Sunday, July 29

Week 56 - What is Private Equity and Why Has It Become a Political Football?

Situation: Back in the day, the division of an Investment Bank that bought companies for a client was referred to as “Acquisitions.” Likewise, the division responsible for subsuming a newly purchased company into another company was called “Mergers.” Then, in the 1980s, we had Investment Banks that performed “leveraged buyouts” by using lots of borrowed money to accelerate the process. That fell into disfavor and has given way to a new nomenclature, “Private Equity,” where private investors take a company out of the public sector (its stock is no longer traded on an exchange) and into the private sector. Indeed, there no longer are any Investment Banks. The last two (Morgan Stanley and Goldman Sachs) converted their charters in 2008/09 to become government-regulated commercial banks.

The truth is that Private Equity does exactly what it says: Private investors buy up all the exchange-traded stock of a struggling public company, which removes that company from SEC (Securities & Exchange Commission) regulation. The purchased company no longer produces quarterly/annual reports, and the investing public no longer has access to its balance sheets, income statements, and statements of cash flows. Then a new management team tries to turn the company around by using its last remaining ammunition (cash flow) and adding lots of newly borrowed cash. If the company’s existing Business Plan is no longer considered viable, it is summarily terminated to make way for innovation, asset sales, and layoffs (“right-sizing”). The purpose of these drastic changes is to restore profits while preserving as many jobs as possible. This process was labeled “creative destruction” in a 1942 book by the late Joseph Schumpeter (1983-1950), the famous Harvard economist. While that excellent book is abstract theory, there is a new book that reveals the living, speaking faces of people who “creatively destroy” a plant and its equipment: “Punching Out: One Year in a Closing Auto Plant” by Paul Clemens (2012, ISBN: 978-0-385-52115-4). We recommend it.

Creative destruction is the ugly part of the story. The pretty part is that the new managers have the advantage of a fresh start, better pay, and more money to spend. The new managers are really no smarter than the old managers (who knew the company and its workers better), and given enough guts, focus, vision, innovation, and borrowed money, most of the original managers and workers probably could have kept their jobs--at least in theory. But does that ever actually happen? Rarely. Check out Ford Motor Company, which did accomplish it. In 2005, Chairman Bill Ford asked the Americas Division President (Mark Fields) to come up with a plan for downsizing and innovation. Mark Fields’ proposal, The Way Forward, was accepted by the Board of Directors in January of 2006. (It looked to be right out of the Private Equity toolkit.) In September of 2006, a new CEO, Alan Mulally, was brought in to execute the plan. He started everything rolling in a BIG way by mortgaging the entire company for $25B. He even mortgaged the logo! The rest is now history. Ford was the only major auto manufacturer that didn’t need a government bailout; it turned a $2.7B profit in 2009 and its retiree health benefit plan was fully funded by the end of 2010. Ford (F) now pays a 2.1% dividend (15% of estimated net income) and has an S&P credit rating of BB+.

Private Equity comes into play when the internal cash flow of a public company is no longer sufficient to maintain its property, plant, and equipment at a competitive level (let alone meet its payroll). The distressed company is said to be “burning cash”. Its stock and bond holders are giving up and selling out at a loss. The company is on the verge of declaring bankruptcy. In this scenario, Private Equity represents its last chance to survive. So, Private Equity is about securing a big loan to a) buy the company and b) make improvements in the company’s cash flow with the hope of taking it public in the future. The new management team often pays itself premium salaries because attractive compensation is thought to incentivize performance, and because they could soon be out of work in spite of their best efforts. (Remember what happened when Cerberus Capital Management took Chrysler private in 2007?) Officers of the newly reconstituted company also enjoy the advantage of less “friction”. For example, there are no time-consuming (and labor intensive) Sarbanes-Oxley reports to file. Nothing magical has been added to the mechanism for making the company’s new Business Plan effective but the glue & sand have been removed from the working gears and levers. How does that work? It works because borrowed money is used to tide the company over while new management fixes problems that had been obvious to old management for some time.

Private Equity was an opaque backwater of finance until the current political season turned “Bain” into a household word. Editorial coloration around that word has often shifted to the red end of the spectrum, suggesting that Bain Capital is doing The Devil’s Work. But the CEO of another finance company has suggested that Private Equity is “doing God’s Work.” Wherein does the truth lie? You’ll have to decide for yourself.

Bottom Line: There is nothing magical about Private Equity. Think of it as extra dollars being deployed by good managers who are trying to save a company by using an innovative new business plan (combined with the sale of outmoded assets), free from prying eyes looking to “see how the sausage is made.” It’s basically the same as Public Equity (where the success rate is about the same if you include government bailouts) but needed changes happen more quickly and quietly. This is something which pleases private investors and makes financing easier to obtain for companies in trouble. Private Equity has now become a political football because 
   a) layoffs happen faster and are often permanent,
   b) the new managers are paid well whether or not they save the company, and
   c) it happens outside the public sphere and SEC regulation.

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