‘Private equity firms can profit off these companies even if the companies don’t survive.’
Part One of a conversation with Brendan Ballou, author of ‘Plunder: Private Equity’s Plan to Pillage America’
Brendan Ballou is a federal prosecutor who previously served as special counsel for private equity in the antitrust division of the U.S. Department of Justice (DOJ). He’s also the author of the new book Plunder: Private Equity’s Plan to Pillage America, which describes in vivid detail the machinations, and the human and societal costs, of the private equity industry.1
In a conversation earlier this week, Brendan and I spoke about why private equity executives have such a dismal record of actually running companies, how the industry’s financial success has been facilitated by the government and funded by taxpayers, and what really happened to Toys “R” Us.
This is the first part of our conversation; the second part is available here. The excerpts below have been condensed significantly and edited for clarity. Brendan spoke with me in his personal capacity, and his views don’t necessarily represent those of the DOJ.
ADAM: Can you start by giving a quick overview of how the private equity industry works—what the industry says and what it promises to do, and then how it actually makes money?
BRENDAN: Their basic business model is very simple: They use a little bit of their own money, some investor money, and a lot of borrowed money to buy up companies. They then try to make operational or financial improvements or changes to those companies with the aim of selling [them] a few years later. That’s it. It’s a very simple idea.
There are three basic problems with the private equity business model. One is that firms tend to invest for the short term—only a few years. The second is that they tend to load up the companies they buy with a lot of debt and extract a lot of fees. And the third is that they tend to be insulated legally from the consequences of their own actions, so while firms generally can direct the operations of the companies they control, they can rarely be successfully sued when those companies do something wrong.
If you asked a private equity CEO about what value they add to the world—what their business model is—how do you think they would describe it?
David Rubenstein, who ran the Carlyle Group, says only half ironically that theirs is the highest calling of mankind. And he says that partly in jest, but I think he is partly serious, too. I think private equity people see themselves—to use the manager of the Yale endowment’s phrase—as a “superior form of capitalism.”2
What they [claim to] do is take sluggish businesses, give them focus, cut slack and cut fat, and transform them into leaner, meaner, more profitable operations. That’s the basic promise of private equity. The problem is that it often doesn’t work.
One of the key points that you make throughout the book is that private equity firms and their executives can still make tens, sometimes hundreds, of millions of dollars in fees, even if the companies they buy collapse or go bankrupt. Sometimes even the fund’s own investors don’t make money, but the firm itself still does. The executives still do.
Tell us what happened with Toys “R” Us—how it went from a successful and iconic retail chain into bankruptcy [and] left employees with a $60 severance, while the private equity-anointed CEO cashed out with a $2.8 million exit package.
It’s a really fascinating story. And I think it illustrates a lot of what works and doesn’t work in private equity. [In] 2005 a coalition of three firms, KKR, Bain, and Vornado, bought up Toys “R” Us for several billion dollars. Now, here’s the trick about private equity: They invested a little bit of their own money and investor money, but most of the acquisition was paid for with debt. And it was [not debt] that the private equity firms would hold—it was debt that Toys “R” Us would be responsible for paying. And that [debt] turned out to be enormous, and enormously burdensome.
In fact, the common story around Toys “R” Us is that it was defeated by Amazon, that the wave of e-commerce made their business obsolete. That wasn’t actually true. In fact, Toys “R” Us was profitable the year before it filed for bankruptcy. The challenge that it had was [that] it was spending as much on servicing the debt as it was on actually making income. So part of the problem with the private equity acquisition was the reliance on debt.
The other [problem] was the disinvestment in the business itself. Reportedly, the private equity firms slashed investment in basic things like store upkeep to such an extent that people were complaining that so much dust gathered in the rafters that it was...falling down onto customers like snowflakes. Beyond just disinvestment, they executed various tactics that brought money from Toys “R” Us to the private equity firm—things like extracting an estimated $180 million in fees.3
It was ultimately [an] unfortunate mixture of debt, underinvestment, and extraction that pushed Toys “R” Us into bankruptcy. And it was one where the private equity firms—at least according to public reporting—actually made money, even though the company itself collapsed.
This point about the private equity fund buying a company but the company, rather than the [private equity] fund, being responsible for the debt—can you explain how that actually works? [From a] rational understanding of how capitalism is supposed to work, that seems extraordinarily counterintuitive.
