Where Private Equity Firms and Personal Loans Collide
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UPDATED: Feb 9, 2021
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As Mitt Romney prepares to take an even larger step into the media’s spotlight, his affiliation with the private equity firm, Bain Capital, is likely to receive even more attention than it has previously been given. Proponents, including Romney himself, claim Bain Capital helped save or produce more jobs than it killed off. Opponents argue that Bain Capital (and all other private equity firms for that matter) is a predatory Wall Street business that profits by performing the final coup de grace on wounded companies.
Whether Romney’s affiliation with Bain Capital is good or bad, it matters little given the fact that the vast majority of the public doesn’t even know what private equity firms do. Instead, they’ll subscribe to whatever their favorite reporter or news agency tells them.
In order to either agree or disagree with the media’s spin on Romney, Bain Capital, and private equity firms in general, it’s crucial that we take a look at what this industry is all about.
Private Equity Firms Defined
Made famous—or rather infamous—by the 1993 movie “Barbarians at the Gate,” private equity firms have become the arch-nemesis sitting atop the Wall Street Throne. Big names like Goldman Sachs, the Carlyle Group, Permira, the Blackstone Group, and, of course, Bain Capital haven’t helped that villain-esque shroud encompassing their industry either. But what exactly do these firms do?
Private equity firms perform the exact service that the industry’s name describes: they purchase equity in other businesses with private money. Much like private investors, private equity firms simply operate on a much grander scale, usually offering millions upon millions of dollars to companies in exchange for a percentage of equity in those companies.
In an ideal transaction, the private equity firm will fork over an amount of money that’s required for a business to gain its footing again, then that company will improve and grow to a healthy level, and finally the private equity firm can sell its stake in the company and turn a profit. Such a relationship is usually great for both the firms and the companies they service.
But that’s not always how these relationships work out.
The Leveraged Buyout
Instead, private equity firms often deal with very volatile and wounded companies. As a result, they offer money, but through a practice called a “leveraged buyout.”
A leveraged buyout occurs when a private equity firm offers money to a company in exchange for controlling power of that company (meaning 51 percent equity or more). But the “leveraged” part of this transaction requires the wounded company to put up collateral of its own. Usually, this is done through the origination of private personal loans, and those personal loans are taken out by the wounded company, and used to help fund the costs of the private equity firm’s purchase of itself.
In other words, a private equity firm says it will help a struggling company, only if that company is willing to hand over a majority stake, and fund the private equity firm’s purchase by contributing money derived from private personal loans.
Sounds kind of backwards, doesn’t it?
As Josh Kosman explains in a recent Rolling Stone article, “Imagine a homebuyer purchasing a house and making the bank responsible for repaying its own loan, and you start to get the picture.”
While Kosman’s example sort of loses its surprise factor given the fact that plenty of homebuyers are walking away from their homes and thus making banks and loan security agencies do exactly that—pay for their own personal loans used to secure real estate—it’s still a valid analogy.
Why Would Anybody Seek These Services?
The thing about capitalism, though, is if supply has no demand, suppliers quickly disappear. If leveraged buyouts were as volatile as they appear on the surface, and as “backwards” as they seem, companies—no matter how wounded—wouldn’t go anywhere near private equity firms and their services.
It’s true that most leveraged buyouts require the wounded company to partially fund its own acquisition through the use of personal loans. But what is the alternative? The company would simply go under. Leveraged buyouts provide a last ditch effort for an experienced group to seize control of a dying business and attempt to bring it back above the surface of the water.
The personal loans and self-acquisition is simply a form of collateral—albeit a very complex form of collateral.
If the private equity firm is unable to help the company, it often liquidates the remaining assets their new acquisition still has, and tries to break even or make some money on their transaction. But if the private equity firm is successful, the wounded company may see a turnaround in productivity, a rejuvenation of jobs, and a more competent business model. At that point, repaying the personal loans required to essentially “buy” the expertise and capital from a private equity firm can be easily repaid.
Consider the story of Levi Strauss, the manufacturer of one of the most famous line of jean pants. Levi sought a leveraged buyout back in 1985, just as the jeans market was shrinking, according to Fortune Magazine. So Levi agreed to leverage their company against its own assets and used a $1.5 billion personal loan to finance their own acquisition.
As a result of the buyout, the company had to close 26 plants and had to lay off 16 percent of their employees—but the end-product of the private equity firm’s work led to unprecedented results: an increase in sales by 31 percent, a fivefold increase in actual profits, the introduction of a whole new line (Dockers), and the ultimate rescue of the company. While losing 16 percent of the Levi’s workforce can be seen as a failure by some, the fact that the private equity firm ultimately saved the remaining 84 percent of the workforce, repaid two-thirds of their $1.5 billion personal loan within six years, and turned the company into a profitable giant once again that later went on to rehire more employees (and is still hiring today) is a huge victory—but a victory that won’t be reported on by many sources.
While private equity firms require their clients to fund their own acquisition with personal loans, sometimes that’s not a bad move. When jobs are saved and profitability is found, those personal loans can be repaid with ease. When layoffs occur but a rescue occurs, future rehires can be made possible. When a company that is already destined to die assumes debt for one last Hail Mary, and catches the end zone throw with the help of a private equity firm, then the leveraged buyout they participated in doesn’t look like such a broken tool after all.
And that’s why suppliers exist.
At the end of the day, the supply is demanded, and if a dying company doesn’t want to fund its own acquisition with personal loans, it won’t. But if it sees a glimmer of hope in the expertise of a larger group, then they’ll likely sign those personal loans emphatically and resign their fate to the hands of private equity firms.