March 29th, 2009 by Gordon Cook
From Hendrik Rood in The Netherlands
This brief explanation in a comment to an article by the Economist on economic populism, takes a priceless summary of the workings of recent private equity take-overs in terms of Adam Smith’s well known example of a manufacturer of widgets …
Private Equity Investor (PEI) has 20 million. He uses it as a security to borrow 200 million from Bank 1 to buy a company Widgets. Widgets is a solid manufacturing business with assets of land, factories, patents, a brand, good will and no debts.
Widgets borrows 300 million from Bank 2 – no problems, it’s a solid business – but here comes the bit where it all goes criminal, but not illegal…
Widgets pays out 300 million to PEI its owner as a dividend, who repays 200 to Bank1. PEI now has 100 million cash, and has done nothing for it. Widgets however has to pay 20 million in interest per year. PEI now has 100 million.
Widgets also sells its assets: land, patents and so on and leases them back for 30 million a year.
The sales bring 200 million which Widgets also pays out to PEI its owner. PEI now has 300 million.
Widgets Pension Fund is ‘restructured’ bringing a liquid 150 million onto the balance sheet. Widgets has liabilities to its pensioners with little to back them. 150 million is paid out to PEI as a special dividend., PEI now has 450 million.
PEI sells the business to a pension fund, for 100 million, less than he paid as it has a lot of debt, but it is a good business. PEI now has 550
Widgets now has 300 million debt causing 20 million a year in interest, plus 30 million in leasing payments. It has pension liabilities and the pension fund is almost worthless. PEI had 20 million at the start of the year and now has 550 million. But the business is still viable, as Widgets can meet its payments.
5 years later -
Sadly hard times come. Turnover drops, prices drop, costs are cut, people lose their jobs, including engineers, managers, the shop floor and the sales team who did real work for years, created real value, invented the patents, built the brand. It doesn’t help. The company has no stores of fat - it goes bust. The banks loans are sour. People lose their jobs, the pensioners cannot be paid.
This happens 100 times so the banks are bust too, but get bailed out by the taxpayer (that’s those guys who lost their jobs and pensions at Widgets)
PEI lives happily in The Bahamas with the 550 million which he ‘earned’ in a fabulous year of ‘value creation’ made possible by the power of free and light touch regulated markets.
Sadly, due to the complexity of all this the bright chaps at The Economist can not quite see why this is a slightly problematic way to run an economy… Honi suit qui mal y pense.
Just recall that the key events that allowed this type of acquisitions due was too low real interest rates (which makes borrowing to execute these schemes extremely cheap) and willingness of many in the banks to earn on the transaction for additional finance and disregard long run risk when interest rates rises.
Any resemblance to the operation of Carlyle, Apax, TPF, Blackstone, Babcock and Browne etc. with regard to telecom operators like Hawaii Telecom, TDC, Eircomm or say cable operators like Ziggo is purely co-incidental, off course.