In the last couple of years articles have begun to appear with titles like:
So, private equity firms (PE) are busy in the housing market. The exact scale of this phenomenon is subject to debate. What’s important is to understand what private equity is and how it functions. Further, it is typical of the finance sector in general, a focus on extracting wealth from existing assets. It is not at all about creating new assets, new productive capacity.
What Is Private Equity?
“Private equity funds are pooled investments that are generally not open to small investors. Private equity firms invest the money they collect on behalf of the fund’s investors, usually by taking controlling stakes in companies. The private equity firm then works with company executives to make the businesses — called portfolio companies — more valuable so they can sell them later at a profit.”1
The investors in PE firms are pension funds, sovereign investment funds, endowments (think Harvard U., etc.), and wealthy individuals. No small fry here. Let’s focus on the last sentence that blandly notes that private equity works with management to make the businesses more valuable. This is where the financial magic is applied. A first step is to load up the acquired company with a lot of debt. Then, trim the workforce. Look around for assets that can be stripped away and sold.
The most fundamental element of PE strategy is leverage.2 On the surface, this works very much the same way as when we buy a house. The PE firm starts out with a downpayment and borrows the rest of the purchase price for a company with loans. But the PE firm does not make mortgage payments. Rather, once the target has been acquired, PE forces the acquired company to take out loans in its name and uses those funds to pay off the loans it originally used to buy the company. The newly acquired company then has to add the carrying cost of this debt to their ongoing business expenses. This looks exactly like the leveraged buyout (LBO) that was first invented in the 1980s. You might say that PE is a re-branding of the 1980s’ LBOs.
PE firms tend to hold onto companies they acquire for three to four years and then sell them on. Even if they don’t make a spectacular profit based on the sale price their acquisition cost was substantially underwritten by the debt paid off by the acquired company. So even a modest profit on the sale of the company looks very handsome relative to the downpayment capital they put in.
PE firms also undertake other forms of financial engineering. For instance, cutting back on employees, benefits, pensions, and selling off assets (asset stripping). “Over the 25 years ended in 2019, PE funds returned more than 13% annualized, compared with about 9% for an equivalent investment in the S&P 500”3 This is just the tip of the proverbial iceberg of financial looting practices that characterize the PE industry. Just to point to one tax loop whole, there is the
In summary, PE firms do not create new value. They do not invest in new technology. They do not invest in new plant, equipment, or employees. Their only objective is to extract money from the companies they acquire.
The Extraction Economy
Over the last 40 or so years, capitalism, particularly in the US and UK, has entered a new phase. The shift in focus in the corporate world to shareholder value as the only purpose of companies has led to very short time horizons. Gone are investments in new technology, new products and services, attention to employee development and retention, really anything that does not contribute to next quarter’s financial results. This is the result of management and Wall St. adhering to Milton Friedman’s famous summary of shareholder value, “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud. 4 His use of the phrase “stays within the rules of the game” can only be greeted with sad irony. The rich and corporations have repeatedly demonstrated that they set the rules of the game. Some deal!
- Chris Morran Petty Daniel, “What Private Equity Firms Are and How They Operate,” ProPublica, August 3, 2022, https://www.propublica.org/article/what-is-private-equity.
- Much of this description of how PE works comes from Eileen Appelbaum and Rosemary Batt, Private Equity at Work: When Wall Street Manages Main Street (Russell Sage Foundation, 2014).
- “Everything Is Private Equity Now,” Bloomberg.Com, October 3, 2019, https://www.bloomberg.com/news/features/2019-10-03/how-private-equity-works-and-took-over-everything.
- Milton Friedman, “A Friedman Doctrine‐- The Social Responsibility Of Business Is to Increase Its Profits,” The New York Times, September 13, 1970, sec. Archives, https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html.