How Private Equity Secretly Broke The American Economy

Ethan
0

In 2023, 642 US corporations filed for bankruptcy, which is a record level since the Great Financial Crisis. What's more shocking is that businesses with private equity ownership have a ten-fold higher bankruptcy rate. 


The issue is that one in every fourteen US employees receives their paychecks from businesses that are privately held. What exactly is private equity, though? How do they own more wealth than all of Apple, Microsoft, Amazon, and Tesla put together? What effects are they having on the US economy? 


How Private Equity Secretly Broke The Economy


What is Private Equity?

Private equity firms or PE firms like Blackstone, The Carlyle Group, and Vista Equity Partners offer exclusive investment opportunities reserved for wealthy individuals and institutions. Basically, PE firms allow the wealthy to pool their cash together into this thing called a PE fund. 


By 2023, PE firms managed around $12 trillion in assets, more than the value of Apple, Microsoft, Amazon, and Tesla combined. But it's what they do with the money that's concerning. Generally, a PE fund has three main objectives 


  1.  Use the cash to buy companies, 
  2.  --------------------
  3.  Collect a massive paycheck. 

But it's the second objective that's changing the American economy for the worse. When it comes to what type of companies PE firms target, they fall into two categories privately and publicly owned companies. 


Basically, privately owned companies are businesses that are not publicly traded in the stock market like Ikea, Lego, and Trader Joe's, whereas publicly owned companies are Apple, Tesla, and Amazon. When a company is publicly traded, everyone from Warren Buffett to your 15-year-old nephew can find that company's stock. 


Public companies on the stock exchange have to comply with SEC regulations and be transparent with their financial performance. Every quarter, their leadership team jumps on calls with their investors and explains what's going on with the business, why Netflix got rid of shared accounts, or how Apple can justify releasing the same iPhone model seven years in a row. But private companies don't need to do any of this. 


When a PE firm buys a public company, that company becomes private. They don't need to share any information, including information as basic as who actually owns the company, how it makes money, or whether it's even profitable. 


Private companies are effectively invisible to the public, media, and regulators. In 2000, private equity firms managed about 4% of total US company equity. By 2021, that number was closer to 20%, meaning about one-fifth of the market has been made effectively invisible to public investors, the media, and regulators. 


PE firm's final objective is to collect a massive paycheck. In theory, how they do this sounds pretty good, but in practice, there are very sinister consequences. But before we talk about what those consequences are, we need to first understand how PE firms became so powerful. 



The Beginnings of Private Equity

In the 1970s, Houdaille Industries ad


In the 1970s, Houdaille Industries was a household name. They were one of the largest auto parts suppliers in the US. Everyone would go to the mechanic and ask for a new set of Houdaille. But in just a decade, the name Houdaille was completely wiped from the American economy because of three people. 


By 1978, Gerald Sartorelli, the CEO of Houdaille Industries, had grown the company to over 9000 employees. They were debt-free and were flush with cash, but he was ready to retire. 


He considered selling all the stock he owned in the company, but then he met three bankers Jerome Kohlberg Jr, Henry Kravis, and George Roberts, otherwise known as KKR. At the time, they were nobodies just a couple of people trying to make it big, but they made Saltarelli an offer he couldn't refuse. 


At the time, Houdaille Industries stock was trading around $14.50 per share, but KKR offered to buy them out at $40 per share at nearly three times the premium. Naturally, Saltarelli agreed and walked away with a nice retirement package and $5 million. 


But how was any of this possible? How did a couple of nobodies afford a 3X premium? But more importantly, how did this deal become the catalyst that shaped the future of the American economy? 


In finance, they call the KKR strategy a leveraged buyout or LBO. Basically, it's when a PE firm borrows a ton of money to buy a company out. Sounds innocent, but what have I told you that KKR and their PE fund put in less than 1% of the total deal value, meaning they spent less than $1 million to close a deal worth nearly 400 million. 


The rest of the $399 million was borrowed from the banks. Imagine if you could buy a $500,000 house and you only needed to put $5,000 down. But the issue isn't that they borrowed the money. Sometimes you just need to take on debt to stabilize a business, which is fine. But it's how they took on the debt.

 

Naturally, you think if KKR borrowed the remaining 99% of the money to buy the company, then KKR would be the one to owe the lenders back. But you'd be wrong. When it comes to a leveraged buyout, the debt is actually in the name of the company. They just bought, who they industries. 


Meaning while KKR enjoyed all the benefits of owning Houdaille Industries, making executive decisions, and taking a huge chunk of any profits, it's actually Houdaille Industries who's ultimately on the hook to pay back the loan with interest. It's this minute detail that would change the face of the American economy forever. 


