Yves here. This is the second part of an interview by Andrew Dittmer with the authors of an important new book on private equity, Private Equity at Work (see here for Part 1).
In this segment, Eileen Appelbaum and Rosemary Batt describe some of the ways that private equity firms make the companies they buy more vulnerable to bankruptcy, yet get away with it. One widely-used method is to take property owned by the company for its own operations, sell it, and require the company to lease it back. The reason that this is pernicious is that it increases what is called “operating leverage.” A company with high fixed costs has high operating leverage. This picture is even worse when you understand that companies that own their own real estate are typically ones like retailers or restaurants with a high degree of variability in their sales levels, either because they are seasonal or see big swings in revenues over an economic cycle. Owning their own real estate helps keep their expenses down and enables them to ride out bad times.
As Eileen Appelbaum explains below, not only is this sale/leaseback strategy (called “op co/propco” for “operating company/property company”) generally risky, but the way that private equity firms implement it often pure and simple asset stripping. The private equity firm sets the lease payments for the operating company at a high level. That means they can sell the real estate at a much higher price, to the detriment of the operating business.
Appelbaum and Batt also describe how private equity firms are big enough borrowing customers of bank that they are able to get the banks to agree to loan structures that put banks at a disadvantage in bankruptcy. That enables the private equity firms to restructure the company’s liabilities out of court. Normally that might seem to be a good thing, since bankruptcy is a costly and fraught process. But as Appelbaum and Batt describe in their book, these restructurings amount to a transfer from lenders to private equity investors. And that’s before you get to the fact that restructurings also provide the general partners more opportunities to charge fees. And by avoiding bankruptcy court, they also avoid the risk that they might have some of their pre-bankruptcy fees challenged as fraudulent conveyance.
By Andrew Dittmer, who recently finished his PhD in mathematics at Harvard and is currently continuing work on his thesis topic as well as teaching undergraduates. He also taught mathematics at a local elementary school. Andrew enjoys explaining the recent history of the financial sector to a popular audience
Andrew Dittmer: Could you talk a little bit about how some PE firms sell off company property and lease it back to the company (the opco/propco model: “operating company/property company” model)?
Eileen Appelbaum: The case of Red Lobster is so egregious I can barely stand it. This is how it happened.
Red Lobster is not performing all that well. It’s profitable, it still generates tremendous revenue, but Darden [Red Lobster’s parent company] now has younger restaurant companies that have faster growth potential, and it wants to concentrate on those. So it decides that it’s going to sell Red Lobster and the best deal it can get is with a private equity company called Golden Gate.
So it sells Red Lobster to Golden Gate for $2.1 billion. And on the morning of the exact same day that Red Lobster announces the sale to Golden Gate, Golden Gate announces that it has sold off the real estate of 500 Red Lobster restaurants for $1.5 billion to a real estate investment trust. What that means is that Golden Gate did this before they even had to borrow the money for the takeover, and as a result, they had to borrow much less. That means there is relatively little debt on the restaurants, but the flip side is that restaurants that were struggling to make a profit now have to pay rent on top of whatever costs they already have – cutting their net annual revenues about in half. They may or may not make it.
We saw this with Friendly’s. When Sun Capital bought Friendly’s, the workers actually welcomed Sun Capital. Sun Capital had said, “Yes we know that the menu is outmoded, and the restaurants need refurbishing. We are private equity; we are galloping to your rescue.”
But what they actually did is they sold off the real estate of the Friendly’s restaurants and then leased the restaurant properties back to the restaurants. At this point, the restaurants had to make rent payments and in short order the chain faced bankruptcy – many of the restaurants were closed, and many, many workers lost their jobs. This was one of the 363 bankruptcies we mentioned earlier, and as a result the pension obligations were thrown on to the PBGC and the costs are now borne by a quasi-public agency, and the workers will not get the full pensions that they were expecting.
The case of Sun Capital was especially egregious, but we’ve seen others. Mervyns is a major department store out on the west coast. It was the anchor of many malls and small towns. But Sun Capital used the opco/propco model, so the properties on which the stores stood were sold out from under them, forcing the stores to pay rent. When Mervyn’s went bankrupt, its unmet liabilities were less than the increase in their rent obligations. You can see from this how destructive the model can be.
When a publicly traded or a family-owned company engages in a sale/lease back arrangement, the company actually gets the benefit from the sale. You can imagine situations in which this would be a good idea. You might want to make investments in your business, and maybe the cheapest form of financing would be to sell the properties, take the bundle of cash to make the investment, and then pay rent to lease back the properties. What makes this different is that you, the company, get the money.
When Golden Gate engaged in the sale/lease back of the Red Lobster restaurants, the money went to Golden Gate. It may have used it merely to defray the cost and not take on debt. It may have used it to pay off other debts. It may have returned some of the money to its investors. It did whatever it wanted.
The important point is that it is likely that Red Lobster didn’t get much or perhaps any of the proceeds. Red Lobster didn’t get the benefit of the sale, but its restaurants are obligated to pay back the rent.
Andrew Dittmer: Another topic you discuss in your book is “amend and extend” deals, in which creditors agree to renegotiate the PE companies’ debt and typically provide them with more time in which to pay. You explain how PE typically structures companies’ debt so that they have smaller amounts of subordinated debt, and that makes creditors holding more senior debt frightened of taking a hit. So they are more willing to agree to new deals that are favorable to the PE firm.
Eileen Appelbaum: That’s right – the creditors know they are at risk.
Andrew Dittmer: In these cases, why aren’t the lenders able to press for a deal in which the equity also gets diluted so that the PE firm takes a hit and loses part of its ownership stake?
