting about this issue before and basically being told that either it wasn’t a problem or that I was imagining it.

3

You just have the company sign papers saying that the debt belongs to the corporate entity and hand over the cash to the investors. The purpose of a corporation or a limited liability entity is to protect the investors from any liability incurred by the corporation. So the corporation is on the hook for the debt, but the investors had the corporation distribute all the money to them.

4

Probably back in 2012, when Mitt Romney was running for President against Obama. Romney’s company, Bain Capital, has a history of doing this vulture capitalism thing.

5

Here’s another article, this one in the New Republic

6

Here’s a simplistic analogy. Pretend that you’re a company. I buy a magic control device and put it on you. It might have been expensive, so i borrowed money. Once you’re under my control, i have you take on the debt. Then i make you give me your house and car. Then i raid your bank accounts. I make you sell your clothes and give me the money. When you’ve got nothing left, I shoot you in the head. The debt dies with you and I have all your stuff.

7

Something similar happens in the 1987 movie Wall Street. Michael Douglas’s character Gordon Gekko is known for buying companies and destroying them for the cash. He does it early in the movie to Teldar Paper, making the infamous “Greed is Good” speech to the shareholders, and later to Blue Star Airlines (where he’s primarily going after the company’s overfunded pension).

Amazingly, this exact scenario really did happen to the French de Vedrines family.

8

To be fair, the venture capitalists don’t generally deliberately seek bankruptcy for their victim companies — if they did, they’d be unable to keep attracting partners.

Rather they structure deals as Heads: I Win; Tails: the Victim-Company Loses.

Despite a high debt, the victim company may be lucky and prosper; vulture gets the quick cash, on-going profit, and can use inside knowledge to get out when the getting’s good. If the company gets unlucky: well, at least the vultures got to scoop big cash from buyers of the stocks and bonds.

ETA: Note that this is unfettered free market at its finest: The company is run for the benefit of stockholders (not employees, customers, or the public); they generally get a big premium over market price for their shares in these deals, and thus are delighted.

9

Fifteen years ago, the private company where I worked was sold to venture capitalists who managed others money. We had no debt, tens of millions in the bank and revenues of a couple hundred million.

We were immediately merged with our main competitor (owned by same VCs and also no debt). Each of the two purchases and the merger let to three rounds of 25-30% layoffs. Big reduction of payroll costs.

Product development ceased and sales push for annual maintenance started.

Loans were obtained (balance sheet looked great) for a series of acquisitions - and to pay back original investors (mostly large state retirement accounts). Three years later the company had a third of its original staff and a billion dollars in debt, half of it junk bonds. Buyout firms had made several hundred million.

Local trade press commented “We used to admire XYZ, Inc. for product engineering but it is now focused on Financial Engineering.”

The firm no longer exists. I have no idea if the loans were ever paid off

10

You’d think that banks would get wise and stop giving loans to companies owned by vulture capitalists.

11

I am currently growing my company. This requires investment of capital and time.

One thing that I notice is that on days when I have a bunch of call-offs, or when I have a bunch of people on vacation, I make more money. There is more profit, because I had fewer people to pay. The downside is that my revenue is lower. So, for example, with a full staff, I might make $100 on $1800, but short staffed, I make $300 on $1500.

When an employee leaves my employ, I also have a boost in profit, as well as when I hire a new employee, my profits take a beating.

If someone were to buy me out, they would see that they make more profit with fewer employees, and so cut their hours or even their employment entirely. This would make more money in the short term, but would always be a higher percentage profit on dwindling revenue.

So, it is a matter of long term investment vs short term gain. With the way the taxes are currently structured, short term gain is more enticing, especially to someone who hasn’t put in any work into creating the capital of the company that they are looking to loot.

Previous generations put quite a bit of blood, sweat, and tears into the companies that exist now, and all these vulture capitalists see is that there is capital that can be converted into liquidity that can go into their pocket. They are willing to destroy not only the livelihoods of the employees of the company that they are raiding, but also cheat lifelong customers out of the value they have come to expect. This decreases the number of jobs available, decreases the variety of goods and services available to the public, as well as raising their price.

For this, they are rewarded not only financially, but are also held as examples to emulate. If you criticize what they are doing, you are just jealous of their “success”.

12

That’s closer to generally accurate though still skewed. The issue of VC became overtly political with people feeling they had to accuse Romney of doing something inherently wrong.

Even in ‘fettered’ capitalism (the only real kind) companies are always supposed to be run for their owner’s benefit first (within the law). Under which principal running something you own into the ground on purpose doesn’t make sense as a rule, and doesn’t happen as a rule. The main exception to the rule is the example given of excessive self-dealing management fees paid to owners, but that’s not as a rule significant.

