Public problems for private equity

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Ethan Wu (0:36)

Thank Pushkin, Private Equity. It's been one of the best returning asset classes of the past, call it 20, 30 years. It's warmed its way into pretty much every institutional investor's portfolio, and it's generated a fair amount of political controversy along the way. But today in the show, investors are starting to wonder, can private equity keep it up?

This is Unhedged, the Markets and Finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu here in the New York studio, joined today by anti-PE, ODB, Robert Armstrong.

Robert Armstrong (1:10)

Yo.

Ethan Wu (1:12)

Do you want to define ODB for the listener?

Robert Armstrong (1:13)

No, I do not.

Ethan Wu (1:16)

Okay, moving swiftly on then.

The reason we're talking about this now, right? PE has been in the ether for a long time, but I think it's increasingly getting more coverage because investors are looking at some of PE's evolving tactics and saying, you guys are looking a little desperate.

Robert Armstrong (1:32)

So our colleague, Antoine Gara, has been reporting for a while now on the fact that private equity funds are turning to, or if you prefer, resorting to, increasingly exotic forms of debt financing to keep their portfolio companies going. So I think a lot of us investors, people in the press, are looking on and saying, we remember that old story about how private equity funds bought companies and made them better.

But now you're doing these sort of financial engineering card tricks, and we're wondering if there's something unfortunate going on behind the scenes.

Ethan Wu (2:14)

Yeah, yeah. And we'll get into all this in more detail because there's a reason that they're getting into these financial engineering tactics. But I think before that, we need to start with, what is PE?

Robert Armstrong (2:25)

Most of the time, we're talking about leverage buyouts.

I am a private equity smarty pants. I have a large pile of institutional money. I take a part of that pile and I buy a company.

Ethan Wu (2:42)

Yeah, outright.

Robert Armstrong (2:43)

Now, the most important feature of this purchase is that I actually don't use that much of my pile of money.

Most of the purchase is paid for by borrowing a lot of money, either from a bank or the bond market or somewhere else. So I own the company in much the way that most Americans own their houses at first, with a tiny little slice of equity or actual ownership and a big old mortgage on top of that.

Ethan Wu (3:13)

Yes. And I think one part of this that does generate controversy is the debt ultimately ends up held by the company in a lot of cases, not necessarily the private equity firm itself.

Robert Armstrong (3:25)

This is the classic criticism of private equity, that they pile a huge amount of wicked debt onto virtuous and hardworking little companies.

And if the companies happen to go bankrupt, because of this immense pile of debt, the private equity executives simply walk away rubbing their hands together and cackling like movie villains. I'm not sure that that criticism is particularly fair, but it gets at something important about the economics.

Ethan Wu (3:58)

Yeah. I'm glad you brought up that homeowner metaphor, because I think that brings us from a description of what is PE, borrow money to buy a company, put simply, to what is the water PE has been swimming in in the past decade, two decades or so.

And with a homeowner, you would like to be in the housing market if rates are low and falling, and your asset price that you've borrowed to purchase is going up. You feel great. You feel like a genius. This, I think, is not too dissimilar from how it's been for private equity in the somewhat recent past. It was a pretty good environment to be in.

Robert Armstrong (4:30)

And now the great time is over. Just as it is for a homeowner who is discovering that mortgage rates can actually go two directions, so private equity is discovering that general interest rates, cost of borrowing can go up, which not only makes your debt more expensive, if you haven't termed it out to the infinite future, it also increases the probability that your asset value is going to fall.