Plunder Down Under: Is private equity all it is cracked up to be?

If you have been paying attention, you will have noticed that there has been a lot of noise made about the benefits of private equity investments over the last few years.

This opaque asset class, previously the domain solely of institutional investors and family offices, is now open to the public, promising both higher returns than public markets and significant diversification benefits.

Large international private equity players are increasingly casting their rods into local waters, seemingly falling over themselves to muscle in on the massive swathes of capital that are available in Australian superannuation funds.

With promises being made and the hordes charging, now is the perfect time to ask some serious questions about this ‘new’ opportunity set for retail investors.

Is private equity all it is cracked up to be? 

Is the opportunity too good to be true, and what is on the other side of the coin? Nothing is ever as good (or bad) as it seems. But how do we find answers to these questions when the opportunity, for Australian investors at least, is still developing? 

The answer is rudimentary – look at more developed jurisdictions for lessons and learnings. On that front, there is no more developed private equity market than that which exists in the United States. 

A lot has been written about the problems of US private equity, perhaps no more definitively than in the book Plunder: Private Equity's Plan to Pillage America. The book was written by Brendan Ballou, a lawyer who served as Special Counsel for Private Equity in the Justice Department's Antitrust Division.

In our interview, Ballou was keen to point out that his views are his own and not those of the US Department of Justice or the US Government.

In this wire, I will lean on Ballou’s book and an episode of the Freakonomics Radio podcast that he was a guest on (which is how I was introduced to Plunder) to outline the major problems with private equity in the US, compare it with the Australian experience where possible, and then – again with Ballou’s help – provide a hypothetical framework within which the Australian private equity experience might best evolve.

Before we begin...

Ballou became interested in private equity in 2020, during COVID-19, as a byproduct of looking at acquisitions that were being made at the time. He was finding that private equity was “everywhere” and that it was generating a lot of negative outcomes.

"It seemed like everything, in the middle of quarantine, was getting bought up," said Ballou. 

"And it was getting bought up by companies that I had never heard of like Blackstone, Carlyle, KKR… and yet there wasn't a lot of work done to try to pull that analysis together and explain why private equity firms often, not always but often, have bad consequences across industries."

What bad consequences is Ballou referring to?

One of the statistics that stood out to me was that, according to Ballou’s analysis of US private equity: 

“Roughly one in five large companies acquired through leveraged buyouts go bankrupt in a decade. This is vastly more than the roughly 2% of comparable companies not acquired by private equity firms that do [go bankrupt]."

Finally, I would also like to point out that any suggestions Ballou makes about how private equity might otherwise exist is not him lecturing other jurisdictions on how it should be done. Rather, they are a product of my questions and trying to apply the learnings to the Australian experience.

The three major problems

If it was not already apparent, Ballou’s book is critical of private equity and, more specifically, the private equity business model. He sees three main problems with the asset class:

1. SHORT-TERM FOCUS: “Private equity firms tend to buy up companies and hold them for just a few years. Three years, five years, maybe a little longer. And how long you invest in something changes your perspective on it. It changes whether you are going to invest in your infrastructure, your R&D, your employees, in customer satisfaction and so forth".

2. RELIANCE ON DEBT and EXTRACTION OF FEES: "When a private equity firm buys up a business, it tends to be the company they buy that is responsible for paying back the debt of the acquisition, not the private equity firm. And that's a financial magic trick that means that if things go well, the private equity firm benefits. But if things go poorly, in large part, the private equity firm can walk away. It's the company that's harmed. At the same time, private equity firms can extract a lot of fees - transaction fees, management fees and so forth that they get directly. Even their limited partners that they invest with don't necessarily get [the fees]".

Highlighting the point above about reliance on debt, and equally parts interesting and terrifying, Ballou said the following on the Freakonomics podcast: 

"Stephen Schwarzman, the head of Blackstone, said — I’m paraphrasing very slightly here — he said, 'In every person’s life, you have to have a dream. And my dream is to get access to 401(k) funds'."

For those unfamiliar, 401(k) funds are the US equivalent of our superannuation funds. Call me cynical, but it puts into perspective the push from international private equity into Australia - perhaps they're after our superannuation honeypot. 

3. LEGAL PROTECTIONS: "The part that interests me the most as a lawyer is that private equity firms are very good at insulating themselves from legal liability for the consequences of their actions. So, if something goes wrong at a portfolio company, the private equity firm can essentially often walk away unscathed".

An example

One of the masterstrokes of Ballou’s book is that he has collected and shared the negative experiences generated by private equity across multiple industries in the US. Although there have been reports of certain egregious cases, Ballou was the first to connect the dots and establish the main consistencies (the three problems noted above) across various industries. These include housing, retail, nursing homes, finance, and even the US prison system. 

One particularly devastating case involved nursing homes and the Carlyle Group’s takeover of ManorCare.

As Ballou described it:

"[Carlyle] executed a lot of fairly standard tactics; a sale-leaseback where it sold the underlying property. It cut staffing and health code violations spiked. When a woman died, her family sued Carlyle for wrongful death.

"But Carlyle was able to get the case against it dismissed and said, 'We were not the technical owners of this nursing home chain, we just advised a series of funds, whose limited partners, through several shell companies, own the nursing home chain.' And that got the case against it dismissed.

