Private equity: vultures, locusts, plundering Anglo-saxons. Private equity buyers buy weak companies, squeeze costs, people and manage hard for cash, and after a few years they sell, making a huge killing and move on to the next victim.

So the story goes, at least so I've heard. It's pretty easy to see some logical problems with these attacks.  Firstly, the new owners buy the company from its existing owners in a free exchange; the sellers sell because it's a better deal than they can get elsewhere. You can only oppose this if you want to interfere with rights of shareholders in choosing who they sell to.

Secondly, the private equity buyer only makes the infamous "huge killing" if it can transform the company into something worth a lot more. Vultures pick the meat off dead animals. Private equity firms buy a run down house, paying above market prices , fix it up nicely, and sell it again. They put down a little of their own money, but borrow the rest, which is just how most people buy houses. Private-equity buyers tend to target companies where they see a renovation opportunity, so the new management makes a lot of changes. Change creates winners and losers. More winners than losers, but there are losers.

What is a private equity buyout?

Private equity means the ownership of the company (the equity) is not traded on a public stock market. Most family owned firms are "private equity", so it nothing new. The headlines are grabbed when public companies become private. This happens when shareholders choose to sell their shares to a new owner, who then "delists" the company from the stock exchange.

Normally, things happen the other way, from private ownership to public ownership.  Companies do this not because it's the law: they do it because most of the time, it is the best way to raise cash for growth. Investing in companies is risky, and banks have for hundreds of years not been interested or able to finance most of the risk. So if private company owners can't borrow the money needed to invest in a new technology or in expansion into new areas, they raise it by selling part of their company (therefore, selling a share of the future profits). The company might flop but it might really take off. Sharemarkets are places that people with ideas and a taste for risk can find people with money and a taste for risk.

So a private equity buyout is not against the rules of nature, but it is a bit odd because it seems like evolution in reverse. It gets even odder when you consider how private equity bids are pieced together.

How does a private equity buyout work?

A private equity buyer needs to get enough money to buy the company from its current owners, its shareholders.

That's sounds simple. In fact, that's how normal takeovers work. What makes private equity deals different is that they are often "highly leveraged".

A typical deal might go like this

  • A private equity buyer offers $10b cash for the shares of Acme Ltd, and the shareholders are delighted with this offer, considering that in the last year, the share price has never been above $8b.
  • To raise the $10b, the private equity buyer contributes $1b and borrows the other $9b.

The second line is interesting.  The $10b buying price is a block of cash transferred to the previous owners. The $10b is made up of $1b of equity (money contributed by the new owners) and $9b of debt. The lenders of the $9b don't own the company, they just lent money and ask for interest (and eventual loan repayment). The 100% owner of the company is the private equity buyer, so for $1b they own something they paid $10b for. Good trick!

If the buyer can double the value of the company to $20b in five years time, it can make a lot of profit from only risking $1b. This high ratio of debt (borrowed money) to equity (own contribution) is why these deals are called "leveraged" buyouts. A lever allows a weak human to lift huge weights; financially, the debt is a lever allowing $1b of money to buy a $10b company. The concept is not so different to buying a house. Usually, you make a small contribution of your own money, borrow the rest from the bank, and you as the owner get the full benefit of price increases in the value of the house, even when you only contributed only 20% of the purchase price.

So it seems that the previous shareholders are happy (they accepted the offer, presumably because it was a higher price than any counteroffers, and they walk away with hard cash). The private equity firm is happy; they just gave themselves a chance to make a lot of money.

The party that looks silly is the lending party. They have taken a lot of risk, it seems, while allowing the benefits to go the private equity buyer. But this is always the way with lenders. This is simply the deal a lender signs up for. 

The lenders get some protection. The company has some assets (machinery, investments, payments due from customers, patents...) and if it all goes wrong, the lenders are ahead of the private equity owner in the queue for compensation.  But the real reason is that private equity buyer promised to pay a good rate of interest, and because the private equity buyer has a good reputation and good plan for being able to pay the interest and repay the loans. The good plan usually involves keeping good senior management and staff from before, adding in some expert managers from the private equity firm, some new discipline over cash management, and some plans to make the company attractive to sell in 5 years time. This can include selling some parts of the company, but it can also mean buying other companies. The lenders go into this with their eyes open. Often the lenders are not banks but investors who buy bonds, and time after time, these bond sales to finance private equity deals have little trouble finding investors.

