Back in February I wrote a three-part series of posts about the abuses perpetrated by private equity (PE) takeovers of American businesses and their manipulation of the U.S. tax code for bad ends. A recent article in the Boston Globe by Evan Horowitz [1] describes how the shine is coming off PE investments, a welcome event, but Mr. Horowitz missed a few key points, so this topic bears revisiting.
Horowitz defines the classic theory of PE well as far as it goes:
“It works like this: Find a struggling company rich with future potential; buy it, using equity from investors along with lots of borrowed money; make operational changes (while exploiting the mathematical fact that debt helps amplify returns); then sell the company for a hefty profit and share the bounty with investors.”
Struggling companies?
The problems begin, the author notes, with a larger number of PE investors chasing a declining number of takeover targets, saying, “with so many PE firms on the hunt, bargain bins are empty and deal prices are going up.” Part of the problem here is the definition of “struggling company.” This idea is a myth that can be traced back to Mitt Romney’s Bain Capital, which first started looking at truly struggling companies, but found the grass was much, much greener targeting “cash cows.” Bain and their fellow PE investors have long portrayed these companies as struggling, but many are not. These are instead often just low-growth, low-debt, high cashflow companies that are undervalued in hot equity markets, not so much “struggling” as failing to meet unrealistic expectations of growth.
Cash cows are often prime takeover targets first because they are “out of favor” with investors chasing growth. Second, their cash-heavy earnings stream often puts them at the top of the income tax brackets with few tax shelters. If a PE firm can bring that rate down through “creative tax accounting,” then net after-tax profits go up. And finally, that “cash cow cash” is the very engine that, if “milked” aggressively (sometimes until the cow is dead), will quickly pay back the invested capital, lowering downside risk.
Debt amplifying returns?
In a nice bit of karma, the very unwise tax act of 2017 cut corporate taxes so much that it appears they have killed one of the “golden geese” driving PE. The basic PE model is to invest very little equity and borrow a lot, often through high-risk, high-interest debt. The “cash cow cash” is tapped to pay the debt service and “carried interest,” rather than re-investing in the business, and the former 35% corporate tax rate meant that one million dollars of interest paid generated a whopping $350,000 tax deduction. Not only has the new rate dropped this to deduction to $210,000, but the new pass-through and other tax changes limiting the deductibility of interest have cut this tax game even further for many companies.
In short, one of the primary benefits of debt-based financing, the tax preference, has largely gone away, an unforeseen consequence of the 2017 tax revisions. Those huge interest payments look much bigger when the deduction gets much smaller.
Selling the dead cow
Bain Capital and its partner investors have found that, having milked retail chain Toys R Us dry, they can’t sell off the carcass, even though it remains the major standalone toy seller in the U.S. [2] There should be some business model that makes that market dominance still viable, even in an Amazon-driven market. But the “dead cow” company is still so strapped with debt that a hard bankruptcy appears to be the only option. Likewise Bain’s acquisitions Guitar Centers and iHeartMedia.
By several estimates, somewhere between 20% and 30% of PE deals end up in bankruptcy. This happens so frequently that you could say that “socializing the losses” through “strategic bankruptcy,” pawning the worst effects of bankruptcy off on the local communities and vendors, is a “feature, not a bug” of the private equity business model. I could list another dozen companies somewhere along the PE-ownership timeline of Toys R Us. We allowed this beast to take advantage of U.S. tax laws and lax worker protections for far too long. The problem of failure in the PE business, however, is that it takes a lot of innocent stakeholders down along with it.
Notes:
- Horowitz, Evan. “Private Equity Is Losing Its Luster; Too Bad You’re Already Invested.” The Boston Globe, 11 May 2018.
- Loeb, Walter. “Bain Capital Sees Three Investments Stumble: Toys ‘R’ Us, Guitar Center And IHeartMedia.” Forbes Magazine, 19 Mar. 2018.