"I think that example illustrates a lot of the problems with the private equity industry. Again, it's an area where firms can benefit if things go well but often walk away when things go poorly." 

One of the most poignant lines in Ballou’s book is the following;

“Private equity firms profit primarily because of their ability to find and create gaps in the legal system."

The example above highlights this.

The Australian experience

“Surely these things couldn’t happen in Australia?” I hear you pondering. Sadly, they already have.

Cast your minds back to 2015 and the Dick Smith saga. At the time, Forager Funds Management CIO Steve Johnson wrote an article titled “Dick Smith is the Greatest Private Equity Heist of All Time”. 

While no one died, I tend to agree. I was an analyst at the time and I remember the story well. Johnson tells it far better than I can, but it has many of the hallmarks Ballou outlined above.

The short version is as follows:

• The company was bought on the cheap, for a sticker price of $115 million
• Anchorage raised and put in around $10 million
• Anchorage sold all the inventory at a massive discount and used those revenues to pay for the rest of the sticker price (the other $105 million) 
• They also conducted massive write-downs and failed to restock
• This step had the effect of making the numbers look artificially strong – for a moment in time
• At that moment in time, Anchorage managed to list Dick Smith at $2.20 per share, with a market cap of $520 million
• Anchorage sells all of its shares by September 2014 at prices slightly better than the $2.20 float price
• Inventory is repurchased, post the sale, for $254 million – paid for by the new shareholders
• The company struggled to sell that new inventory and the rot set in

From Johnson’s article:

"Operating cash flow was negative $4 million, as inventory increases further and suppliers demand payment, decreasing accounts payable. The business is required to take on $71 million in debt to fund a more sustainable amount of working capital. As the benefit of prior accounting provisions tapers off, profit margins fall, and the company reports a toxic combination of falling same-store sales and shrinking gross margins in the recent trading update."

In 2016, Dick Smith was bought by Kogan.com (ASX: KGN) and delisted from the ASX. Kogan acquired the name and took over operations, but it provided little solace to those affected. Across Australia and New Zealand, 363 stores were shut. More than 3,000 people lost their jobs. Shareholders took a bath. Everyone who was involved got hurt - except the private equity firm in question. 

Anchorage Capital made off like bandits 

to the tune of half a billion dollars.

To be clear, Anchorage did nothing illegal and I am not suggesting from the comment above that they did. Later that year, the Senate announced an inquiry into the Dick Smith collapse but nothing ever came of it. Anchorage had used a legal accounting manoeuvre to write down the value of its inventory. 

So yes, this has happened in Australia before and will likely happen again. 

What is the solution?

While I have painted a pretty dire picture so far, it should be said that not all private equity is bad and the Australian experience has been, and likely will continue to be, different than that seen in the US. I am personally invested in private equity and Ballou notes that “there is always a role for private investment in an economy”.

"You always need somebody willing to put up the money to build a factory or hire new workers or whatever it happens to be," said Ballou.  

That said, he believes there is a clear framework within which private equity could exist without creating some of the externalities that it currently does.

"So how do you do that in a way that's positive rather than destructive?" he asks.

With Australia’s less developed but burgeoning private equity opportunity in mind, I asked Ballou to participate in the following thought experiment:

If you were building, from scratch, a framework for private equity to operate in, what would it look like?

The framework that Ballou outlined addresses the three problems discussed earlier: Short-term investments, reliance on debt and fees, and insulation from liability.

"There are things that lawmakers and regulators can do to incentivise long-term investment. I don't know how Australia's capital gains rate works, but you can stagger it to incentivise longer-term investments.

"On debt and fees, you can make debt acquisitions slightly less financially attractive relative to equity investments. You can also discourage the use of fees that go directly to the private equity firm rather than to the other limited partners and so forth.

"And most importantly, I think you can clarify the law to ensure that if you have operational control over a business, and you get to set who gets hired and fired, who the executives are going to be, and what the strategy is going to be. If you can control these things, you can be held responsible for what those companies do.

"I think if you do that, private equity firms will become much more responsible generally, and the money that they provide, the investment that they provide, can be a much more positive part of your economy," Ballou added. 

Conclusion

The final question that I put to Ballou concerned investors who already are, or are considering, investing in private equity. 

After all, private equity is here to stay, and Australian investors will continue to be presented with the opportunity to participate. So, how can one know the good operators from the bad?

Ballou noted that private equity firms get much of their money from public pension funds in the US. These include the teacher retirement funds, firefighter retirement funds, etc.

“Many of these funds have public meetings where private equity firms will disclose information about their investments and their strategies. So that is one way here in the US that people can learn about what private equity firms are doing," he said. 

“I'd encourage folks to look at what's already publicly available. A lot of investment information is available online either through open sources or subscription sources." 

Finally, Ballou offered the following sage advice:

“As a general piece of advice for investors that are thinking about private equity, don't underestimate your own power," he said. 

"Private equity firms need money to make investments and they need your money. Don't forget that with your money, you have the ability to direct the operations of these firms and can help determine whether the things that they do are going to be positive or destructive." 

Plunder: Private Equity's Plan to Pillage America is available on Amazon. I highly recommend it.