It isn’t what killed Bon-Ton; as far as I can tell, they never were sold to an investment firm. The positioning of their brands as mid-tier department stores, without much in the way of uniqueness, probably doomed them (especially since they never really got big into online retailing). They hadn’t been profitable since 2010: they seem to have borrowed a lot to buy up regional chains, and when the recession hit, they never seemed to have recovered.
TRU was bought by Bain, KKR, and Vornado (private equity firms) in 2005, so they may have contributed to its death, but TRU was also getting killed by Amazon, Wal-Mart, and Target, so they might have been doomed anyway.
Much of your post is valid, and it’s good to provide a soberer outlook on OP’s question. However there are some misconceptions reflected in your tone.
First of all, while rational economists and policy makers have advocated “fetters” on capitalism as long as there’s been capitalism, we’re now in Trumpist America and rational policy makers are in short supply. Pruitt, Mnuchin and others are removing the “fetters” as fast as they can. Paul Ryan and other GOP leaders are devoted fans of Ayn Rand. The schism in the present-day GOP is not about how much “fettering” capitalism needs — it is the schism between “purists” who want the entire government to wither away, and the “kleptocrats” who want the government to actively steal from the public and further feed the greed of the super-rich.
Second, the idea that companies are run for owner’s benefit, while perhaps true in a trivial literal sense, ignores the realities of post-rational American corporatism. The “owners” of a corporation typically come from one of two groups: (1) investment firms which own shares in hundreds of companies — they’re not concerned if KMart stock falls since Amazon will rise as a result and counterbalance; and (2) gamblers who bought their KMart shares this morning and may well sell them this afternoon.
The notion that Procter and Gamble is run for the long-term benefit of, well, William Procter and James Gamble, is just a quaint relic of the world advocated by Adam Smith.
Finally, the snide claim about “they had to accuse Romney of doing something inherently wrong” is unbecoming. Rationalists on both the left and right were proud of Romney, though a majority were happy to give Obama a second term. Still, examining Romney’s career was more sensical than babbling about Hillary’s shrill laugh.
Private equity investors pool their money together (generally into a private fund) and pick a target company. The PE fund then makes arrangements to borrow the rest of the money it needs to buy the target company. There are many variations but two basic structures are that the PE fund can either: (1) get temporary financing in its own name, or (2) it can negotiate with banks for the target company to borrow the money contingent on the PE fund closing the purchase of the target company. So, when the transaction closes and the PE fund owns the company, one of two things happens. If the PE fund borrowed in its own name (example (1)), the PE fund will direct the target company to borrow a bunch of money in the target company’s name. Then, the company will use that money to pay a dividend to the PE fund, which the PE fund will use to repay its temporary financing. In the end, the target company is the only borrower left. Alternatively, at closing, the target company can use the PE fund’s money and borrow the rest of the money itself (example (2)) to buy all the shares owned by the old shareholders. Again, the only entity with debt outstanding is the target company.
Not quite, because the lenders won’t agree that any promise to repay is as good as any other. Otherwise, every borrower would just stiff the lenders by finding some near-bankrupt borrower to assume the debt. Merely having the target company agree to take on the investors’ debt doesn’t do anything to relieve the investors’ obligation to pay. The bank would have to agree to release the investors’ from their promise to repay.
Venture capitalists are people that find small companies with big growth potential and invest early in the hopes the company will grow to a huge success later. Think of the early investors in Google or Uber. They try to profit by either selling the company later (say, to Google or Microsoft) or by taking the company public (like Facebook).
Private equity investors are people that buy operating companies and operate them as private companies. Generally, they look for struggling companies that have some worth greater than their market value. These are usually but not always public companies. Generally, the strategy is to either (1) manage the company better so it generates more profits, and then resell the more profitable company, or (2) tear it to pieces because the parts are worth more than the whole. Strategy (1) sounds nice. Managing better can mean investing new capital and growing the company. It can also mean, as K9befriender discusses, just cutting staff to goose profits and make the company look better. Strategy (2) sounds terrible and it really is for workers. It generally means things like laying off all the employees, selling the tooling to China, and selling the real estate to condo developers.
“Vulture capitalists” are private equity investors with an abbreviated label that really belongs to venture capitalists. It’s easy to get them confused but this thread is really about private equity investors. Some investors, in fact, use both strategies. I understand, for example, that Bain Capital made both venture capital and private equity investments.
