Swathes of Capital - Private Equity

The book gives us a very good overview on how and why Private Equity has created a niche for itself. It also shines a light on how this industry operates. It identifies subsidiaries neglected within corporations or mismanaged businesses and tries to implement improvements in them making them more efficient cash flow generating businesses. The timing of the buy at the right times during a business cycle also helps a great deal. Often this is accompanied by a low interest rate in the credit cycle.

Private Equity (PE) is often pilloried for being quick-buck artists who make a quick return by slashing jobs thus cutting expenses and earning money by a very high amount of leverage. The book does a great job in explaining how Private Equity goes about it.

• It looks for businesses that can use some operational efficiency and for various reasons (public companies focused on short-term/less access to capital) cannot make those improvements itself. PE then installs managers/executives or retains key people from the target company to do a turnaround or make-over of the business.
• Academic research does provide evidence that yes, for the first couple of years there are job cuts however once the business stabilizes it results in higher job openings.
• It can also be argued that Private Equity acts as a bridge between two stages in a company’s life. Create Long Term Value for a business that is mismanaged or a company whose ambitions are thwarted by the parent.
• Private Equity is also a source of funds to companies at the time of need (in a trough in business cycle).
• Often, Private Equity pares down their stake but continues to hold on to their positions belying the belief that they are quick-buck artists.

Leverage Buyouts

It is no different than how one gets a mortgage for buying a house.

If one has $100 and buys an asset, and sells it for $120; making a $20 profit

With a $80 loan from banks, and $20 of their own (equity) - they buy an asset, and sell it for $120 - thus walking away with $40 profit.

In Leveraged Buyouts - income covers rent, property taxes and upkeep. Since PE firms pay some small amount of down payment and force the target company to pay for interest after loading it up with debt, it ensures that the interest expense is so big of an item to deduct.

It is like an income property where rent covers the mortgage. Property taxes and maintenance.

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Private Equity does have some tax advantages which are in the news often 

1. They often load a tonne of debt on their target company, and the company has to pay interest on the debt which can be deducted.

2. PE also works on the 2 and 20 model. That is they take a 2% of fees on all the assets under management even if none of the money they raised wasn't invested in anything. Once invested, they take a flat 20% cut on the profits. And this cut on the profits under the current tax code goes under Capital Gains Tax (i.e 15%). Thus, having the PE partners on WallSt. pay less than the cleaning ladies in their offices.

Lot of people say it should count as income thus subjecting those profits to a 37% tax rate ($578k or more income slab).

PE firms have faced economic crises before. And each time they have emerged stronger.

It is because they have tons of cash/capital (as of Q1-2023 easily $0.75 tn) to buy companies, real-estate and debt at a time if there are distress sales.

What can we learn from a PE firms’ modus operandi?

It is always good to buy assets of companies (in physical fields) that are below the replacement cost. Prices have a natural tendency to rise where the supply couldn’t expand much.

The book provides another confirmation that as the market rises, the investors are willing to pay higher multiples on cash flow or earnings. Similarly, when markets fall, multiples recede. Thus, it is important to understand capital cycles.

Private Equity profits arise from leverage, increase in long term value of the company, increase in cash flow and well-timed buys.

It is also true private equity has beaten returns of all pension funds and even index funds, thus even pension funds invest in them.

How the World Really Works

The crux of the book is that a poor understanding of energy has some overzealous young activists calling for a near-instant shift from fossil fuels to “superior” green and renewable electricity.

The author takes us from the basics and builds up our understanding. For example, he says we cannot talk about electricity if one doesn’t understand electrons. And then explains why we can’t store enough electricity for a medium-sized city of 500,000 people even though we have all sorts of technology available.

I started with the section on Understanding our Material World - very eye-opening!

There are four building materials of the world - 

• Plastics

• Ammonia

• Cement (Asphalt)

• Steel

These four materials account for 25% of global CO2 emissions.  

