The Cast of Characters
The theater of private equity (PE) investment has been living a tawdry melodrama. The key character is cheap debt — a seductive siren that has led many a PE firm down a boulevard of financial recklessness. Over the years, amid historically-low interest rates, private equity’s executive suits have become habituated to using cheap debt to fund their acquisitions. However, recent rumblings in the financial markets suggest their free-wheeling party might be heading for a rude awakening.
Debt-Fueled Spree
Let’s set the stage. Picture this — a private equity firm purchases a company, burdening it with large amounts of debt, often amounting to several times its earnings. The debt is cheap, the interest rates low, allowing the business to service it without seeming to sweat. The PE firm squeezes out profits, camouflages performance through financial kung fu, and eventually exits with a handsome return. Lather, rinse, repeat.
Cheap Debt: A Double-Edged Sword
Yet, cheap debt in high doses is a double-edged sword. It enables gains in good times, but sharply amplifies risk if conditions change. And change they do — a bump in interest rates, a slowing economy, or a global pandemic, for instance, can all make the servicing of such debt unsustainable.
Reality Check: The Toys ‘R’ Us Story
Take Toys ‘R’ Us as a startling case study. Saddled with $5 billion in debt following its 2005 leveraged buyout by private equity firms Bain Capital, KKR, and Vornado Realty Trust, the company was driven to bankruptcy in 2017. A beloved childhood retail giant reduced to ruin, thousands of jobs lost, all while the PE firms reportedly made a cool $470 million in fees and interest.
Sowing the Seeds of Destruction
Alice Korngold, author of “A Better World, Inc.”, put it aptly when she said, “Private equity firms have been all too happy to over-leverage companies, sowing the seeds of destruction.” Leverage, in private equity’s lexicon of financial engineering, often signals the thin red line between ingenuity and insanity.
The Calm Before the Storm
As we stand at the precipice of a possible financial shift, looking at signs of increasing interest rates globally, the PE industry appears to be at a critical inflection point. After years of feeding on cheap debt, the firms could find themselves struggling to adjust to a new, more demanding reality.
In Waiting: Lessons and Takeaways
While it’s tempting to think that PE firms might learn their lesson from past fiascos, the track record is dismal. As the canary in the coal mine has oft been ignored, the upcoming financial turbulence may finally force a check on private equity’s addiction to cheap debt. As always, who will be left dealing with the mess is highly predictable: the businesses bought, their employees, and in many cases, the tax-paying public itself.
Keep a keen eye on the moves in Wall Street and London in the coming year: there may just be a reckoning waiting for the masters of PE universe.