Yup.
It’s not just luck. Private equity funds are often hoping the company turns around due to more investment or better management.
In fact, the earliest corporations were founded solely for the public benefit. These were institutions like municipalities and churches that needed eternal life in order to continue after their founders died. Nobody wanted the church to close and be sold off because the minister died.
Later, sovereigns created the “modern” investment corporation by granting corporate charters to private groups but even these were really for the benefit of the sovereign. First, the charters were really rewards to people that the king favored. Instead of paying money to people who had done favors for the king, he could instead give them a charter, which was a monopoly on some line of business, such as an overseas trade route. These corporations had other benefits, such as limited liability, which meant that if the company couldn’t pay its debts, the losses would fall on the lenders. In this way, the corporation was structured to insulate the crown from the risk of bad ventures. In return for these corporation benefits however, the king got a lot. In addition to using charters to reward his friends with something created out of thin air, the king could expect the corporation to provide services to the crown, such as by bringing in revenue to further enrich the treasury. Shares were transferable and so they were quickly traded among the wealthy, creating the modern stock market. People were willing to buy they because corporations could distribute profits but shareholders weren’t personally responsible for losses. Potential losses were limited but potential gains were unlimited.
In America, sovereigns (states) still charter corporations, but they don’t come with monopoly powers any more. Still, states give corporations perpetual life and their owners get limited liability and transferable shares so the corporation can provide benefits to the state. Generally, the assumption is that corporations encourage investors to take on risks that they would be unwilling to take on without the limited liability shield. Thus, corporations will undertake risky activities like building railroads, mining, and operating airlines that would be risky to conduct otherwise. In return, the state should expect benefits like new goods and services, jobs for its citizens, and tax payments. This last bit seems to be where the social contract is breaking down.
Credibility is important for PE firms because they otherwise couldn’t get loans. Generally, they try to repay the loans. Lenders demand higher interest rates on these deals because they recognize the risk of default. If default occurs, lenders can still get some money out by seizing the assets of the corporation. Sometimes though, lenders do just take it on the chin. They probably won’t lend to that company again but, realistically, that company is already down the drain.
In most public companies, there isn’t one person with “ultimate control.” If you say the CEO has ultimate control, the board of directors would disagree. If you say the chairman of the board has ultimate control, the other members would note that the chairman has no unilateral authority to act without the consent of the board. If you say the largest shareholder has ultimate control, would you still say that if the largest shareholder owned only 5% of the company?
Limited liability has encouraged companies to take a lot of risks that have paid off for America. We wouldn’t have companies like automakers or skyscraper construction firms without limited liability. I like having cars and tall buildings in my life.
The physical assets are often worth more than book value too. For example, assume that you bought the Empire State Building in 1951 for $50 million. If half the value were the land and half were the building, your books would depreciate the building over a number of years and the books would assume that the value of the land stays the same. So, if you owned the Empire State Building today, your book value would show $25 million for the land and nothing for the building. Do you think the Empire State Building today is worth only $25 million?
Money can be made from a bankrupt company but it is not a business model.
Buying a company and then borrowing money and then declaring bankruptcy is possible but most lenders are not going to loan to a company whose business model is borrowing money and not paying it back.
Take as an example the company (RJR Nabisco) in Barbarians at the Gate. The “leveraged buyout” was initiated by the management, but then KKR decided they could beat that offer - essentially to buy out all shareholders and take the company private. It started because the managers recognized that the traditional operations grossly understated the real value of the company. (And the winners used the act that they then owned RJR to use its good name to have it borrow tons of money to pay the shareholders- plus sticking the shareholders with bonds from RJR. ) Similarly both A&P and Greyhound, IIRC, were targeted because under accounting rules, real estate assets were valued on the books as what they were paid for, and clever buy-out artists saw that the actual value had greatly increased - downtown properties bough 50 years or more before were worth a lot more. Buy out the company, sell the assets, collect dividends and then unload the company.
