Monday, December 26, 2016

Is Private Equity Evil?

Is private equity evil?

The New York Times has been running a series of articles decrying the excesses of private equity and arguing that somehow private equity is inherently evil and a detriment to our society.  While it may be true that some private equity firms may have engaged in nefarious dealings, that is not what the New York Times is talking about.  According to the New York Times, merely making money using private equity is evil in and of itself.

What is private equity, anyway?   In order to understand the issue, you need to understand what the terms mean.  Public equity you are probably more familiar with, is this represents the publicly traded companies on the New York Stock Exchange the NASDAQ and so forth. People get together and buy stock and form a company which raises capital to build factories or make other investments which hopefully generate a return on the capital.
Well, that was the theory anyway.  In this modern "dot com" world, people offer stock not to raise capital to build a company, but to create a vehicle to allow them to cash out of their formerly privately held companies.  And just as some private-equity firms have done nefarious things, many publicly held companies have been guilty of equally bad, if not more horrific things in the past. Dumping toxic gas in rural India and killing thousands, for example as Union Carbide did back in the 1980s.  Public equity is no less culpable than private equity, which is one reason this series of articles in the New York Times is just ridiculous rabble-rousing nonsense.

Private equity, as the name implies, is money that is held and invested by private individuals and not through publicly traded stock. This could comprise family-owned companies like the Chamberlain garage door company or the the S.C. Johnson Company, or private equity firms which accept investments from individuals and then manages those Investments.  Private equity even includes local mom-and-pop owned stores and the like.  As you can see, there's nothing inherently evil in private equity.

Private equity has many advantages over public equity in terms of how they can invest and manage their investments.  Publicly traded companies have to publish their balance sheets every year (or even quarterly) and thus make available to the public everything they do. This makes it harder to make strategic investments as everyone is aware of what you are attempting to invest in or do.

The biggest problem with public equity is the obsession with stock price.  As I've noted time again at this blog, small investors are obsessed with stock price and rarely give a thought to price to earnings ratio or dividend payments.  All of the financial channels and financial pages obsess about stock price above anything else, is if it was the only form of return from an investment.

High level managers of many publicly traded companies are paid in terms of stock options. Thus, for example if you are the President of a company and given an option to buy the company stock for $10 a share, it is in your best interest to drive the stock price up as far as possible. If you can drive the stock price up to $20 a share, you can literally double your money overnight by exercising your option.

The problem with this model, is that it encourages managers to look at short-term gains and not long-term gains. When you incentivize managers to pump up the stock price, they will do exactly that, even if it means in the long-term the company may suffer. Stock price is not the only indicia of a company's success, and if you incentivize people to maximize stock price, it can produce skewed results.

Thus, public equity in many ways can be worse than private equity, not only in terms of bad things that publicly traded companies do, but how the finances of publicly traded companies can be manipulated.  Many small investors have lost their shirt buying stocks in publicly traded companies only to find out that the stock price has been a manipulated through some sort of scheme. Remember that Enron was a publicly traded company.  Still sure private equity is inherently evil?

Private equity firms have some advantages in the marketplace in that they can look at long-term gains and profits, versus short-term stock price spikes. Since they don't have to answer to shareholders or disclose their finances to the public, they can operate with more freedom. They can also choose to take larger risks, which can result in far greater rewards.  Private equity firms are often the only investor is willing to touch very risky and toxic assets.

The New York Times uses several examples of how private Equity firms have invested in various industries, and decries these as somehow being inherently evil merely because the people involved made an astonishing amount of money in a short period of time.  However in most cases, publicly traded companies or government agencies would not have touched these investments with a ten-foot pole, as they were too risky and too toxic.

The Hostess company, manufacturer of Twinkies was one of their early examples.  As you now well know, the Hostess company went bankrupt, actually twice, in the last few years. The structure of the Hostess company was very similar to other large corporations I worked for in the past, such as General Motors or United Technologies. General Motors use a "vertical integration" system to manufacture every part of the automobile other than the tires and the gasoline in the fuel tank.

This vertical integration model take advantage of economies of scale on which made a big difference back in the 1930s and 1940s.  Being able to beat their competitors in the market meant that they had to keep their costs as low as possible.  However, by the 1960s, this model started to fall apart.