The big cash they (VC vultures) get from buyers of stocks that’s from selling the company when/if they’ve made it more valuable, which is how they make big money. That’s the basic story subject to exceptions, or fraud where it can be proved (but fraud isn’t limited to any particular financial structure). A VC company isn’t gteed to lose money where the company ends up getting liquidated, but big scores for them come from making the company a lot more valuable while they own it.

So the last paragraph is key. If a company has the potential to be worth a lot more than its market stock price , which is how the VC’ers can offer a substantial premium over market to the pre-buyout owners, take the company private, make it over and sell it for a big profit to another set of stockholders when the company goes public again, there must be something inefficient at the company. Weeding out inefficiency is not painless for all involved, never has been nor ever will be.

And same answer why banks haven’t ‘wised up’ and stopped making loans for buyouts. Because a high enough % of loans get paid back to make it a profitable business considering the rates charged, aside from cyclical calls or commentary that banks are making too easy (or not easy enough) loans at a particular part of the business cycle which one often hears. And again the basic role of bank credit officers is to act in the interest of bank shareholders, not people comfortable with the status quo at borrowers, bought out companies or anybody else they lend to.

13

In the background,

  1. Some bond holders are being enticed to make a dubious investment. Since they lose during bankruptcy too.

  2. Academic economists have noted that takeovers provide a mechanism for abrogating implicit contracts that exist between workers, suppliers and the firm and vacuuming the surplus contained therein. Here is a link to a 1988 paper by Lawrence Summers and Andrei Shleifer (two big names in economics). http://www.nber.org/chapters/c2052.pdf It was later published in Corporate Takeovers: Causes and Consequences., edited by Alan J Auerbach, 33-56. Chicago: University of Chicago Press, 33-56. http://www.nber.org/chapters/c2052.pdf [INDENT][INDENT][INDENT] This chapter examines theoretically and empirically the elements of truth in the claims that improved management and redistributed wealth are the sources of takeover premia. We show how hostile takeovers can be privately beneficial and take place even when they are not socially desirable. Our argument does not invoke tax, financial markets, or monopoly power considerations. [/INDENT][/INDENT][/INDENT] I’m not claiming that this is settled opinion in the discipline, only that it’s definitely not something that can be just brushed aside. I linked to one of the earlier papers on this subject: there have been others since.

ETA: The link shows an old Brookings paper: there is commentary by other economists at the end.

14

That’s somewhat tangential to what’s being asked/asserted here in the question and various posts. It’s examining whether an increase in the value of companies as a result of ‘hostile takeovers’* corresponds to a net social gain. In none of the examples were the companies ‘run into the ground’ in the sense of the other media articles quoted in the thread.

It’s certainly an opinion, but the paper is basically non-quantitative and speculates ‘what if’ examples based on real cases: it doesn’t claim to prove anything categorically. To oversimplify only slightly I think, it’s basically arguing that an increase in market value of a company, not running one into the ground, that results from something like no longer overpaying workers more than the actual value of their work, is a transfer from those workers to shareholders. That’s kind of obvious I’d say. Then further and potentially less obvious, though I agree it can’t be entirely brushed aside, the way that process plays out with information asymmetry between managers and workers could result in a net negative (company loses workers who know the company so can be more productive than new workers; but the former workers also make less)**.

Leaving it with the problem (also just an opinion, mine) with left leaning economists in general, or at least the implications left leaning politicians and voters often take from their work. They point out market failures or possible ones anyway, but they usually fail to show how and who (what panel of neutral wise men and women, presumably working for the govt) could instead make these decisions and that turn out a net social positive compared to relatively more freedom for money to find its own level so to speak. Arguments against concepts like capitalism, or democracy for that matter, don’t just need to show the market or majority of voters aren’t always right: obviously neither is always right. They need to show that some alternative top down management of the process would work better. The paper doesn’t do that or pretend to, but the common reaction is to take that further step in the political realm. “Larry Summers is a big name in economics, he says mergers can be a net social negative, so obviously they must be regulated more strictly”. But that doesn’t really follow. Again a common pattern IMO, not attributing it to you personally BTW.

*which doesn’t map one for one with ‘vulture’ firms: their takeovers aren’t necessarily hostile (meaning to the existing owners but sought by those owners), nor are the examples given in the paper typically of companies taken private which is the general MO being discussed here.
** you can’t pay people more than their work is worth forever in a troubled industry. There’s a reference in the paper to other work showing that wages vary considerably supposedly randomly for the same work. There’s some truth to that undoubtedly. But a lot of that applies to smaller companies which are doomed eventually because they pay workers too much, but nobody notices when they then go under, small firms are constantly arising and going under. And it’s also of limited application to say an airline or steel company already on its way to going under because of lower cost competitors of a different form (newly founded airlines) or somewhere else (imports). In that case yes it’s a transfer from ‘stakeholders to shareholders’ when a takeover results in lowering labor costs, but the existing situation wasn’t necessarily sustainable and the argument in the paper doesn’t seem to account for that.