However, there’s the famous saying often attributed to Napoleon - “Never attribute to malice that which can as easily be explained by incompetence.” Department stores came along a century or more ago and were in their heyday more than 50 years ago. The business model is pretty much obsolete and the famous ones have been dropping like flies. Similarly, Chrysler (and much of the Detroit auto industry) failed to note and adapt to the changing consumer preference for automobiles; there are plenty of other such problem companies. In tech, they come and go in a decade. Meanwhile tech is severely disrupting almost every brick-and-mortar business. Yet, management in all these companies seems to be at most giving lackluster response to the changing world. Is it stupidity? head-in-the-sand denial? Ebullient optimism that things will turn around? We see something similar with cable companies - they seem to be in total denial that “cord-cutting” is a problem; it is assumed when millennials start reproducing, they’ll want cable despite evidence to the contrary.
Not entirely irrelevant no, but pretty much tangential.
The OP and following discussions seems to me is clearly aimed at cases where the market value of the company is decreased, in the limit to zero, what ‘running into the ground’ means in ordinary language. Especially cases where the company market value decreases in the limit to zero, but the buyer nonetheless makes money. That can and has happened, but it’s a distinct (arguably very small) subset of mergers.
The paper you linked, tangential though not irrelevant to the discussion, is dealing with how to think of increases in the market value of companies taken over in mergers (not particularly limited to leveraged buyouts, since the capital structure of the company once bought isn’t relevant to their argument). It supposes a starting claim that the value increase is seen as entirely as a positive for all concerned, a fairly extreme assumption if not quite a straw man. Then it points out some very obvious ‘other sides of the coin’ to some aspects of that value increase. If it’s because, as in some of the examples given, the previous management was paying the workers more than their labor was worth, that was a ‘rent’ (in the economics meaning of that term, an overcharge basically) that was going to the workers. Now if the new management cuts wages to market, it’s going to shareholders. Just a transfer they argue, not an efficiency increase. Like I said, that’s to some degree obvious: if it was indefinitely sustainable to pay workers more than the market value of their labor but management stops doing so, that ‘rent’ is taken from the workers and transferred to the shareholders. But IMO the paper tends to ignore the normal implication of a rent, ie. that in the long run it would be arbitraged out anyway, IOW again for a firm like an airline under deregulation of a steel tube company in a globalizing market, the implicit assumption the workers could otherwise indefinitely have reaped that rent, of being paid more than market, is questionable.
Although, again the paper further theorizes cases where asymmetry of information results in a net loss all around. Eg. to put in more current numbers, say an airline’s flight attendants earn $30 and the market value of the work (going rate at lower cost competitor) is $20. But the flight attendants don’t realize their work is only worth $20 and $30 includes a ‘rent’ of $10. So they refuse a cut and all get fired. The airline hires new people at $20 but their lack of institutional knowledge and memory makes their work at least for a while, only worth $15. Meanwhile the fired people get new jobs being paid $15. Everybody loses.
One can posit all kinds of ways that trying to turn around troubled companies can backfire (anecdotes of workers aside, takeovers seldom happen at companies which are highly profitable leaders in their markets, the general insistence is usually ‘everything was going OK’, but the market generally disagreed even with that). But the paper really is talking about a different issue than the thread mainly. How to look at it with takeovers increase the value, not how ‘raiders’ can make money decreasing the value. A narrative of mergers as being about destroying value while making the buying entities rich naturally goes down a lot smoother than the more complicated reality, I suppose.
Also there remains in IMO the very big difference between showing negative or even inefficient outcomes of markets and showing that a system of collective dictat would work better (though for some corners of the economy it might, not impossible, but must be shown in my view: market imperfections themselves don’t justify collectively directed economic outcomes).
and 3. are purely political. If you want to say I asked for it, I guess OK, but IMO a lot of the posts in the thread are based on what people remember from the attempt to tar Romney. Some contradict others.
This is of more substance but again it brings in an issue which actually cuts in a different direction. Taking companies private aiming to increase their value and take them public again at a profit, if a problem, is not at all similar to the problem supposedly caused by index investors (not caring which specific firms in an industry group are run better than others, or particularly wanting them to compete hard).
The private equity owner’s position is basically the opposite. Very likely the whole buyout entity, and absolutely the people in charge of that purchase only care about raising the market value of that company. That coin has other sides as in the discussion of Summers et al’s old paper, again the basic point of which is that not all such value gains reflect efficiency gains. Some are transfers to shareholders from employees, suppliers etc. Which again IMO is pretty much obvious. But definitely not the same supposed evil as index investors’ effect, almost a three bears kind of thing. Index investors (supposedly) don’t care enough about making particular companies more competitive. Here it’s claimed private equity cares too much. So who is just right? What makes anyone think they can pull outside levers at no cost to shift things to ‘right’? This is what I am most profoundly skeptical of.