Again, it is tempting to say this was a union problem - and the unions were certainly were a big part of the problem - but it was also a management and shareholder problem.  As I have noted before in this blog, when a large company moves to town, everybody sees what kind of taste they can get from the enterprise. The unions want higher wages and especially union dues from their members. Management wants big salaries and to hang on until they can retire with their cushy pensions. The shareholders one huge dividends and big increases in share prices. The state, county, and local governments all want a taste of those tax dollars.  No one, it seems, really wants the enterprise to succeed in the long-run.

Everybody looks out for their own self-interest, this is human nature.  As a result, the 1960's and 1970's many corporations felt embattled. Local factories were being taxed to death while workers went on strike for even more wages.  Management basically gave up and gave themselves a bonus and settled the strike and pushing off the day of reckoning by offering huge retirement benefits which were never properly funded.  This is public equity at work.

Hostess suffered from a number of such problems. They had a large number of factories in many States making everything from Wonder Bread to Twinkies. They also own their own fleet of trucks and hired their own union drivers who worked exclusively for Hostess delivering the baked goods.  At their height they had over 18,000 employees nationwide.

While that model might have worked well in the 1950s or even the 1960's when the trucking industry was regulated, today if you are running a bakery you don't also want to be running a trucking company.  It is far more efficient and easier to farm out the trucking part of the business to a company which specializes in transport.

Hostess went bankrupt a few years back, and an initial attempt was made to reorganize the company. However union members were not willing to go along with cutting benefits and the new management didn't have the courage to close down factories (again raising the ire of the unions). So Hostess ended up in bankruptcy again

At this point, who would take over such a nightmare?  Public equity companies would not dare take such a risk buying a company with such a poor track record and such entrenched difficulties. The government couldn't - or shouldn't - take over a company like this, as the government is least prepared to operate such an enterprise profitably.  (Although I'm sure he will the New York Times think that would be the best solution for everything).

Enter private equity. They purchased some of the assets of the company in bankruptcy but not all of them. They bought the factories which looked like they could be made profitable, as well as the intellectual property -  the trademarks (brand names).

As a new company, they started out without the debt of the old company or the overhead of a large number of obsolete factories.  They also declined to get involved in the trucking business, instead relying on other companies to deliver their goods to grocery stores and Walmart and the like. This cut the number of employees from 18000 to less than 1800.

But even then, they were still troubles. A plant in Illinois could not be made to operate efficiently and had to be closed and demolished. This was of course, upsetting to the employees involved, as they hoped that the resurgent hostess company would revive their small town. However, investors are not in the business of social engineering, but in building and operating profitable enterprises.  Unprofitable factories cannot be run forever based on goodwill and social engineering.   It's been tried - in England, in the Soviet Union, in Cuba.  It doesn't work.

Now, when I said that the new Hostess would shed of all of its previous debts in bankruptcy, this also included pension obligations to the many laid-off and retired employees. This is where things get sticky. The New York Times posits that it is unfair that these workers, many who spent their lifetime working for Hostess, should lose part of their pensions. (at least a portion is guaranteed by the Pension Benefit Guaranty Corporation) while private Equity managers take-home pay checks in the hundreds of millions of dollars.

And if you looked at the pre-bankruptcy hostess and the post-bankruptcy hostess as being the same company, then perhaps this argument makes sense. However, the new Hostess company is a privately held company which comprises purchased assets bought in bankruptcy.  This is not some new-fangled financial strategy or legal paradigm, it is time-honored bankruptcy law.  When you buy your neighbor's tractor at his farm bankruptcy auction, you don't assume the debts of his bankrupt farm.  That's how bankruptcy works.

Indeed, we could not expect the private equity investors to voluntarily assume the pension liability of the company, it any more than we would expect a publicly held company to assume this liability voluntarily.  For a publicly held company, Not only would it be bad business, it would be it would result in a shareholder derivative suit for malfeasance.

But private equity companies merely bought assets in bankruptcy.  They were not the ones to underfund the pension plan for decades in a row. They were not the ones who went on strike for higher wages and expanded pension benefits while at the same time failing to ensure these pension benefits were properly funded. There are a  number of bad actors in this scenario, and private equity is the least culpable of them all.

Think of it this way. You buy a car for $20,000 and it turns out to be a lemon. You go to sell the car and all you can get for it is $10,000 which is a good bargain to the person buying it from you. Naturally, you are upset that you have lost half your money, which is a bad thing. But it is it the fault of the person buying the car from you that you lost this money? Are they morally obligated to pay you $20,000 for your car?  Believe it not, some folks actually think so!