15

The current Sears owner, Sears Holdings, formerly Kmart Holdings, has a history of this.

The people in charge of Kmart kept borrowing money to “refurbish” their stores. After each cycle the stores looked the same. No improvement in sales.

Eventually the debt got so high Kmart went bankrupt. The company that owned all the debt ended up as the holding company for it. The “managers” of Kmart got suitably rewarded by the debt owners/holding company. The stock holders got zip.

But Kmart was worth money since it owned all that property. So this one-minute-ago bankrupt company bought Sears. (One of those phony “mergers” but basically a high debt buyout.) Changed the name to Sears Holding and starts looting.

Companies controlled/owned by the owners are getting all sorts of deals on debts and Sears name brands. Stores are being closed. It’s being gutted.

Some other company controlled by the owners is going to end up with the valuable stuff and everyone else gets a smoking crater in the ground.

It’s a widespread game: get a company with assets and reasonable stock value to go into debt to you. Trading stock value for debt. To these people, you don’t want to own stock, you want to own debt. When you force it to go belly up as the value equals the debt you own the company. You are a winnar!

16

I have solved this problem.

Eliminate all corporate debt.

By decreeing it the personal debt of whoever has ultimate control of the corporation.

17

That would cause more problems than it solves.

The better solution is to tax the hell out of individuals who do loot companies.

Raise the upper tax brackets to 70+% or higher, 90+% is not unreasonable, even. Make gains on short term (less than 10 years) investments taxed at the marginal rate, rather than the discounted rate. If I can destroy a dollar of wealth in a company that I own and only receive a few cents on that dollar, I may be more inclined to leave it in the company, and control the wealth in that way. If I am only paying 21 cents on the dollar, then there is no reason not to convert as much capital to liquidity as possible, and move that liquidity into my own pockets.

You can’t solve people from being greedy, but you can create incentives that makes their greed less destructive, and sometimes even productive.

18

Not wholly tangential. The OP asks how buying a firm and running it to the ground can possibly be profitable. One mechanism involves asset stripping, but the stock market generally values a company at levels above its book value. So how can such a deal take place?

The answer is companies have assets other than physical. A big one involves the good faith of its stakeholders. For example, firms with lower job security need to pay higher wages - look at construction for example. That creates an opportunity for plunderers - buy a company offering a high job security/low wage combo and start downsizing. In other words, rip up pre-existing implicit contracts and extract the rents. A similar approach can be applied to customers and suppliers: cash in your good reputation.

The 1988 paper I linked to was one of the first to outline that framework. In the years since, there are others that have explored different applications.

19

not only the points made so far, but… The main issue is long-term vs short-term. A company generally plans for the future as a continuing enterprise.

One of the first Accounting 101 questions they ask you goes something like this:

Bob takes over the company from his dad. The company has 10 delivery trucks costing $50,000 each. They write these off over 5 years at 20% a year, so the profits declared to the tax people are $100,000 less than what Bob actually sees in the bank. Bob takes this money and buys a fancy car. What is wrong with this scenario?

The problem is a real business must invest in the future. Mattress-making machinery wears out. Store fixtures need to be updated or the store looks tired, delivery trucks need to be replaced or deliveries fall behind. If you are a tech company, R&D and product development are critical. (Blackberry, anyone?)

It doesn’t need to be Venture Capital. Shortsighted management can ignore reality, produce spreadsheets with unrealistic sales projects to keep Wall St. happy because analysts will tell them they need to cut costs to keep stock prices up. This quarter is more important that the 10-year-plan. If management falls for this BS, or sees the wrong cost-cutting as the path to quarterly nirvana then the company is also doomed.

But… VC and buyout artists are a particularly insidious disease. They are strongly committed to immediate profits, future viability be damned. Plus, they are gambling on the lending community being stupid enough to trust the (previously) good name and goodwill of the bought-out company to provide the buyout funds. And if 2008 has taught us anything, it’s that investment banks and institutional investors are monumentally stupid lemmings.

20

ftg already mentioned Sears/Kmart, is this also what happened (is happening) to Bon-Ton (Bergner’s, Boston Store, Carson’s, Elder-Beerman, Herberger’s, Younkers), Toys R Us, and PetSmart?