Also private equity is hard to rationally shoehorn into the supposed big problem of ‘short termism’. Their horizon isn’t decades, what market force’s horizon actually is? But it’s not quarter to quarter as public companies are accused of looking due to market reaction to quarterly earnings, or second to second in the trading day like stock traders (an observation highly subject to connection with the actual behavior company managers, a connection seldom given). It’s at least a few years typically. So the ‘compared to what?’ problem, and inability to assess costs of alternatives (by somehow forcing ‘just right’ by govt action) and really none are given except by the vaguest inference*.
Again as final note, the issue of large institutional investors potential anti-competitive influence is a pretty much completely different concern than one about private equity. And I am not convinced it isn’t overhyped. But in general my target for reform of markets would be looking at ways monopolism has crept back in, so I wouldn’t necessarily disregard the impact of institutional investor ownership patterns, as frankly I kind of do the complaints about private equity where people can’t show violations of current laws.
*often nostalgic, well the way it used to work…but look for example at the market value of the US stock market compared to what it used to be and as a % of the world’s (much higher than it used to be). Any market valuation can be second guessed, but if political judgment completely replaces value as a measure, that’s a path to disaster. As in Summers’ paper, an increase in company value may have at least a partial social offset somewhere else. But you can’t ignore market value, which you kind of have to in order to say the US corporate system is fundamentally dysfunctional.
It’s interesting to consider that Sears, TRU, and PetSmart were all denounced by many people as category-killers that wrecked small businesses on their way up. TRU was still doing well enough to swallow the beloved FAO Schwarz several years after the Bain takeover.
And while the debt overhang didn’t help, they were likely doomed anyway. Amazon, Wal-Mart, and Target are killing all of the toy stores and low-end department stores.
This is very naive. Keep in mind bankers are not loaning out their own personal money. They are loaning out other people’s money.
The big S&L scandal of the late 1980s had many, many examples of this. Some of the bad loans were just stupid mistakes based on the belief that real estate prices would keep rising. But many were buddy deals. You loaned a pal a large amount of money to buy some property at highly overvalued prices. Gets a bonus for making such a big loan. The pal would take the money and award big salaries and bonuses to himself and his execs at his company. Not paying back the loan. The bank forecloses. It’s win-win for the execs involved.
This wasn’t a rare problem. 1,043 out of the 3,234 S&L’s in the country went under.
You know how many S&L’s had to be bailed out by the FSLIC before Reagan?
Two.
Things changed in the 80s when it came to business (and government) ethics.
The S&L industry died because its asset portfolio was fixed, long-term, and low-rate, but its liabilities suddenly became volatile and high-rate with the oil embargo and the end of the gold standard. Its problems were structural, and it was doomed.
Arab Oil Embargo: 1973.
Nixon taking the US off the gold standard: 1971.
S&L Crisis began: 1986.
Maybe you want to revise your thinking there, okay?
What actually happened just before this that took S&L failures from an extreme rarity to dozens folding a week? Couldn’t possibly be the deregulation that allowed people to loot them, could it? Nah.
One, of many, many examples of the political side of this was The Keating Five. All five of whom promptly left office never to be seen again. Oops, looks like one is still in office!
Again, read “Barbarians at the Gate”. The management concluded the company had been run historically to not report huge profits. RJR spent money on private jets, they hired celebrities to to play golf with clients for big money, and so on. Plus, it was discounted as a tobacco stock since tobacco was gaining a bad reputation by the 9180’s. The inside management team figured they could take it private at $56 a share and collect sweet dividends. (In the end, bidding went up to $108.)
They weren’t planning to loot and scuttle - rather, they were going to pay themselves massive dividends instead of running the company lax and easy. But like most privatization deals, the plan was to pay themselves first like Rich Dad.
“Dick Smith” was a very well known brand name and a respected company here in Aus.
The deal was that the new owners took all the money out of the company (easy to do, since they were the owners). Then listed the company and sold all the stock on the market. To suckers. The suckers bought stock based on the reputation and value of the old company, and on the representation that the new company was so well managed that it could handle the massive debt by somehow massively increased profits. But it wasn’t true. The company was broke, went bust, and closed.
