Private Equity Explained: Are the “Barbarians” Really at the Gate?
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Certain quarters of the press have recently reported concerns with private equity (PE) firms. Louise Matsakis wrote in Wired about “the devastating impacts of one of the most powerful yet poorly understood forces in modern American capitalism. Flush with cash, largely unregulated, and relentlessly focused on profit, private equity firms have quietly reshaped the US economy, taking over large chunks of industries ranging from health care to retail, often leaving financial ruin in their wake.”
This is an odd statement; every firm would like to be flush with cash, and every firm ought to be relentlessly focused on profits or it will cease to exist. Personally, I truly wish there was some aspect of the American economy that was largely unregulated. Finance is one of the more regulated parts of the American economy. However, private equity has caused a recent stir, and it is proper to take a deeper look.
What Is Private Equity?
Private equity firms are investment firms. They look for underperforming businesses to buy, reorganize, and (hopefully) bring to profitability. PE firms take their acquisitions private to have more flexibility in how they reorganize; therefore, they do avoid some financial regulations, but it is a stretch to call them unregulated.
It is not unlike some of Warren Buffett’s activities with Berkshire Hathaway. There are important differences, many due to Buffett and his late partner Charlie Munger’s personal style and investment approach. But the bottom line is Buffett buys firms and sometimes replaces the management, just like PE firms. However, Buffett is brilliant, successful, folksy, and a legend, so he tends to be left out of these sorts of criticisms.
Despite recent press, private equity is not new. There is some disagreement among business historians, but it can be argued the first private equity transaction was J.P. Morgan’s purchase of U.S. Steel in 1901. And a form of private equity, venture capitalists (VC), has been around a long time too and is praised, celebrated, and featured on the popular show Shark Tank. The main distinction between VC and PE is that VC investors usually do not take a management position; PE does.
Should We Be Concerned?
Yes and no.
There are journalists concerned about PE firms taking over everything from hospitals to bowling alleys. But are these concerns well-founded? PE firms only profit if their investments are profitable; if a firm is failing and opportunities exist for improvement, new investment and better management should be welcomed. But making a firm efficient often means layoffs and selling assets, actions that cause real pain. And some critics seem upset that PE management alters the nature and culture of the firms. None of this should be ignored, but what should also not be overlooked is that the firm was probably going bankrupt and everyone was in jeopardy, and the pain comes from undoing what should never have been done in the first place.
But the actions of some PE firms do lead to consolidation within industries, and that can result in monopoly-like behavior, such as declining quality enabled by less competition and driven by the need to cut costs and the desire for quick profits. But this is not unique to PE firms; management of any sort can take this approach, and it can yield poor results (Buffett is a long-term investor). Such an approach can result in some small towns being disproportionately impacted, towns that may already be reeling for other economic reasons.
An example of all of this comes from possibly the most famous private equity action of all time. Kohlberg Kravis Roberts (KKR) bought RJR/Nabisco in 1988 for $25 billion. The episode was chronicled in a book by Bryan Burrough and John Helyar called Barbarians at the Gate, which was turned into a movie of the same name starring the late James Garner. It was a classic PE play at all levels; RJR/Nabisco was definitely underperforming, and several groups showed interest in buying the firm, including a group led by the then-CEO Ross Johnson. KKR was not the highest bidder but was viewed as the most reliable bidder by the board, offering $109 a share (almost a doubling per share from when the bidding war started), with a leveraged buyout (LBO), meaning KKR borrowed the purchase funds against the firm’s assets. It raised all sorts of concerns in the media about the LBO “craze” going too far.
Part of the inefficiency was that the firm was too large and had lost its focus; it produced cigarettes, snack foods, canned fruit, soy sauce, and packaged food, owned 20% of ESPN, and much more. KKR sold off many of these properties, reorganized the company, and took it public again three years later. But, in the process, 2,000 people lost their jobs, and the standard conclusion is that no one but the selling shareholders really made any money from it once the debts were paid. In many ways, it was much activity with very little result; RJR, Nabisco, and KKR still exist as separate companies.
Conclusion
Like anything, there is good and bad with private equity. A poorly managed, inefficient firm should face competition; just the possibility of replacing management and being reorganized can keep some firms on the straight and narrow, focused on serving customers as efficiently as possible. However, there is nothing inherently superior about PE firms; they are run by humans with their own strengths and weaknesses, and some may well be barbarians and undertake actions that create private benefits at the expense of the firm and ultimately the customers. It is fun to have all the perks of senior management even if you are not very good at the management part. Fortunately, markets tend to punish poor management and wasted resources. A poorly run private equity firm faces at least two kinds of competition: investors will stop investing with them, and other private equity firms will outperform them. Throughout history, the solution for poor performance in the market has been competitive pressure and creatively talented entrepreneurs always looking for opportunities. Business barbarians, whether they run large corporations or the local bowling alley, frequently meet their match in the entrepreneur.
