I’ve been wanting to write about what might be called the private equity paradigm for some time. On the other hand, I don’t see any way for me as a portfolio investor to make money from research I might do–other than to keep as far away from private equity deals as possible–so I haven’t done as meticulous job of research on this post as I would if it involved a stock I might buy. So regard this more of a preliminary drawing than as a finished picture.
When a private equity firm acquires a company, it seems to me it does five things:
–it cuts costs. The experience of 3G Capital seems to show that typical mature companies are wildly overstaffed, with maybe a quarter of employees collecting a salary but doing no useful work. Private equity also uses its negotiating power to get better input pricing, although it passes on little, if any, of the savings
–it levies fees to be paid to it for management and other services
–it increases financial leverage, either through taking on a lot of bank debt, or, more likely, issuing huge swathes of junk bonds. An equity offering may happen, as well
–it dividends lots of available cash generated by operations and/or sales of securities to itself, thereby recovering much/all of its initial investment
–it then sits back and waits to see whether (mixing my metaphors) this leveraged cocktail to which it now has only limited financial exposure, sinks or swims.
Caesars Entertainment has added a new twist to this paradigm. In 2013, its private equity masters seem to have decided that sink was the more likely outcome. Rather than simply accept this fate, they began preparing a lifeboat for themselves by whisking away valuable assets from the subsidiary that is liable for the company debt into another one. In January 2015, after this asset shuffling was done, they put the debt-laden subsidiary into bankruptcy.
Junk bond holders sued. Litigation has been protracted and has reportedly cost $100 million so far.
Media reports indicate that the case is now approaching resolution–either through negotiation or court ruling. My no-legal-background view (I was a prosecutor in my early days in the Army, but that says more about the Uniform Code of Military Justice back then than about me) is that: these asset transfers can’t be legal; and the junk bond loan agreements should have had covenants that explicitly bar such action. So I’m not sure what has taken this long.
Whatever the outcome of the case is, I think it will shape the nature of private equity from this point forward.