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The Rigged Game of Private Equity

posted by Adam Levitin
The Stop Wall Street Looting Act introduced by Senator Warren has the private equity industry's hackles up. They're going to get a chance to say their piece at a House Financial Services Committee hearing on Tuesday. The bill is a well-developed, major piece of legislation that takes a comprehensive belt-suspenders-and-elastic waist band to limit private equity abuses: it's got provisions on private equity firm liability for their portfolio company obligations, limitations on immediate looting capital distributions, protections for workers and consumers in bankruptcy, protections for investors in private equity funds, and of course a reform of private equity's favorable tax treatment. The bill shows that Senator Warren truly has the number of the private equity industry.
In this post I want to address the provision in the bill that seems to truly scare parts of the private equity industry: a targeted curtailment of limited liability for the general partners of private equity funds and their control persons. This provision terrifies some private equity firms because it requires private equity to put its money where its mouth is. The provision is essentially a challenge to private equity firms to show that they can make money off of the management expertise they claim, rather than by playing rigged game with loaded dice. 
Private equity claims to make money by buying bloated public companies, putting them on diets to make them lean and mean, and then selling the spiffed up company back to the public. The whole conceit is that private equity can recognize bloated firms and then has the management expertise to make them trim and competitive. If true, that's great. But as things currently stand, it's near impossible for a private equity general partner—that is the private equity firms themselves like Bain and KKR—to lose money, even if they have zero management expertise. That's because they're playing a rigged game. The game is rigged because there is a structural risk-reward imbalance in private equity investment. That's what the limited liability curtailment in the Stop Wall Street Looting Act corrects. Here's how the private equity game is rigged:  
The private equity business model is built on a unique combination of extreme leverage plus control over portfolio companies. Private equity firms (the general partners) buy portfolio companies in highly leveraged transactions and then manage those portfolio companies. Now, leverage and corporate control can themselves each individually be abused. As stand-alones, however, neither is necessarily a problem. But the combination of leverage and control can be particularly toxic. Here's why.
In a world of limited liability, any investment creates a lopsided risk-reward profile. The investor gets all of the upside if the investment pays off, but has limited liability limits the downside—the investors loses its investment and nothing more. All the more so if the investment is leveraged—that is some of the funds are borrowed on a non-recourse basis. The investor is on the hook for a sum certain—the its own invested funds, but gets all the upside and only has to repay the borrowed funds if it makes money on the investment.
Having the sort of lopsided risk-reward balance is economically equivalent to having purchased a call option on the investment asset with a strike price of zero—the purchase price of the option is equal to the downside exposure, and any increase in the asset’s value is a gain. Black-Scholes’ option pricing formula holds that the value of an option increases with the volatility of the underlying asset value because of the lopsided risk-reward balance. So if one holds an option, one wants to increase the volatility of the underlying asset’s value.
If you're not knee-deep in Black-Scholes and don't want to dig into the math, you can see the point  with a simple illustration. Suppose I have an option to purchase a share of IBM stock for $10/share, exercisable in one month. Let's assume that IBM's stock price fluctuates between a high and a low, and there is a 50% chance it is at the high price and a 50% chance it is at the low price. If IBM's stock price fluctuates between $1 and $19, the option is more valuable than if the stock fluctuates between $9 and $11. The average valuation is the same in both cases, but in the former case, I have a 50% chance of making $9, while in the latter case I have a 50% chance of making only $1. If the option is out of the money (that is the IBM share price on the exercise date is below $10/share), it doesn't matter to me how out of the money it is. The point to see here is that an option is more valuable the more volatile the underlying asset price is.  
Now in the private equity situation, the underlying asset is a portfolio company. The risk-reward imbalance makes the investment in the portfolio company more valuable if the portfolio company has greater volatility its value. The value of a portfolio company, however, is not a random occurrence, beyond the control of the private equity firm. Instead, the value of the portfolio company depends on how the private equity firm manages it. If the portfolio company pursues riskier strategies—like loading up on debt and cutting anything seen as superfluous to immediate value, like R&D—the portfolio company's value is likely to be more volatile. Private equity firms are able to control the volatility of the value of portfolio companies by having corporate control over them.
The combination of risk-reward imbalance with control over the investment's volatility is the private equity business model in a nutshell. This is what distinguishes the risk-reward imbalance in private equity from the risk-reward imbalance that inheres with limited liability and makes private equity particularly problematic. It's the combination of control with the risk-reward imbalance that makes limited liability in private equity materially different from limited liability when I own a share of IBM stock. I can't control the volatility of IBM's share price. Private equity can control the volatility of its investments.  
Now limited liability always creates a lopsided risk-reward balance. But private equity does things to make this imbalance massively more lopsided. It does so through three levels of additional leverage. First, there is leverage at the portfolio company leverage. Portfolio companies are acquired primarily with funds borrowed by the portfolio companies themselves (that’s an LBO). The private equity fund might contribute 30% of the purchase price, but 70% will be borrowed. Because the borrowing is by the portfolio company itself, not the private equity fund, this borrowing is effectively non-recourse, so the private equity fund only repays if it makes money; if the investment turns out to be bad, the private equity fund can walk away at only the loss of the 30% investment.
Second, the fund itself might borrow with “subscription line financing,” meaning that there might be fund-level debt. Fund level leverage increases the returns on successful investments.
And third, the general partner in the fund—that is the private equity firm itself—is structurally leveraged because most of the investment in the fund comes from the limited partners. The general partner might contribute only 1% of the fund. So even without fund-level leverage, the general partner is putting in only perhaps 0.3% of the purchase price of the portfolio company.
The result is absolutely insane levels of leverage for the private equity general partner. For every $100 of private equity investment, the general partner contributes only perhaps 30¢. Yet if the value of the investment goes up by $100 (that is, it doubles), the general partner might have a claim to $22 of that $100 increase (2% base plus 20% of profits). That's a $22 return on 30¢. And that's not counting all the management fees, etc. that the general partner can siphon off. Keeping this ratio, in this scenario, the general partner stands to make $73.33 for ever dollar it risks. In contrast, if a bank wanted to make a $100 investment, it would have to put up $8 of equity. If that investment doubled in value, the bank would stand to make only $13.5 for every dollar of equity it risked.
Private equity general partners operate with a sort of leverage that is impossible to find elsewhere in the financial system. It’s near impossible to lose money over a diversified portfolio with this sort of leverage and limited liability plus a fee based on assets-under-management and other management fees, particularly when you control the risk of your investments. This is the nature of the rigged private equity game. You don't need any managerial expertise whatsoever to make a lot of money playing this game.   
Some commentators have bellyached about the foundational nature of limited liability to the economy. As I’ve written previously, limited liability is vastly oversold and creates a regressive externality. The general merits of limited liability aren’t what’s at issue with the Stop Wall Street Looting Act, however. The bill doesn’t take issue with limited liability generally. It takes issue only with private equity’s unique combination of extreme leverage and corporate control, and it does so in the least invasive way possible: the Stop Wall Street Looting Act doesn’t restrict acquisition of corporate control. The market for corporate control remains unaffected. Nor does the bill restrict leverage at the portfolio company or fund level (doing so would be very difficult to do legislatively because of the challenges in defining leverage). But by eliminating limited liability for private equity general partners (and only them), the Stop Wall Street Looting Act effectively eliminates the risk-reward imbalance in private equity, such that there would be control combined with risk that is commensurate with reward. That means that private equity general partners can still make boatloads of money on a diversified portfolio….if they actually have some management skill, as they claim. If they don’t, then they’ll go out of business.  
In short, the Stop Wall Street Looting Act eliminates a structural subsidization of private equity general partners that has resulted in a bloated private equity industry that has created a lot of negative externalities for American workers, taxpayers, and the environment. Eliminating that structural subsidization returns the private equity industry to true capitalism—survival of the fittest in an unrigged market.
So which private equity firms do you think are going to be yelling the loudest against the Stop Wall Street Looting Act? My money says that it's the ones who know that they don’t have any actual management expertise and whose livelihood depends on the game staying rigged.  