So the “re-organisers” paid to buy the company, took out of the company, sold the company for $$, and wound up with a profit of $ + $$ - $ = $$. Original owner got $, final owners paid $$ and got nothing.
In tech stocks, I’ve seen some really weird examples of irrational valuation. (Which would in turn could lead to various strange buyouts.)
E.g., Palm (the old PDA maker) was at one time a subsidiary of 3Com. 3Com owned most of the stock of Palm but some was public. The market value of its Palm shares (the stock price multiplied by number of shares) was higher than the market value of 3Com. I.e., simplistic math told you that the rest of 3Com had a negative value, which was absurd.
Similarly, Seagate once mostly owned a backup software company and that piece was valued more than all of Seagate itself.
And these weren’t secrets. The oddities were discussed in online tech publications which is where I heard about them.
Too many people think markets are rational. Not remotely.
So oddly valued companies will draw the attention of takeover artists of all sorts of flavors. Including the gut and dump kind.
Companies sometimes have irrational valuations but this isn’t enough information to judge whether these are good examples. Just realize that any business can have a negative value if it manages to accumulate more debt than its business comes to be worth. Imagine, for example, that my company owns $150 million in Tokyo real estate. I borrow $200 million to build a hotel elsewhere in Japan. I spend half the money on land and I spend half of it constructing the hotel. But, the day before I am supposed to open the new hotel, it is completely destroyed by a tsunami. I have no insurance. The land is still worth $100 million but I have lost $100 million on the building. So, now I have land worth $100 million, Tokyo real estate worth $150 million, and debts of $200 million. The whole company is worth $50 million, even though my Tokyo real estate portfolio is worth $150 million all by itself.
Similarly, 3Com’s investment in Palm may have been rationally worth more than the value of the whole of 3Com if, for example, the rest of 3Com was a horrible money-losing business with billions of dollars of debt and no hope of recovery. If the Palm subsidiary wasn’t saddled with that debt and was otherwise a promising business, 3Com’s investment in it could easily be worth more than the rest of 3Com. This kind of thing actually happens frequently. Yahoo is a great example. How Jerry Yang Killed Yahoo, By Saving It
Let’s say I loan you $1,000. I would not be cool with you moving that debt to Susan the bag lady and then shrugging your shoulders and pointing to Susan when I asked for repayment.
I know companies are different than people but still…
If I loan Bain Capital $100 million to buy Widget Co. I consider the debt to be held by Bain Capital and not Widget Co. I do not understand how Bain can just shove the debt off on to Widget Co. and then tell me to go pound sand when I ask for repayment of the debt pointing to, now bankrupt, Widget Co. as the holders of the debt.
They can’t for exactly the reasons you explain with your bag lady example. The easiest way to accomplish that objective is getting Widget Co. to borrow $100 million and then use the money to pay a dividend to Bain. Bain uses the dividend it receives to repay its loan. Bain is now debt-free and Widget Co. is now $100 million in debt.
The operative part is that the lenders have chosen to lend money to Widget Co. and the lenders expect Widget Co. to repay the debt. If Widget Co. is a bigger financial risk than Bain, Widget Co. will pay a higher interest rate for its new loan.
He was correct about the business model being broke but wrong about the precipitating event. In order to stop the inflation of the 1970’s the Federal Reserve significantly raised interest rates. They had been as low as 4.66% in 1976 and then spiked to 19% in 1981. They stayed high for almost 5 years. Loaning money at 5% and borrowing it at 10% is a great way to lose a huge amount of money so the only way for S&Ls to survive is to chase returns with risky investments which is what they did. Many of those risks did not pan out and one third of them went under.
You see this ALL the time in the business world. Companies tend to get really stuck on just what their business is or what services they provide, and often don’t see the forest for the trees. Often these companies double down on whatever their historical business is, thinking that if they dominate that, they’ll be successful, when in fact they should probably be doing something else entirely. An example would be Blockbuster; instead of trying to be a better physical video rental place, they should have led the charge on streaming video rentals. Or Kodak; they should have realized that film was dying a quick death, and moved into digital cameras/photography with everything they had. Or moved into something else entirely… digital photography has relatively low barriers to entry- look at how many phones and what-not have cameras on them.