The Houdaille deal was historic and Wall Street started to pay attention. But when the 1981 recession hit, things became bad. Houdaille was in deep trouble. Normally, when a business faces financial pains, it can borrow money against its equity to shore up its cash flow. 


But Houdaille Industries wasn't a normal case. Thanks to KKR, the entire value of the company was tied up in debt. Paying off this debt was the biggest expense on the balance sheet. KKR hoped they had a bit more time, but now Houdaille Industries was bleeding as a fix. 


KKR sold seven of the company's business divisions at a significant discount and eliminated over 2000 jobs. Then KKR borrowed even more money and put the debt on her doorstep not to. Overall, Houdaille's business opens new avenues such as online sales or updating the infrastructure, but simply to pay the investors out. 


A year later, KKR sold off Houdaille's remaining divisions. Houdaille Industries, a pillar of American manufacturing that had previously enjoyed more than 50% market share, was completely wiped from the face of the Earth, but KKR deemed it a success story. 


They walked away with millions in profit and rose to become the second-largest PE firm in the United States. But it wasn't just KKR who saw this as a win. 


How Private Equity took over the economy

By 1989, PE firms bought out more than 2000 companies valued at more than $250 billion. Wall Street saw leveraged buyouts as a golden moneymaking opportunity. Many acquisitions met the same fate as Houdaille, but investors didn't care. Neither did regulators. 


How Private Equity took over the economy


From 1920 to 2000, about 310 companies went public every year. But since 2001, that number has more than half to 118 companies. Businesses were now retreating back into the shadows, walled off from public scrutiny shortly after pension funds and university endowments joined in. 


There are universities like Yale, University of California, and Georgia Tech. Then there are pension funds like the California Public Employees Retirement System and the Pennsylvania Public School Workers Fund. Out of the top ten pension funds in the country, eight invested more than 45% of their total capital in private equity between 2005 and 2008. 


Before this, pension funds and school endowments were mostly invested in low-risk assets like US government bonds, and for good reason. The money in these pensions was primarily used for retirement, teacher salaries, and research. 


You know, things that you don't want to gamble money on. It was one thing if billionaires wanted to gamble away their money in private equity funds, but it's another. If a teacher's retirement plan was on the line by 2022, more than 1 in 10 US pension funds were invested in private equity. 


Thanks to all this new capital, PE exploded from $62 billion invested in 547 leveraged buyouts in 2001 to 775 billion invested across more than 2500 buyouts in 2007. 


But there was a problem

While the flip-and-strip strategy of milking investments was profitable, PE firms knew it wasn't sustainable. A 2019 research study found that companies bought by private equity firms are ten times as likely to go bankrupt. There is a vision of Healthcare, Neiman Marcus, A&P, and J.Crew. 


The problem is, that when a PE firm buys a business, its objective is to maximize profits, pump up the company's value, and then sell it. They'll raise prices and severely cut expenses, lay off workers, cut salaries, and lower quality. 


Imagine your favorite smash burger chain, Magic Lamp Burgers as great service, huge portions, and unlimited soda refills. After a PE firm takes over, the burgers now taste like cardboard. You're getting charged for extra sauce, and you pay an extra fee to dine in. 


Chances are you're gonna stop going there. You'll get your burger fixed somewhere else. You have a choice. But what if you didn't? PE firms realize that buying companies in a competitive market probably isn't ideal. In economics, they call this elastic demand. 


Basically, what are the chances you as a consumer will switch to a substitute product if its price goes up or quality goes down? If Netflix starts to charge $100 a month, chances are you're just gonna switch to Hulu. If Poland Springs starts to taste like expired milk, you'll just buy Dasani. 


Different products and services have different degrees of elastic demand. The more competition, the more elastic it is. But there are some products that are inelastic, meaning you'll still buy them regardless of the changes because you don't have another choice. 



Also Read:

What Happened To Browser Toolbars?

Exploring Walmart's Flower Selection: Types, Prices, and Options

What Happened To The Once-massive Telecom Company Sprint

Why LinkedIn may be the most powerful social media platform

How Did Europe Fall So Far Behind In Technology



The next target for Private Equity

And those are the exact industries PE firms are turning towards now, specifically two industries that are the backbone of our economy. Firstly, there's education to talk about. Education and tuition are basically inelastic. 


Nowadays, a college degree is required to compete in the job market, and the pressure to get one means that even families that can't afford the cost of higher education will still find a way. Over the last decade, PE firms bought nearly 1000 universities and colleges. 


In 2006, PE firms like Goldman Sachs bought the College Operator Education Management Corp in a $3.4 billion leveraged buyout, with the intention to sell it later at a profit. By 2016. Enrollment tumbled, staff were let go and campuses closed down. 


With a company on the brink of bankruptcy, the PE firm sold the remaining college assets to Dream Center Education Holdings. In two years, that organization collapsed. Professor Charlie Eaton and his colleagues know a thing or two about this. 