It’s a sort of incredible magic trick that private equity firms are able to perform. What happens is, the company...will buy up a lot of their own stock so there’s only a little bit of equity still outstanding. They’ll use that borrowed money to do it. They’ll essentially take on a lot of debt so that there are fewer owners of the company. And then what equity remains, the private equity firm will buy, and they’ll [do] that with their own money.
What it means is, there’s ultimately only one owner of the company, which is the private equity firm, but there’s a whole lot of debt that was required for the acquisition that the company—not the private equity firm—is going to have to pay.
The conventional narrative around Toys “R” Us and so many iconic retail chains going bankrupt or just falling apart in the 2000s and 2010s—the narrative was that [they couldn’t compete with] Amazon. You never really hear about the private equity angle. I wonder what you make of [the fact] that private equity almost escaped responsibility, at least in the public understanding of how these big household names collapsed.
I think it’s a narrative that has worked well for everyone except, potentially, customers and employees. It worked well for Amazon to show that it was a dominant force in commerce. It worked well for the private equity firms, which avoided criticism.
The people [who] ultimately lost out were the employees and customers of these businesses. There’s one study that says that private equity firms and hedge funds were responsible for [nearly] 600,000 job losses in the retail sector over a decade at a period when the retail sector, counter to the popular narrative, was actually gaining new jobs.4
I think what’s going on is private equity firms can often profit off these companies, even if the companies don’t ultimately survive or succeed. But it’s a story that thus far hasn’t been particularly widely reported.
Despite [private equity’s] reputation [as] masters of free markets and bare-knuckle economic competition, a lot of them are really bad at running companies. They’re good at manipulating and taking advantage of the bankruptcy process. They’re not very good at business.
You just have to look at private equity executives’ biographies. It’s not a statement about whether or not they’re good or bad people or anything like that. It’s just: What are their backgrounds?
Very few private equity executives have experience in product management, engineering, logistics, marketing, or sales. What they have their background in is finance. And so when they look at companies, they are generally predisposed towards making financial changes rather than operational ones.
Now, oftentimes when private equity executives are forced to make operational decisions, it goes rather poorly. The New York Times did a really interesting story about when a private equity firm bought up Payless ShoeSource and installed a finance executive in charge of the shoe company rather than a shoe executive.5 They [made] all sorts of mistakes—for instance, shutting down a quality control factory in China that ensured the shoes actually were what they said they were. As a result, they started getting shoes that were mislabeled or in the wrong size and so forth. The executive [also] apparently had an idea to start selling World Cup-themed flip-flops with different countries’ flags but chose countries where [Payless] didn’t actually have stores.
That’s just one example, but I think it illustrates that when private equity executives look at companies, they’re often doing it with a financial rather than an operational lens. And when they do take an operational perspective, it often isn’t terribly successful.
KKR [one of the private equity firms that purchased Toys “R” Us] made a ton of money off of the whole Toys “R” Us fiasco, even though its investors may actually have lost money. How does that work? How can an investor lose money, but the fund or the firm can still cash in?
It’s a really important question. And I think it teases out a tension that isn’t particularly well understood, which is that sometimes private equity firms’ interests are contrary even to their own investors’ [interests].
One thing that firms will sometimes do is contract away their fiduciary obligations to their own investors, which is sort of surprising. You wouldn’t expect that an investor would allow that sort of thing. Nevertheless, it happens.
The way that the firms allegedly made money—even when Toys “R” Us failed, even when their investors didn’t make money—was through a series of management and transaction fees. Basically, firms will require a company [that they’ve bought] to pay it money with some regularity, just for the privilege of being owned by the private equity firm. And that money typically goes to the firm, not to the firm’s investors.
An analysis by Axios suggested that Toys “R” Us’s private equity owners actually made more money through those fees than they spent on the acquisition, and made a profit.6 The PE firms walked away with money, even though the company collapsed, and even though the investors didn’t necessarily do well, either.
This is the first of a two-part conversation. You can read the second part here.
https://www.plunderthebook.com; https://www.theatlantic.com/ideas/archive/2023/05/private-equity-firms-bankruptcies-plunder-book/673896/
https://americanaffairsjournal.org/2018/02/private-equity-overvalued-overrated/
https://www.axios.com/2017/12/15/toys-r-us-not-a-total-loss-for-private-equity-fund-managers-1513305992
https://www.populardemocracy.org/pirateequity
https://www.nytimes.com/2020/01/31/upshot/payless-private-equity-capitalism.html
https://www.axios.com/2017/12/15/toys-r-us-not-a-total-loss-for-private-equity-fund-managers-1513305992