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Siphoning Value through Captives: Private Equity and Securitization

posted by Adam Levitin

Yves Smith has a fascinating post about how private equity firms (which, as she notes in the comments is largely a polite rebranding of "leveraged buyout firms") charge fees for services provided by captive affiliates to their portfolio companies.  On some level none of it is anything so new--part of the LBO game has always been to suck out fees and dividends from the target company, while gambling that the target would be able to service the debt incurred for its acquisition.  Even if the target goes bankrupt, the LBO sponsor may have still made money because of the fees and dividends. 

What I thought was really interesting here was to see the parallel with the private-label mortgage securitization market.  

In securitization, as with private equity, investors have very limited ability to see into the financial details of the operations.  It makes it very difficult for investors to know if their economic agents—the servicers or the private equity firms—are siphoning away value.  Thus, RMBS investors lose out when servicers use captive insurers for force-placed insurance and captive property management company to winterize or sell a property--all at much higher than arms-length prices.  Those are costs that the servicer recovers and which reduce the RMBS investors' recovery.  Same deal with private equity--the sponsor has a contractual 2 & 20, but to the extent that funds are siphoned out of the portfolio companies through captive fees, the portfolio companies will be less valuable. 

Missing in both situations is some sort of truly independent and motivated monitor.  For RMBS, this is the problem of the do-nothing trustee,.  Private equity doesn't have any such monitor.  The only discipline is, in theory, the market, as PE firms that siphon off too much value will have lower returns to investors.  But if all firms are engaged in this sort of behavior (and of course they would be because it offers immediate concrete benefits, rather than uncertain long-term benefits), then it's not clear how much good market discipline will do.  One would hope that if the returns get low enough that investors would bail from private equity, but who knows.  

Comments

I don't know about the private-label securitization market, so I won't comment on that. But all of the academic evidence that I'm familiar with points in the opposite direction on private equity. PE firms typically enhance productivity in their portfolio companies and they don't reduce employment on average. See papers by Josh Lerner as well as a recent paper by Shai Bernstein that show this.

Also, since this is a bankruptcy blog, there is also a recent paper by Hotchkiss, Smith and Stromberg showing that PE-sponsored companies don't fall into financial distress more often than other, similarly levered firms. And, when they do enter distress, PE-backed firms tend to resolve the distress more quickly and are more likely to exit as a going concern.

Just putting that out there, as I think that PE firms get vilified often while all of the evidence I'm aware of points to them enhancing their portfolio firms.

Not sure I understand how an external force can with competence state Credit Slips is only a Bankruptcy blog, when clearly written within the Credit Slips "About Us" it states in part "About Us: A blog on all things about credit, bankruptcy, consumers, and financial institutions..."

Reply to Ben. I invite your attention to a May 6, 2014 speech by Andrew J. Bowden, Director, Office of Compliance, Inspections and Examinations entitled "Spreading Sunshine In Private Equity".

Of the more than 100 firms that Bain Capital bought and flipped under Mitt Romney, the Los Angeles Times reported that four of the ten largest went bankrupt. How can all that money be extracted by these fly by night operators and emerge stronger. It's not like a founder such as Henry Ford did building his company. Also, you might want to take a look at the allegations regarding KKR.

FWIW: The paper by Hotchkiss et al referenced by Ben, above, is "Private Equity and the Resolution of Financial Distress," available at SSRN.

I think you're misreading the Hotchkiss et al. paper. What I take from it is:

(1) PE-backed firms are more heavily leveraged than non-PE backed firms, but controlling for leverage, they are no more likely to default. So PE control is not per se creating defaults (why would it), but PE-backing does seem to relate to higher leverage, which is itself the gateway to default.

(2) PE-backed firms resolve financial distress more quickly than non-PE-backed firms, but that's to be expected. PE-backed firms will generally have only one problem--they're overleveraged. That's relatively easy to resolve, especially if it is only leverage in the form of financial contracts, not pensions, etc. The PE firms have already likely slimmed down in all other regards, so there's not much left to do than renegotiate the debts, and as the PE backers are repeat players, it's not surprising that they do this well.

I don't see anything here that takes away from the "dark side" view of PE. The criticism of PE has always been that it results in overleverage and ensuing financial distress. This paper doesn't dispute that. It just says that once there is financial distress from overleverage, PE isn't making things worse.

To rephrase my prior comment, I think the study shows that PE firms are better at digging themselves out of the holes they created. Perhaps better not to create them in the first place...

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