| Private Equity is neither private nor equity. It used to be called LBO and then it was re-branded. It is perfectly legitimate to take on leverage to exploit some opportunity. That's what every startup funded by a loan does. It is a bit more difficult to fund such opportunities in established businesses. It's would be rare that the parts are greater then the whole or that management is provably so bad you're almost certain to gain a return on investment simply by changing management. It happens, but it is quite unusual for the markets not to exploit situations like that very quickly, long before it gets to PE or LBO. So that why are LBOs and PE so common? For one debt is a multiplier, invest 10, get 12, profit 2. Invest 100, 10 of those equity, 90 leveraged, get 120, pay back 100, profit 10. 10 is way better then 2. But that's not all. There's also regulation, regulation gives lenders seniority in the bankruptcy process. First common shares are wiped out, then senior shares, then debt, then senior debt. In other words, all the share holders could be wiped out, but the debt holders can still get their money back. And then there's taxes, debt is often favored in taxed. So why wouldn't you prefer debt over equity? Debt is almost always better, except when you lose. If you invest 10 and you lose half, you have 5 left. If you borrow 90 invest 100, lose half, you're wiped out and then some. To improve things, perhaps we shouldn't treat debt so much better then equity when it comes to taxation, and other regulation. We definitely should have real bankruptcy, not tax payer bailouts. And we definitely should keep an eye out for situations when the people in charge don't have their own wealth on the line. If they win - big bonuses, if they lose - at worst no bonuses. That's not the correct incentive system, that's a guarantee for disaster. |