And let me give you two real-world examples to illustrate this analogy.   When I was in college, I was looking for a "parts car" to get parts to repair my pizza delivery car which I had wrecked (not while delivering pizzas, fortunately).   I found one in the "Pennysaver" (the Craigslist of the day, in paper format) for $100.   I went to look at it.  It had been hit in the back and the rear fender was pushed into the rear tire, which was shredded.   I gave the guy $100 and he signed over the title.

"Are you gonna get a tow truck to haul it away?" he asked.  "No, " I replied, "I'll just drive it home."   "But it ain't driveable!" he exclaimed.  He then watched in wonderment when I pried open the trunk, took out the bumper jack (remember those?) and stuck it in the wheel well and started jacking until the wheel well started to spread apart, freeing the shredded tire.   I put the spare tire on (back in the days of full-sized spares!) and then started it up.   "Runs fine," I said.

"Sheeet!" he moaned, "If I'da known you coulda done that, I wouldna sold it!"   And I just replied, "Well, I'll sell it back to you for $200 if you want it - for my labor and expertise and all."  He was not happy.   I drove the car for a couple of months and then took it apart to repair the remains of my other car, building a welded-together frankencar.

The point is, I saw opportunity where other people saw disaster.   He thought the car was "totaled" and could only be moved with a tow truck.  I saw a car that could be made to run with little effort and had some residual parts value.   Not only did I use the parts (doors, etc) to rebuild my old car, I sold over $150 in parts off the car, which offset my purchase price.

Now multiply this times a million or a billion and you have private equity.

Or take one of my foreclosure purchases.   We bought a duplex that the previous owner walked away from.   He had mortgaged it for $140,000 to pay for remodeling, and then realized, when the market tanked, that he owed more money on the house than it was worth.   At the same time, he came into an inheritance of another house (his Father's) so he made the strategic (in his mind) decision to walk away from the mortgage on the duplex and move into his Father's house.

He saw no value in this duplex, which he thought would never be worth what he had invested in it.  I bought it for $95,000, completed the renovation he had started, and rented it out at a modest profit.   A decade later, we sold it for nearly $300,000.  Does this make me "evil" for seeing value where others saw only unrecoverable losses?   Do I owe the guy who lost the house part of the profits from selling it?   Bear in mind that when I bought it, I though that maybe a decade later I might make enough money to buy a car - the market going berserk never entered my mind.   I used private capital (much of it borrowed) to invest in an undervalued asset and turned it around.

And if this is evil because it is private equity, is public equity just as evil?   Bear in mind that Warren Buffet uses public equity in the form of his Berkshire Hathaway Corporation (of which I am a Class-B shareholder) to buy undervalued companies and then turn them around.  Is he "evil" for seeing value where others see only losses?   For seeing profit where others only fear?

In a way it's the same kind of deal with Hostess and "private equity" - a term which in and of itself sounds scary, particularly the way the New York Times uses it. Private equity purchased some of the assets of Hostess bankruptcy. The people who lost these assets, the shareholders the bondholders, and the pensioners, got a raw deal. But you can't expect the purchaser of the assets in bankruptcy to pay more than market value for them or indeed assume liabilities they are nor liable for merely to make things "fair".

Unfortunately, this Hostess situation illustrates the problem with the defined-benefit pensions, and how defined-benefit pensions are bankrupting corporations across America as well as local and State governments. So long as a company is growing in market size and number of employees, a defined benefit pension scheme mightl work - much as a Ponzi scheme continues to work so long as people continue to invest in it.

The problem we had at General Motors - and with  most American companies - is that we were losing market share and moreover as our plants became more automated, required fewer and fewer employees. Promises made back in the 1960s to employees for pensions we're not fully funded and when these employees retired in the 1980s and 1990s and onward, there wasn't enough money to pay them. Compounding this wass the increased life expectancy of these retirees as well as the increased medical costs.

The beef the New York Times has with the entire situation is that these investors who bought the wreckage of the company in bankruptcy made millions while the pensioners lost tens of thousands each and the employees were out of a job.   This would indeed be an outrage if there was some causal connection between the profits of private equity and the pain of the employees.

