Private equity has long been a driving force for transformative change in corporate finance, often seen as a means to rejuvenate struggling companies. However, recent research from California Polytechnic State University sheds light on a changing landscape, indicating that the private equity industry may be more turbulent and controversial than previously believed.
According to the study by researchers Brian Ayash and Mahdi Rastad, large companies acquired through leveraged buyouts (LBOs) face a ten-fold increase in the probability of defaulting on loans. LBOs are a process where a company is acquired predominantly using debt rather than cash and stock to get the highest rate of return on your capital, with the company's assets serving as collateral for the loan.
This alarming statistic reveals a concerning trend in the industry. Approximately 20% of these large LBO-acquired companies go bankrupt within ten years, in stark contrast to a control group's bankruptcy rate of 2% over the same period.
Moreover, research published by worker groups, including the Private Equity Stakeholder Project and the Center for Popular Democracy, suggests that private equity firms have been responsible for 1.3 million lost jobs over the past decade. This revelation underscores the socio-economic impact of private equity practices and raises questions about the industry's long-term effects.
With three distinct "waves" of bankruptcy exits by companies acquired through leveraged buyouts, there is ample data to support this growing sentiment. The first occurred between 1990 and 1992, with 42% of exits resulting in bankruptcy. The second wave was from 2001 to 2003, following the dot-com bubble burst, when 38% of exits led to bankruptcy. The third wave transpired during and after the financial crisis, from 2008 to 2010, with 35% of exits ending in bankruptcy. Since then, plenty of companies acquired through leveraged buyouts have declared bankruptcy with the recent wave coinciding with the pandemic era instability; J.Crew, Neiman Marcus, Hertz and Chuck E. Cheese accumulated debt during LBOs and went bankrupt in 2020. Clearly, these findings emphasize the susceptibility of leveraged buyouts to economic fluctuations.
The reports also highlight how certain industries bear the brunt of these challenges. Retail companies, for example, experienced the highest bankruptcy rates, with 41% of leveraged buyouts leading to bankruptcy between 1980 and 1995 and 23% between 1996 and 2007.
“With retail businesses so dependent on consumer preferences and commercial rent prices — both of which are prone to fluctuate — the margin for error has never been smaller,” quips Steve Salis, entrepreneur and businessman based in Washington, D.C.
Overall, the common perception that private equity firms target struggling companies to make them more efficient is slowly crumbling. Instead, more people -- from activists to industry insiders -- believe the leveraged capital structure prevalent in these transactions may be speculative and potentially detrimental to the long-term stability of the acquired companies.
These distressing statistics bring to the forefront a fundamental question: why do private equity firms continue to thrive while the companies they acquire often face failure?
One key factor contributing to the success of private equity firms is that they are typically insulated from the consequences of their actions. They also benefit from tax advantages that allow their executives to pay lower tax rates than the average individual. This combination of insulation and tax benefits creates a scenario where private equity firms reap disproportionate rewards when their strategies succeed while facing fewer consequences when things go awry.
“Even if a company goes out of business, it doesn’t necessarily mean the private equity firm hasn’t materially profited from that deal.”
Furthermore, the private equity industry often employs a legal double standard. While they exert effective control over the companies they acquire, they are rarely held legally responsible for the actions of these companies. This mismatch allows private equity firms to take considerable risks and engage in short-term thinking that can put their businesses in peril. The prevailing system often benefits private equity firms at the expense of other stakeholders.
Despite efforts by past administrations to close the carried interest loophole and other favorable tax treatments, private equity opposition has consistently thwarted reform attempts. Even as recently as 2021, the industry spent millions lobbying to protect these tax advantages. As a result, changes to tax laws were weakened, ultimately benefiting private equity firms.
In the current dynamic economic landscape, the traditional paradigms of capital asset management and private equity, where principals could simply acquire assets, make minor adjustments, or oversee operators, are no longer tenable. Today, the demands placed upon fund managers necessitate a much more hands-on approach. A growing number of industry experts believe -- to truly capitalize on enduring generational opportunities -- modern principals and fund managers must know how to operate businesses themselves, getting into the weeds if necessary. This contemporary environment requires investors to do more than merely manage operators.
“I feel strongly that the emergence of limited partner investments in operations-laden asset managers who are hands-on with their businesses is the new wave of investing.”
In speaking with Steve, he seems to not only embody this evolving paradigm, but also seems to demonstrate the culmination of this new wave of founder-operator-investor leadership. With a proven track record disrupting markets as a founder, scaling businesses as an operator, and breathing new life into heritage businesses as an investor, Steve's triple-threat approach serves as a model for others to emulate and a beacon of hope for private equity firms looking to rid themselves of future headaches.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.