Image Source: Bloomberg Gadfly, "Private Equity Examines Its Distressed Navel", by Lisa Abramowicz
Imagine this scenario: Let's say you own a house worth $50,000 that is in bad shape. The roof needs fixing, the toilets need to be replaced, and new carpet needs to be laid down. You come up with a cost of $15,000 to make the home repairs yet you only make $10,000 a year in income.
Now let's suppose a firm comes to you and says they'll loan you $25,000 to help you with the cost of renovating your home. The catch is, they take a 50% ownership stake in your home while you renovate it and will take $2500 a year from your salary to pay themselves while you fix the house.
After ten years, with you making $7500, the house gets fixed but you can barely cover the mortgage payments on the house. Suddenly, you file for bankruptcy and the house goes on the market for sale and is bought for $30,000. The firm still earned back its $25,000 they loaned you and gets a 50% on the sale of your house, even though they loaned you money and put you in the poorhouse!
Sounds crazy? Welcome to the world of private equity investing!
I got to thinking about this topic after reading this article on Bloomberg Gadfly by Lisa Abramowicz. Seems as if there are a lot of investors who are hopping mad at private equity firms which drove Payless into bankruptcy. The interesting thing to note from the chart above however is that fewer companies bought by private equity are filing for bankruptcy than in years past.
So, to get an idea of what this is all about, let's start with the question, what is a private equity firm?
A private equity firm is a company which invests in businesses that do not trade on public markets like the NASDAQ or the NYSE.
Private equity firms make money by buying and then selling poorly performing companies. Sometimes, a public company may find itself in deep financial trouble. Public companies may turn to private equity firms to inject a lot of cash into their shaky business' operations for an equity stake.
Private equity firms employ lots of debt to buy the business. Usually, the business may be a low-profit-margin operation like a retailer or a food distributor. Private equity firms will then take seats on the company's board to change corporate management.
Once a new management is in place, the operations of the business may change to improve the operating margin. Changes could come in the form of delaying equipment upgrades, selling unprofitable lines of business or holding the line on hiring while trying to jump start sales of existing products and services. These changes to business operations can take a number of years to accomplish.
While the companies undergo a change in their operations, private equity firms will pay themselves an income in the form of dividends from the company they bought. The dividend payments, however, may be a drain on a company's already strained cash from continuing operations.
Once sales improve and the cost of those sales are held in check, however, the private equity investors will want to realize a possible profit on their investment. Thus, the company may be relisted publicly on the equity markets or they may be sold to another company for a price higher than what they invested.
If the company, however, cannot pay back its debt obligations from the private equity firms, the company could then go under, leaving private equity investors holding the bag, which is what happened with Payless.
So why does this matter to you as an investor?
There are many private equity firms which trade publicly in the equity market like KKR, The Blackstone Group & Apollo Global Management. For every company that went under because of private equity investment, there are just as many success stories of companies being brought back from the brink of financial disaster by private equity investments.
In short, look closely at the success rate of private equity investments in the companies they invest in. The higher the number of successful deals they make, the greater the likelihood that private equity investors are aligned with the interests of both individual and institutional investors.
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