Ammonia as per the author is the most important of the four. It is used to make nitrogen fertilizers. Ammonia is manufactured using Haber-Bosch synthesis and is one of the most crucial inventions in the world. It is responsible for almost half of the nitrogen that’s applied to the world’s fields. And has helped with increasing the food production and harvests specially in Asia where populations have continued to rise. Africa, the continent with the fastest-growing population, remains deprived of the nutrient (Nitrogen) (the use of NH3 is one-third of Europe) and is a substantial food importer. If there is any hope for Africa to be self-sufficient in terms of food - it needs to boost its Nitrogen supply. 

Worth remembering that Nitrogen is a barrier to higher crop yields. The Green Revolution wouldn’t have happened without better crops and higher application of Nitrogen based fertilizers.

In terms of carbon footprint - Hydrogen for this reaction comes from either coal/natural gas/oil through processes that release CO2.

Plastics in the form of polyethylene (PE) [polybags] , Polyvinyl Chloride (PVC) [plumbing], PolyPropylene (PP) [car bumpers] and Polyethylene Terephthalate(PET)[plastic bottles] is manufactured using petrochemicals. Plastics are also widely used in healthcare - gloves, gowns and masks, and their importance was highlighted during COVID-19 when there was a scramble to airlift their supplies from China.

Steel is an alloy dominated by Iron (Fe). Cast Iron, hot metal produced in a blast furnace is through a process which requires coke (coal) and Iron Ore mined from the ground. Steel is used just about everywhere in the modern day city.

Cement, a component of concrete, is produced by heating limestone in a large kiln. Over time, we moved to reinforced steel in every large modern building and transportation infrastructure. However, there are factors which result in cement’s deterioration like algae/bacteria growth, tension and moisture. Especially, in the U.S where the infrastructure has been awarded the grade D+ and needs large quantities of replacement concrete and new concrete. 

In terms of future outlook, the world now consumes as much steel in one year as it consumed in the first half of the 20th century. It is unlikely that the above four industries will get rid of their dependence on fossil fuels in the manufacturing process. Even if it were to do that, it would put almost all low and middle income countries at a huge disadvantage. That’s the major criticism of Green New Deal or environmental activists that there is no proposal on how to electrify the major building blocks of society.

Carbon footprint of Food Production

There has been growing discussion around how much carbon footprint the whole food production creates. I liked how the author explained the energy consumption in growing, harvesting crops and on meat from farm to table.

The benchmark he laid out was plain sourdough bread, a staple - which is made from flour and water after the wheat has undergone Milling - removing the seed's outer layer. A kilogram of bread requires ~250mL diesel equivalent.

It was surprising to find that a kilogram of chicken also requires a somewhat similar energy requirement (~300mL diesel) as bread. The author pointed out that the price of a kilo of bread is somewhat the same as a kilo of chicken. 

However, it was interesting to learn about CAFOs (Central Animal Feeding Operations) - a facility where tens of thousands of animals (birds in this case) are put in rectangular structures where they are crowded in dimly lit spaces. And that the process of raising an animal + feeding it (corn/soybeans) + slaughtering + processing + retailing + storing + Home refrigeration + finally cooking - is all quite energy intensive. If we are to map types of meat, based on energy intensive - chicken is the lowest and beef among the highest. Seafood is the highest in terms of energy, it is somewhat the same idea however we need to add diesel fuel consuming trawlers and shipping boats to catch which adds a lot. Sardines is the lowest among seafood requiring ~700mL/kg of diesel, almost a bottle of wine. And shrimp or lobsters are the highest in the seafood category.

Attempts to do greenhouse farming like for tomatoes especially in regions of Spain is also energy intensive as you need plastic films to create the greenhouse effect and heat it. Not to mention, the other things like transporting harvest from Spain to Sweden on trucks and poor working conditions for workers who are predominantly immigrants.