Professor Eaton analyzed how PE buyouts impact higher education. They looked at 88 PE deals involving nearly 1000 schools with PE ownership and discovered two things. 


First, the students' future outlook became much worse. Students who attended schools acquired by AP firms had a 13% lower chance of graduating and also earned 5.8% less in the job market. 


Second, everything became more expensive in 2007 when the Fed raised the student loan borrowing limit. PE-owned schools raised tuition fees at faster rates than comparable non PE owned schools, meaning students had to take on more loans for worse education. 



But this next target might be worse news


But it's not just the education industry. PE firms are also targeting health care. Studies show that 70% of baby boomers will need some form of long-term care. The problem is, baby boomers have culturally shifted away from large families and multigenerational living. 

40% of baby boomers live alone, 20% have no children, and 20% have no partner or nearby family members. As a result, assisted living, hospice care, or nursing homes are the only options for this group. From 2000 to 2018, PE investment in nursing homes grew from less than $5 billion per year to $100 billion in 2018 alone. 


Similarly, the number of deals each year increased from 78 to 855. In 2007, Carlyle, a PE firm, acquired HCR Manor Care, a nursing home, for $6 billion, most of which was borrowed money that Manor Care would have to pay back. But almost immediately, Carlyle sold off all of Manor Cares real estate to quickly recover its initial investment and make a nice profit. 


The problem is that Manor Care now had to pay nearly half of $1 billion every year in rent to stay in the buildings they previously owned. Carlyle also charged Manor Care $80 million in transactions and advisory fees, bleeding them dry. 


The consequences were brutal cost-cutting, layoffs, health code violations, and worse patient outcomes. But it didn't last long. By 2018, Manor Care declared bankruptcy with a staggering $7 billion in debt. Carlyle couldn't care less. They already got their money back and even profited millions. 


But this was only one nursing home company. Professor Atul Gupta and her colleagues looked at the data across many more. She and her colleagues found that nursing home companies owned by PE firms saw a 10% spike in patient mortality, meaning an additional 22,500 lives were lost in a 12-year study because of PE ownership. 


These nursing homes were also 50% more likely to drug their patients because sedated patients meant the nursing homes didn't need to hire as much staff to care for them, but at the same time, they raised their prices. 


The problem is, that more and more nursing homes are experiencing staffing shortages, overcrowding issues, and many are operating at a loss as a result. Over 1000 nursing homes have closed since 2015 and more are on their way. 



How Private Equity could ruin the economy?


Looking back, it's clear that this was only the beginning of private equity, a blueprint that laid the foundation for how the American economy was set to change forever. It signaled two major consequences. 

Firstly, there's the next target on the agenda to think about FTC Chair Lina Khan knows a thing or two about this. In 2023, she and her colleagues sued a Texas-based company, US Anesthesia Partners, and private equity firm WCAS, for executing a roll-up. 


Basically, a roll-up is when a PE firm buys up all the small businesses focused on the same type of services in a specific area and then merges them. Sometimes this is good news. If 50 local small businesses selling magic lamps were owned by one company, operations could become more efficient, resources could be shared, and materials could be bought in bulk. 


As a result, they can pass on the savings to the customer. But for PE firms, it's a different story, PE firms consolidate local businesses to create a monopoly and raise prices. In 2022, Jama Internal Medicine found that when anesthesia companies backed by investors took over a hospital, outpatient, or surgery center, they raised prices by an average of 26% more than facilities served by independent anesthesia practices. 


Next, there's what's happening behind closed doors. Imagine what your goals are if you're a homeowner versus if you're a home flipper. If you're the former, you'll want to make your house a nice place to live in. You'll buy better-quality floors, countertops, and lights. 


Every decision you make is guided by one question Will this make my home better for me and my family in the Long Term? But a house flipper is only concerned about making a profit. Let's get the cheapest appliances. That door is gonna break in five months. Who cares? That crack needs to be fixed. Just paint over it. Flippers buy to extract as much wealth as quickly as they can. 


Now replace the homeowner with a privately held company and the home flipper with a PE firm. The people who would actually put the effort in to improve a business will not be able to compete with someone who just plans to liquidate or paint over the water damage. 


The eventual fallout and bankruptcy aren't their problem or concern because they never had any intention of staying. The problem is, instead of having high-quality industries or houses that aren't held together by duct tape and paint, you have a few wealthy people and a whole lot of crap that isn't their problem. 


But what if I told you that PE firms taking over businesses should be the least of your worries? What most people don't realize is that something is secretly taking over American neighborhoods. This thing has virtually no restraints and has been transforming the housing market and the cities we live in. 

Post a Comment

0Comments

Post a Comment (0)