#50 What is private equity?

And what does the private equity industry tell us about American capitalism?

Author

Dr. Dan Smith
March 11, 2024

March 11, 2024

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Dr. Daniel Smith

What is Private Equity?

Last week, federal regulators from the Justice Department and Federal Trade Commission (FTC) announced that they're investigating the effects of private equity investments in the American healthcare sector.

One of the private equity strategies under scrutiny is the practice of healthcare “rollups,” i.e. a private equity fund buys different companies in the same market in order to consolidate the businesses and make them run more efficiently.

Higher prices, less competition: Regulators and experts are arguing that private equity companies are hurting consumers and market competitiveness by buying and consolidating healthcare practices in different medical specialties.

  • Private equity firms have spent close to $1 trillion on nearly 8,000 healthcare deals over the last decade.

  • Researchers found that private equity investment led the charges-per-patient in some practices to rise by as much as 50%.

  • Separate research has shown that “purchases of nursing homes by private equity firms are associated with higher patient mortality rates, fewer caregivers, higher management fees, and a decline in patient mobility.”

I previously covered private equity firms in my newsletter on private market funds, which also discusses hedge funds and venture capital funds.

Today’s newsletter will explain:

  • How does private equity work?

  • What do critics of private equity say is wrong with the industry?

  • What proposals do politicians and regulators have for dealing with private equity?

By the way: Today’s newsletter is sponsored by The Rundown, a daily newsletter focused on artificial intelligence with over 500,000 subscribers. Learn more about The Rundown at the bottom of this email.

How does Private Equity work?

The private private equity investment process works as follows:

  • raise money from clients that are typically institutional investors or affluent individuals to form a private equity fund

  • use that money and take on debt in order to buy major stakes in private companies or take a public company private

  • put in new managers and executives to lead the portfolio companies (PE firms usually refer to the companies they own as their ‘portfolio companies’)

  • implement cost-cutting measures to make the company leaner and more capable of paying off the debt load built up from the acquisition,

  • ultimately sell the company or take it public at a profit

The key pitch of private equity funds to investors is:

Give us your capital to buy undervalued or mismanaged companies, we will whip them into shape with our management practices and industry expertise, and we will both get rich when we sell these newly-efficient companies for a hefty profit in a few years.

Playing the long game: The private equity industry isn’t going anywhere. The number and size of private equity firms has grown steadily since the 1980s, with the growth trend accelerating in recent years.

From 2016.

Private equity fund assets reached $5 trillion in 2021 — more than double the total in 2016.

What’s wrong with Private Equity?

Pros and Con Men: Private equity firms claim that they produce value in companies by bringing strategic expertise and financial know-how, helping them to become more profitable and valuable in the long-term.

Critics argue that private equity firms are only focused on enriching themselves at the expense of the business, selling its most valuable assets, laying off the company's workers, and saddling the company with debt in order to secure a bigger pay-off for themselves.

The private equity industry has come under fire before. Progressive Senator Elizabeth Warren (D-MA) has long been a critic of the industry. She has said that the industry enables “legalized looting” which:

“Makes a handful of Wall Street managers very rich while costing thousands of people their jobs, putting valuable companies out of ­business, and hurting ­communities across the country.”

In 2019, Warren and other Democrats introduced the Stop Wall Street Looting Act as a way of addressing concerns about the private equity industry.

Among other things, the bill would eliminate the carried-interest loophole that helps private equity firms to pay lower taxes.

Brendan Ballou, federal prosecutor and author of Plunder: Private Equity's Plan to Pillage America has argued that “private equity firms have replaced the investment banks of the Great Recession in terms of their importance” to global finance.

He also noted that the complex legal structure by which private equity companies own portfolio companies protects them from accountability if these companies fail or break the law:

“[Private equity] funds ultimately buy companies, whether it’s nursing homes, single-family rentals, veterinary clinics, OB-GYN practices.

The really interesting thing about that, and I think what drew me to this as a lawyer but also concerns me as a citizen, is that because of the layered ownership structure of private equity firms, oftentimes private equity firms have control of the companies they buy but very little responsibility when those companies do arguably illegal things.”

Private Equity: American Capitalism at its Best or Worst?

Private equity firms’ heavy use of debt at companies at companies they acquire, growing extraction of cash from companies through debt-funded dividends, and limitation on their own liability increasingly set up a ‘heads I win, tails you lose’ structure where private equity firms can make substantial profits for themselves regardless of the consequences for workers, consumers, communities in which their companies operate, tenants, government payors, and others.

Jim Baker, Executive Director of the PE Stakeholder Project

Groups like the Private Equity Stakeholder Project bring attention to an important issue: the difference between the interests of shareholders and stakeholders. 

Shareholders are the people who actually own the company, while stakeholders are the people who are affected by the company.

That could mean:

  • Employees and their families

  • Other local businesses that rely on the company for business

  • The community whose schools and infrastructure are partially funded by taxes paid by the company and its employees

If we’re just focusing on the interests of shareholders, private equity companies are fantastic. If we think about the stakeholders, who might lose their job or their pension due to cost-cutting measures implemented under private equity ownership, we are getting a completely different picture.

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The 2009 NYT documentary Flipped: How Private Equity Dealmakers Can Win While Their Companies Lose is well worth watching for those who want to learn more about the topic.

ART OF THE DAY

The Persistence of Memory by Salvador Dalí. 1931.

Thank you for reading. Please reply to this email if you have any thoughts or feedback.

Yours,
Dan