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.