And in some instances, there is.   Bain Capital - Mitt Romney's firm - used to buy companies that were not in bankruptcy and then spin off divisions loaded up with the company's debt, including pension debt.   These companies were designed to fail and take out the pensioners.  They would then repackage the remainder and sell the company on the open market - as public equity - and walk away with huge profits.   It is one thing to buy a company's assets in bankruptcy, when you are not obligated to take on the company's debt obligations, it is another to buy a company and walk away from debt intentionally.  But again, this is not a crime limited to private equity - publicly traded stock companies do the same sort of thing, and if you don't believe me, watch what happens to Sears in the coming months - and what has been going on over the last few years.

The flip side of the coin is what would have happened if private equity had not bought Hostess?  Well, if there were no buyers for the assets of the company, then everything would be liquidated.  The "intellectual property" (brand names) would be sold off to a competitor, and the factories sold as mere real estate.   Everyone would have lost their jobs and the pensioners would be in the same situation as before - perhaps worse, as the amount realized in bankruptcy would be far less.

And that is the problem with the New York Times article.   They decry "taking a profit" in private equity as somehow inherently evil or wrong, merely because on the flip side of the bankruptcy, other people are losing money.   But what is the alternative?   Regulating how much profit somene can make?   Passing a law that says that people who used to own something should profit when you fix it up and improve it?  That is not a workable solution.

In another part of the series, the New York Times decries private equity for buying up those crappy mortgages that went bust in 2008.   In case you forgot (like most of America at this point) back in the 2000's under the Bush administration, lending practices were loosened to the point that anyone could get a mortgage on anything, paying ridiculous prices for houses on weird loans that made payments "optional" - but reset over time to onerous.

While banks are to blame for offering these screwy loans (and deserve to lose money as a result), it was the home buyers who signed the loan documents - no one put a gun to their heads.   The loans went bust, of course, and even today many people are upside-down on these loans and facing  foreclosure almost a decade later.   I hope our Canadian friends are watching this.   This is not unusual, either.  I was buying foreclosures in 1998 - a full decade after the meltdown of 1989 which of course, never happened as we all know, right?

The New York Times makes it sound awful that the people who bought these loans actually want them paid back and for some weird reason, just don't "forgive" billions of dollars of mortgage debt.   They are actually foreclosing on people who haven't paid their mortgages and that is just so outrageous it should be stopped!

This is the same old tired argument made by the Left over the last decade - that mortgage debt should be forgiven and houses handed out for free to certain people because, well, because it would be fair, right?   But fair to who?  What about the people who made their mortgage payments or bought houses they could actually afford?   What about people who decided to rent instead of buying?   It is fair that we give away free houses to people who make the most irrational and irresponsible financial decisions and then punish those who are fiscally responsible by using their tax dollars to give away free houses to others?

Another supposed outrage which parallels the mortgage crises is how private equity firms are buying up public utilities such as water works and sewage treatment plants.   Again, these firms didn't put a gun to the head of local municipalities and force them to sign over ownership rights.  Rather, these municipalities recognized that they had mismanaged their public utilities for decades and could no longer operate them.  Piping repairs were deferred or ignored in favor of paying public (union) employees more and more - as well as promising hefty pensions.   Taxpayers "revolted" rather than pay more taxes or higher water bills.  Eventually the piper had to be paid and the New York Times wants to make it out like private equity is somehow to blame for a New Jersey town neglecting its water pipes.

But the ultimate irony that the series in the New York Times fails to realize is that private equity firms rarely keep assets for the long haul.  Like an antique dealer, they buy a "diamond in the rough" at a junk shop, polish it up and wax it, and the put it on display in their antique shop, doubling or tripling their money.   Private equity firms usually try to "spin off" their acquisitions as Initial Public Offerings (IPOs) in new stock companies - public equity.   And again, no one is putting a gun to anyone's head and forcing them to buy the stock, which may or may not be a good deal.

It is not clear from the New York Times series where they are going with this.   Are they saying that private equity should be outlawed?  (good luck with that!)  Or merely heavily regulated (if so, how?).   Or are they just trying to fan the flames of discontent to the drumbeat of "income inequality"?   I think the latter.   We are told that it is bad that some people have more money that us, simply because it is bad.   Never mind that the poorest person in the USA lives like a king compared to world income standards - we should judge our self-worth and the "fairness" of our economic system by comparing the wealthiest to the poorest.

But what does it mean to have all this mega-wealth anyway?   And that is the topic of my next posting.

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