[edgefield]

I’m struggling to understand how the standard PE model works, particularly the debt component. PE firms seem to target mediocre businesses, load them with debt, and then harvest returns and eventually the assets. Why would a bank loan money for such an arrangement, given how often these businesses end up in bankruptcy (Toys R Us as an example)? Is the debt collateralized and bundled with better performing debt or sold off to an unwitting buyer?

[JumpCrisscross]

> PE firms seem to target mediocre businesses, load them with debt, and then harvest returns and eventually the assets

Private equity no longer necessarily involves large amounts of debt, i.e. LBOs. Most managers have an economic effect they deploy to bring efficiency to an industry. The first popular one was deconglomeratisation. Then capital structure management. Digitisation and supply chain management followed. In each phase, they delivered then overcorrected.

Hospitals initially started on the scale side. The thesis was that the biggest cost centre is administration, so if you linked together the administration of many hospitals you could reduce costs compared to private practices. This initially panned out. But hospitals are natural monopolies; those initial theses were rapidly corrupted.

> given how often these businesses end up in bankruptcy

Private-equity backed companies tend to be more resilient, not less [1].

[1] https://siepr.stanford.edu/news/private-equity-firms-show-re...

[Projectiboga]

It is a mix of tax loopholes. They can load up on debt, pull cash out. The big scam is share buybacks, they use the loans to by up their own stock. That was illegal from the 30a-80s, the Regan administration legalized it and it's been a race to the bottom. The other part is banks create money at multiples of their deposits. Fractional reserve lending. This creating money and then charging interest that isn't created is the root of this mess. They system worked well when there was fresh land and slaves to grab. It has continued w industrial growth. But now we are running out of oil to pump and other resources are starting to become scarce. This whole private equity is becoming a shackle on our economic system, almost 24% of the economy is controlled by private equity, and a chunk of that is carry forward profits which aren't taxed until withdrawn. They get to sell not pay capital gains and go into the next one. Good luck trying that yourself.

[bigbuppo]

Buy the company, saddle it with the debt used to acquire it, take all its real estate and transfer it to a separate company, make the company rent from the company that owns the real estate at inflated prices. If its something like a software company you convert its software to a rental model and keep jacking up the price so that now an annual subscription costs the same as the perpetual license price from three years ago with 25 years of maintenance. Sure, you just lost 98% of your customers, but really, you just need one or two customers that can't leave you to keep it running in perpetuity. In the case of a retail store, though, you just run the store into the ground over the next year or two and now your real estate division is the #1 creditor of the retail chain and gets first pick of the liquidation and it now owns the real estate, which it then sells for 10x its real value to a developer who will bribe the local approval board to turn the area that is zoned commercial only due to flood risk is now overpriced homes or condos. When everything floods the victims that bought houses or condos will have to move elsewhere.

Or, your PE firm is actually owned by a foreign country and they don't care about profit as their long term goal is wrecking your country's economy.

[cameldrv]

There are different playbooks, but one is to take a declining business and cut unprofitable parts until it becomes (at least temporarily) profitable. The debt has a higher interest rate that reflects the risk of the strategy not being successful (hence being called junk bonds).

Even in the case of bankruptcy though, the bondholders may still come out OK. Toys R Us actually made about 5 billion in debt payments in the years it was privately owned, and it took about 5 billion in debt as part of the buyout. The bondholders may not have gotten the return they were expecting, but they mostly got their principal back.

All of that said, the real problem as I see it with PE is that it's just so exploitative. The only thing that matters is the investor's money. For example, one very common strategy after a buyout is to cut quality in various forms. People may have a positive quality impression of a store or a brand, and then keep buying it even after the PE company cuts quality. It takes them a while to realize that the product they're buying is not what it once was, and so the PE firm is making money by tricking people into buying bad products.

The hospital case is just an extreme example of this where the cuts in quality lead to people getting sick and dying.

[tdullien]

"it depends" - but there are several components at play:

PE benefited greatly from a long-term decline in interest rates. The amount of debt a company can service at a given profitability is directly related to the current prevailing interest. So as long as interest rates drifted down, PE firms could buy, load with debt to be paid out as dividend, and sell again, sometimes to the next PE buyer.

Secondly, banks will not hold this debt directly on their books, but either sell bonds directly (the low interest environment led to some life insurers and other long term investors to buy pretty risky corporate debt) or repackage them with (hopefully) uncorrelated debt to obtain better ratings (price).

There's an argument that the success of PE funds had everything to do with them being a macro bet on falling interest rates.

[JumpCrisscross]

> an argument that the success of PE funds had everything to do with them being a macro bet on falling interest rates

It’s incorrect. The leveraged buyout, for example, found its footing in the high-rate environment of the early 1980s.

[tdullien]

Doesn't that have more to do with Michael Milken pioneering junk bonds, which then vastly expanded the available credit?

As in: The fact that the 80s had comparatively high interest rates doesn't matter to the argument, as the necessary infrastructure to issue and trade high yield corporate debt quickly didn't exist - so in some sense effective interest rates dropped from infty to something, enabling the entire LBO model.

And since then, with the exception of the recent hiccup, the long term trend in interest rates has been downward?

What's your read?

[JumpCrisscross]

> Doesn't that have more to do with Michael Milken pioneering junk bonds

Capital was uniquely available in the 1980s. But Milken was a symptom, not the cause. The booming American economy provided the fuel, but digitisation turbocharged the engine: issuing, pricing and trading securities, in particular bonds, became easier very quickly. (This is why your stereotypical trader from the 80s has an accent and is uncouth. They replaced blue-blooded bankers who had run bonds, calculating prices and yields by hand using tables.)

Put another way, America is “unusually good at creating tradeable claims on the profits and revenues that its economy generates” [2]. Computers amplified that strength and prompted massive opportunities in reshaping the economy.

> with the exception of the recent hiccup, the long term trend in interest rates has been downward

Yes, this is a function of increasing stability and time horizons [1]. That said, the relevant frame is a fund lifespan, usually 5 to 10 years. (Unless you’re Warren Buffett.) In those intervals, the long-term signal is dwarfed by short-term noise.

[1] http://www.economist.com/news/finance-and-economics/21598651...

[2] https://www.bankofengland.co.uk/-/media/boe/files/working-pa...

[tdullien]

I haven't checked in depth, but ... while the Fed funds rate has oscillated a bit ("noise") the curve for 10- or 30-year t-bills or mortgages is much smoother, and newly issued junk bonds will track those more than the Fed funds rate.

And I'd be surprised if in the period between 1980 and 2021 you could find a 10 year interval that didn't exhibit significantly lower rates at the end than at the beginning, and only a select few 5-year periods.

You seem to have the viewpoint that this had nothing to do with the historical performance of PE funds?

[JumpCrisscross]

> this had nothing to do with the historical performance of PE funds

It had a strong effect. But it’s far from dominating. Compounding PE’s performance woes are that fundraising is easier when the economy is strong. That is why there has been a tendency of the largest LBOs happening just before a downturn; the last cycle’s was Twitter.