Why do private equity firms have a worse reputation than VC, Banks, or other investment firms? Is it deserved or unwarranted?
In: Economics
Banks, at least on paper, do something we consider good. They hold a lot of money and use it to invest. They use the returns on those investments to issue loans to people. People pay back those loans, with interest, and that interest ALSO counts as an investment. Without banks, most people couldn’t start a business, own a home, or buy a car. So we think they are manipulative and shady, but think they probably do more good than harm.
VCs are sort of like that, but more self-serving. They have a lot of money. They look for businesses that are a little too risky for banks. See, banks like you to have a plan like “start a restaurant” that has a pretty straight line towards profit. But some people want a business like, “Sell a new computer operating system” that sounds too risky. VCs offer money to these risky businesses in return for things that will be worth a lot more than the interest the bank would’ve paid. Like, a bank might charge 6% interest on a certain business loan. A VC is going to ask for a 50% share of profit. That’s a big ouch. People who take this capital are gambling that they’ll make so much money they won’t care if they lose half. So again, like banks, we kind of consider these people a little shady, but a ton of very good businesses couldn’t have started without them so we put up with them.
Private Equity… well, hmm. On paper it doesn’t sound bad. They are supposed to manage “investments” so that the people who invest in them get their money back. They aren’t really giving loans, it’s more like they’re taking other people’s money and promising to turn it into more money. Kind of like an investment manager. Again, we don’t tend to like people who work with money but this isn’t bad.
But some people find some tactics PE firms use to be abhorrent. This isn’t the ONLY way PE firms work, but it happens a lot. They’ll buy a business, like Sears, that’s losing a little bit of money. On paper, their job is to save the business and make it profitable again. Usually, that looks pretty easy: if you close some of the stores or lay off some people, that usually gets things profitable and you can try to build up from there. It sucks. Business is rough.
But that’s not what the people who bought Sears did. They never planned to “build up from there”. Their goal was to try and get as much money out of it before it died as possible without actually spending money to invest in it.
So the first thing they did was make Sears sell all of its land and property to their firm. Now they *lease* that land and property to Sears. That means every year Sears has to pay them a lot of money just to exist, which is a weird thing to do if you’re trying to save the company.
They did other weirdo things. Like, before Sears sold, they had a super good deal with brands like Whirlpool and Craftsman. In return for promoting those two brands, Sears got favorable prices and was able to make more money from selling them. But the guy the PE firm appointed ignored that, and encouraged salespeople to talk up other brands. He jacked up the prices on those brands so they’d have the same margins. The original companies did not appreciate this, and ultimately the deals were terminated. He didn’t have deals with the other brands. Why did he do it? What business sense did it make? Well, the PE firm paid him a bonus for increasing sales of the other brands. It cost *Sears* money, but he got a share of the extra money he made short-term.
The perception is they’re doing the minimum they can to keep Sears open, and using their lease to take ALL of its money away. It is not a business that will ever grow. If you get a job at Sears there is no “up” to bet promoted to. It’s like an elderly person on life support that will never come off. One day, it won’t be able to pay the lease, and the firm will close it, ending thousands of jobs, and sell or lease the real estate so they keep profiting.
That’s what people don’t like. Some PE firms buy a company not to *save* it, but to drag out the death as long as possible so they can squeeze every dollar out of it. This usually makes things worse for customers, but since the brand still has recognition it makes it hard for new competitors to show up until the death is complete. Since the goal is not to make the company better, every employee is on a dead-end career path that can only end in termination without benefits. Philosophically, we don’t like the idea that someone can be running a business and *not care* if it fails.
So while bankers and VCs are disliked, PEs are more often compared to vampires and mosquitoes. Not all PEs do this. But enough of them to make people angry.
It’s deserved. The main reason is differences motivations.
See, private equity firms get BONUSES based on hitting certain profit goals (I am oversimplifying how these deals are structured but that’s the basics). Big bonuses to the tunes of millions of dollars.
So, for private equity firms they are actually more motivated financially to make profits skyrocket as much as the can in the short term, because that’s how they get the highest bonus payouts. And are not really motivated by the long term sustainability of a company because if the company does go under, they don’t care, they’ve already made their money from it.
As opposed to other relational investments that only make money really if the company is in fact successful long term.
Wendover Productions on YouTube made a great video detailing Private Equity called “how private equity ruined America”
The goal of banks and VCs is to make money by investing money in things they think will grow into something bigger and better
Private equity does the exact opposite. They buy distressed businesses that have valuable assets (property, products, intellectual capital) that are worth more than the business itself. The private equity shop buys the business and sells off everything of value making more money than they paid for the business. Then they fire all the staff in the name of “efficiency” and sell off the shell of the business. Actual real life vampires.
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