The recent attacks on private equity are anticapitalist claptrap, Jonathan Macey — professor of corporate law, corporate finance and securities law at Yale Law School — says:
Private-equity firms make significant investments in companies, mainly U.S. companies. Most of their investments are in companies that underperform industry peers. Frequently these firms are on the brink of failure.
Because private-equity firms are, by definition, equity investors, they make money only if they improve the performance of their companies. Private equity is last in line to be paid in case of insolvency. Private-equity firms don’t make a profit unless their companies can meet their obligations to workers and other creditors.
The companies in which private-equity investors are able to turn a profit generally grow, rather than shrink. This is because the preferred “exit strategy” by which private-equity firms profit is to take the private companies in which they invest and enable them to go public and sell shares that will help the company grow even stronger. As for turnaround success stories, Continental Airlines, Orbitz and Snapple have all benefitted at some time from private-equity investment.
Or take Hertz. Ford sold Hertz to private-equity investors in 2009 for $14 billion. These investors were able to take the company public less than a year later at an equity valuation of $17 billion. The Hertz success story is consistent with the empirical data that indicate companies owned by private-equity firms typically outperform similar companies that do not have a private-equity investor (as measured by profitability, innovation and the returns to investors in initial public offerings).
Private-equity firms not only help corporate performance, but in the long run they lead to more employment and higher wages as well. The alternative to the leaner, smaller firms created by private equity are bankrupt firms that do not employ anybody. And private-equity firms tend to use more incentive-based pay than other firms. A 2008 Government Accountability Office (GAO) report shows that the companies in which private-equity firms invested had low employment growth relative to their peers, and their employment growth rose after they were acquired by a private-equity firm.
All more-or-less true — but not entirely, as commenter Constantine Gonatas notes:
“Equity investors do not get paid until the creditors do. ”
This is true in bankruptcy, but not necessarily in private equity because what happens is often the private equity owners take on additional debt then dividend the proceeds – frequently paying back their initial equity investment and far more. His statement is technically true but applies only to a particular circumstance (bankruptcy). The implication that it may be generally true appears to be misleading.Furthermore, his conclusion that private equity owners would never pay dividends if that would put their investment into insolvency, because it’s both illegal and they would get sued, is only really applicable to a situation where the company would become immediately insolvent. It does not apply to the many cases where after the dividend, the company still had enough cash to pay its immediate bills but not enough to cover interest and principal repayments in less than rosy scenarios where the company doesn’t “turn around” as the new owners hoped. This happens very often during recessions. In fact, one banker mentioned to me once that if private equity owners’ holdings don’t go bankrupt a fair percentage of the time, “they are not taking enough risk. (ie. leverage)”
What we have here is a governance and agency problem because the private equity owners are never taking risks with their own money. Heads they win, keeping 20% of the profits (their compensation being taxed preferentially at capital gains rates, unlike the incomes of the poor slobs who toil to make their holdings succeed), tails the employees and debt holders lose. In fact, the debt holders almost always lose because the value of the debt goes down when the company is leveraged – even if the new debt is mezzanine, it still deprives the company of cash to meet future obligations.