Last year, a group of progressive nonprofits reported that of the 14 largest retail bankruptcies since 2012, 10 had involved companies owned by private equity. The thud of corporate failures has become so constant that it’s essentially become a meme in the financial press.
…Private equity investors have a reputation for being corporate looters that buy and pillage businesses for profit before moving on to raid the next unsuspecting office park. Sometimes, it’s undeserved. But often, it’s entirely earned.
…They’re often criticized for laying off workers and even cutting pay in the name of improving efficiency. But the much bigger problem is that they sometimes cripple previously functioning businesses by loading them up with unsustainable amounts of debt. They do this in a few ways.
First, the industry revolves around deals known as leveraged buyouts, where investors put up a small amount of their own money to purchase a company and borrow the rest. The business being acquired then becomes responsible for paying the debt, which increases its risk of going bust. Private equity shops are also notorious for extracting cash using “dividend recapitalizations,” a charming tactic in which they force companies to borrow even more money and use it to pay investors. Beyond that, they often charge the businesses they own millions in management fees.
Thanks to all of these tactics, private equity can often make money off a company even if its business fails.
… Sometimes, firms just dial up investment in the businesses they acquire and try to expand them. Recent research has shown, for instance, that consumer product companies that get bought out tend to increase their sales by jumping into new product lines and markets.
…Economists debate how often private equity deals actually end with businesses filing for bankruptcy, but one recent paper looking at public companies taken private pegged it at 20 percent, compared with just 2 percent for similar businesses that weren’t targeted for buyouts. Sometimes, even well-intentioned deals devolve into the high-finance version of shoplifting. When Sterling Investment Partners bought out Fairway in 2007, it intended to turn the local, family-owned chain into a national brand. But it badly botched the effort, in part because it picked terrible locations for expansion and loaded it with debt in the process. Eventually, it resorted to taking the unsteady company public and extracting a giant dividend payment in the process. A few years later, Fairway would enter bankruptcy.
…Take Toys R Us, which ended up shouldering billions of dollars in new debt after it was poached by a group including KKR. The company was stuck paying hundreds of millions every year toward interest, which insiders say made it impossible to invest properly in the business and compete as Jeff Bezos’ kraken devoured the toy business.
… for the most part, mixing private equity and troubled industries like retail seems to be a recipe for trouble. (For another sad example of what happens when private equity shops invade a sector with a fundamentally dying business model, see metro journalism.)
…Private equity has boomed over the past couple of decades in large part because borrowing has been incredibly inexpensive. More deals are inevitably going to lead to more disasters. But free-flowing credit may also be encouraging the industry’s worst habits.