Capitalism in its Purest or Most Cynical Form?
Private equity has often been touted as the purest form of capitalism. Others, however, see it as its most cynical manifestation. The truth probably lies somewhere in the middle.
Private Equity: A Brief Overview
For the uninitiated, private equity (PE) firms buy businesses, often with the intention of making improvements and selling them for a profit down the line. On paper, it’s capitalism at its finest. Money is at risk, substantial efforts are expended to enhance value, profits are made and losses are endured. But like all things, it’s not quite as simple as it appears.
The Case of Toys ‘R’ Us
A classic case study is the much-loved retail giant, Toys ‘R’ Us. In 2005, three PE firms bought Toys ‘R’ Us for $6.6 billion, with about 20% ($1.4 billion) as their own equity and the rest as debt placed on the company. Twelve years later, the company filed for bankruptcy.
Sure, you could point to new competition from Amazon and changing toy-buying habits. But a financial autopsy of its collapse shows that the company was making enough to maintain operations, but not enough to service its debt. The massive interest payments, a legacy of its purchase by three PE firms, suffocated the company. In the process, 33,000 jobs were lost.
Signs of Financial Manipulation
In some cases, PE firms indulged in financial engineering instead of operational improvements. The actions of PE firms in the Toys ‘R’ Us saga raised a few eyebrows.
In 2010, the PE owners did a sale-leaseback of the company’s properties. This allowed them to take out $500 million in a one-off profit. But it meant that Toys ‘R’ Us started paying rent on previously owned properties, increasing its operational costs.
Later, there was a dividend recapitalization, where Toys ‘R’ Us borrowed even more to pay a dividend to its PE owners. These actions made the position of Toys ‘R’ Us even more precarious.
The Bitter-Sweet Tears of Private Equity
Herein lays the cynical aspect of private equity. The PE owners typically make their money upfront through deal fees, management fees, special dividends and financial engineering. In effect, they’ve often taken their profits before the business improvement phase begins. They win, whether the underlying company improves or not.
Conclusion: Capitalism in its Purest or Most Cynical Form?
So, is private equity the purest form of capitalism? In a sense, yes. It involves risk, reward, value creation, opportunity and the laws of demand and supply in its rawest form.
But at the same time, private equity is arguably capitalism at its most cynical. It has the potential to turn companies into debt-ridden zombies, mired in complex financial transactions designed to benefit the financiers behind them.
And amidst the stratospheric profits of the PE firms, one cannot deny the very real, very human costs: jobs lost, pensions slashed, suppliers unpaid. In the final analysis, private equity serves as a harsh reminder — capitalism is a powerful force that can create value but, left unchecked and skewed in favor of the financially savvy, it can also unleash destruction.