I see the argument, but have one question. PE requires debt. It can't coerce lenders into lending new money, and lenders should price risk into the debt. (Yes, I know that old debt is only protected by fraudulent transfer law.) If the leverage is as extreme as you say it it, why do people lend into PE vehicles?

I have my own doubts about PE, but they mainly concentrate on a known market imperfection--equity is ridiculously overpriced, and PE is very good at producing pretty accounting statements that comply with GAAP but conceal trouble down the road.

It's a great question--why doesn't the market price against excessive leverage?

The key part of the answer is that the funding for LBOs is typically secured by a first lien security interest in virtually all of the portfolio company’s assets. If the LBO-lender is fully or over-secured, it won’t take losses, so who cares about the excessive leverage? Instead, the losses will fall in the first instance on the PE fund's equity interest and then on unsecured creditors—vendors, the PBGC, tort victims, and unsecured bondholders. That was certainly the case with Caesar’s Entertainment (an Apollo buyout) and Tribune (a Sam Zell buyout)—the pre-LBO bondholders took it on the chin, not the secured lenders who finance the LBO. To be sure, the secured lender could end up undersecured, but if the financing is for 70% of the purchase price, that should create some cushion.

Beyond this, there might be agency problems within the secure lender. Suppose the lender books fees immediately, which affect this year’s bonuses, but only faces credit losses several years in the future. If so, there’s a risk of bankers acting in their own interest and not in the bank’s interest.

Additionally, the loans that finance LBOs are being syndicated in an originate-to-distribute market. Such markets can produce informational asymmetries in general, but there's a further twist in that a lot of the syndication pieces are being gobbled up by CLOs, which have many of the asset incentive problems as the CDOs that purchased the dodgier pieces of private-label mortgage securitizations during the housing bubble.

Finally, it might well be that LBO-financiers are pricing against excessive leverage. But if they do, it only incentivizes the PE funds to try and squeeze more blood out of the portfolio company stone.

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