The author is careful enough to not suggest that we abandon meat eating (in his view Africa needs a lot of nutrition) but he does highlight the excessive meat consumption in some countries specially U.S and China (~150kgs/per capita annually) compared to India (~4kg/per capita annually). He says the room to reduce carbon footprint is to go on a moderate carnivorous diet for high income countries and avoid food wastage.

Dependence on Fossil Fuels in Renewable Energy Movement

• Lots of materials which were needed in modest amounts before would now be needed in unprecedented materials.
• Even infra for sources of renewable energy like Wind and Solar are built on top of fossil fuels. For example: to construct a wind energy farm (symbol of green electricity) would require foundation to be laid by reinforced concrete; towers, blades and rotor are made of steel; gearbox requires oil lubricant. Parts of a turbine are so huge that they have to be transported piece by piece to the site for assembly via trucks which run on diesel fuel. Ironically, even before the wind turbine is functional it has accumulated a large carbon footprint. 

Why is the renewable energy transition going to take a while?

• Is it possible to have complete electrification of transport in 2-3 decades?
• What about ships which are the backbone of global trade?
• Currently, African nations rely on fossil fuels to supply 90% of their primary energy. What miraculous options will be available to them that are not only less carbon intensive but also cost-efficient within a decade?
• Let's talk about the most realistic solution which is capturing carbon from the atmosphere and storing it away underground. Worth noting, that this technology is still being worked on and far-away from commercialization.
• The author raises a great point in my view which is when was the last time America built anything on time? Atleast, not since WWII ended. Even regular projects for renovating public transit stations, or even installing a bathroom exceed the timelines and budget overruns. Plus, the NIMBY movement will not make it easy to have millions of miles of pipelines needed to transport captured CO2 to storage tanks in Texas. Keep in mind, the huge oil & gas pipeline network today is a result of 100+ years work and trillions of $ investment.

Thus, the following comments from the author seem appropriate  -

The current zero-carbon future plans are flights of fancy unencumbered by real-world considerations.

History does not unfold as a computerized academic exercise with major achievements falling on years ending with a zero/five.

Reality presses in from both ends.

What can we do in the meantime to preserve the environment?

On this I liked the author’s realistic nuanced suggestions.

• We can improve buildings’ efficiencies with the same materials for long lasting energy and carbon emission savings.

• Install triple window panes to insulate.

• Proper wall insulation.

• Highly efficient heating furnaces.

• Reduce the adoption of SUVs; more public transport

• Clear cut evidence that a SUV emits 25% more CO2 than a standard car. And there is now 250 million SUVs on the road

• SUVs are now the second highest cause of rising CO2 emissions behind electricity generation and even ahead of heavy industry, trucking and aviation.

• Reduce food wastage

The author does talk about how in the past all forecasts (which were sensational) about how the world was going to run out of XYZ or something have proven wrong mostly. He attributes it to the indomitable spirit of human ingenuity.

One of such misleading pronouncements he gives an example of is the below tweet.

Which implied that the fire in Amazon forests in Brazil was a much bigger deal as those forests are a source of 20% world’s Oxygen, causing alarm, hysteria and the top most item to be discussed in the G-7 meeting. This is precisely an outcome of poor understanding of how Oxygen is formed.

Conclusion

Non-carbon based energies can replace fossil fuels (Carbon) in 1-3 decades only if there is willingness to take cuts to other standards of living in affluent countries and deny countries in Africa and Asia improvements by even a fraction of what China has done in the last 20 years.

P.S -

The author seemed to have some interesting thoughts around how good humans are at controlling their own fate. He took the example of COVID and remarked that COVID exposed emptiness of any quests to have space flights, precision and personalized medicines. Why the world's richest country supposedly failed to provide its healthcare workers with low-tech PPE? In his view, long tail events have a bigger impact on how we live. (9/11, covid, WWII).

Surprising to me - he believes that even without the vaccines the pathogen would have stopped once it had infected a large number of people or mutated to a less virulent form.