But all that debt does change the way the company must be managed, and now we are getting to the crux of the matter. Paying the interest on this huge loan requires the company not just to make "profit", but to make good hard cash, lots of it, and to make the cash quickly and regularly. The ability to generate cash is essential to private equity. And this is where the controversy comes in. People who are opposed to highly leveraged deals say that a normal, public company is not under such huge pressure to generate large amounts of cash in the short term. The change to leveraged private equity ownership will mean the firm is under a lot more pressure to "pay the rent" each month. R&D programs may be cut. Jobs will go, most likely. Some parts of the firm may be sold to raise cash.  

Vultures, locusts, a plague, Anglo-Saxon plunderers and rapists ...

So you can see what private equity buyers are sometimes called "vultures": they risk only a small amount of their own money, they put the company under huge cash pressure, they sell bits of the company, they crack down on employment and expenses, they cut spending on R&D, and then they sell the firm and make a huge profit due to the high leverage.

But there is one crucial things to consider.

  • The eventual resale of the company

The one and only way the deal makes really good sense to the private equity firm is to sell the company for a lot more than they paid for it. They paid more than anyone else thought the company was worth, so they need to really improve the value of the company to get anything out of it. Really, it seems obvious that the private equity buyer is completely dedicated to adding value to the company. This might be bad news for R&D programs which are not going to pay off, but it is good news for R&D programs that make sense. And while some part of the company might be sold, other smaller companies may be acquired. 


Managing for cash is bad for the company, its workers and society ...

Clearly, private equity buyers want to sell the company for much more than they paid for it. They can't use hypnotism on potential buyers: they need to genuinely convince the market that the company has been transformed. So you should at least be skpetical of claims that private equity destroys companies. 

However, the pressure to generate cash can transform companies. The companies that are most transformed by this are companies which have been managing cash badly. Such companies are attractive to private equity firms, because just like some people know how to transform houses with leaking walls without spending much money, private equity firms are specialists in getting cash from badly maintained companies. Companies which already manage cash well are not very attractive targets. So almost by definition, private equity targets are companies which will go through a lot of change under the new ownership.

There is nothing wrong with generating cash. All basic finance books define the value of a company by its cash flows. The cash is paid to the financiers of the firm: the shareholders, and the lenders. In practice, shareholders expect their investment to pay in two ways: they expect some dividend payment, but also they expect the price of the shares to increase. A dividend is a transfer of cash to the shareholder, but share market prices increases are only paper increases of value. The theory says that if the share price goes up despite the company not paying out much cash to shareholders, it is because the market expects future cash payments.

A lender however does not have a share that can increase in value. A lender's only return is the regular interest payment, which is a cash transfer. When 90% of the finance comes from lenders, these regular payments become huge. 

Some people complain about this. Do they have a right to complain? At first glance, no. The lenders accept the situation, and the owners of the company accept the situation, and they made the deal. But people who work for the company get nervous. They feel that the need to make regular large cash payments is a big threat to the viability of the firm. In my experience, this is a reaction to change. If the company has the potential to make more cash, sooner or later the owners of the company will demand that it happens. If current management fails to deliver, then via a takeover new management will state to the market that they can do a better job, and they prove it by paying above market prices for the shares. 

The ultimate test of management

Shareholders trust management to make the most of the company. But in life, sometimes you need to call the police, and so also in capitalism. Sometimes, managers don't work hard enough, or they are not smart enough. Shareholders need a way of taking back control of the situation. They can elect a new board, but that takes time, or they can sell their shares to a new management team. For shareholders this is very clean: the new owners make a promise they can do a better job, and they put their money where their mouth is. Private equity buyouts are one way this can happen. They actually apply under only special circumstances: when it is cheap to borrow money (low interest rates), and when the target company can substantially improve its cash makings. For the employees of the firm caught up in this, it may mean a loss of job security, long hours and a short term focus. But sooenr or later, the owners of the company will demand change one way or another, and there should be some assurance that the new owners want to make substantial improvements and find a new owner in a few years. And the fact that they could borrow so much money means they are good at doing this.