Eileen Appelbaum: I think, again, it’s the asymmetric power. I think that private equity says, “Ok, we’re on the verge of bankruptcy. You can take this deal we offer you, or you can throw yourself on the mercy of the bankruptcy courts.”
With the amend and extend agreements, banks and other creditors can act as if the asset will pay off in the end. They aren’t forced to mark it down as much. They take a haircut on the initial loan, but that’s it – they don’t have to say, “And by the way, the rest of this is probably not too stable either.”
Andrew Dittmer: Why do you think non-PE companies don’t pull off these amend and extend deals as frequently?
Eileen Appelbaum: For one thing, they don’t have as much debt. But I think a big piece of it is the relationship that the PE funds tend to have with banks. They go back to these banks every other day for more loans, and the banks can make a lot of fees from securitizing the loans used to finance the initial buyouts. A publicly traded company just doesn’t have that kind of relationship with banks and other top-tier lenders.
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I am reminded of a line (really just about the only good thing) from the movie “Warlords of the 21st century.” The bad guys show up in town and the head bad guy says to his 2IC “Prepare the men for inventory and requisition” The 2IC yells “You heard the man LOOT! LOOT!” And of course these deals wouldn’t work is somebody wasn’t overpaying for the OpCo when the PE firm was finished looting. Who is fooled into believing that after the PE company is finished looting the remainder is worth anything and isn’t headed towards bankruptcy?
I would guess that several million people who voted for Romney were fooled about this process. Not that Obama was much better, of course, so I voted for Stein.
Interestingly, yesterday I got an email from the American Economics Association with the contents of the latest American Economic Review. An article caught my attention. It was on private equity. I no longer subscribe so can’t get the article, but here is the abstract:
“Private equity critics claim that leveraged buyouts bring huge job losses and few gains in operating performance. To evaluate these claims, we construct and analyze a new dataset that covers US buyouts from 1980 to 2005. We track 3,200 target firms and their 150,000 establishments before and after acquisition, comparing to controls defined by industry, size, age, and prior growth. Buyouts lead to modest net job losses but large increases in gross job creation and destruction. Buyouts also bring TFP gains at target firms, mainly through accelerated exit of less productive establishments and greater entry of highly productive ones.”
Seems pretty hard to believe to me. I have yet to see a newer, more highly productive KB Toys.
Here is the link:
https://www.aeaweb.org/articles.php?doi=10.1257/aer.104.12.3956
That study was addressed long form in Appelbaum’s and Batt’s book, and it is covered short form in the next segment of their interview. The appalling bit is after having done such a careful survey (and it was remarkably careful how they matched PE establishments to controls), how they cooked the results.
Get a load of this: many PE companies do roll-ups, as in industry consolidation plays.
The studies treated acquisition of “establishments” as job creation.
So let’s say a PE firm first bought a company that had 5000 jobs. They fire 500 people. But they also buy a smaller company with 750 people. This study treated that as having net created jobs.
I am not making this up.
They give themselves away by the phrase “highly productive”, which as you know in Econospeak means more output per unit of labor, and therefore less labor.
But of course this industry is not about being productive–it is about being extractive.
They Don’t Teach Stuff Like This at M.I.T.
The good thing about private equity is that, for every PE Firm 1 that destroys a company there’s a PE Firm 2 ready to ride in like the cavalry in Hollywood movie set in 1873 with an equity infusion to rescue it.
From this we can derive the equation that PE1 – C = PE2 (Eq. 1.1), where C = company and where PE1 = 1/C (Eq. 1.2) by insinuation.
Therefore, as C goes to zero, PE1 goes to infinity. As PE1 approaches infinity, it owns nearly all assets in the universe. However, it has to share those assets with PE2 the way two tennis players competing in a match share the same tennis ball.
Mathematically, this is self evident from Eq. 1, as both PE1 and PE2 go to infinity together as C goes to zero, and PE1 = PE2 when C = O. What’s also clear is that C can’t go all the way to zero, or Eq. (1.2) is undefined, since division by zero is against the law. Not that that matters anymore, but in math you can’t fake it forever.
This means there always has to be some C in order for PE1 and PE2 to get filthy rich, and that they get rich not by maximizing C but by minimizing C. QED from Magonia
I find the last part of this interview a bit mind-blowing. PE’s creditor’s willingness to extend credit in the face of the PE firms intentionally bankrupting the PE-owned companies is clearly malinvestment. I haven’t the skills to calculate the effects of such decisions, but on its face, it seems a clear loser. Yes, I understand that when facing a loss, the wise money manager looks to minimize those losses – I simply cannot fathom how restructuring debt minimizes losses. Or, is this another example of looting in which bank officers gobble-up fees and leave the bank holding the bag? I guess I’ll buy the book.
Again, I refer you to Caesars, which is the poster child for opco/propco and amend-and-extend (pretend?) deals. I was once told by a legal expert that the original Caesar LBO, which included an opco/propco structure to fund the transaction, could have easily been considered fraudelant conveyance. But since the company never filed and was able to survive for another 6 years post-LBO, this claim will never see the light of day. Elliott recently filed an entertaining lawsuit about all the steps that the PE firms (Apollo/TPG) too to “brazenly loot” the company.
This sounds a lot like an asset-stripping operation, possibly shading into fraudulent conveyance depending on the value of the assets. I am reminded of the dot-com era story where divine inc. acquired RoweCom, a subscription management company for academic journals with no relation to divine’s business, purely (or so it was later alleged by RoweCom) because they operated on a prepay model and had access to a large pool of subscriber cash. The money mysteriously vanished, divine went bankrupt within months, the subscriptions collapsed, and few of the publishers were ever paid.
The thing I can’t figure out in this case is that Golden Gate still paid $600 million for Red Lobster net of the real estate assets. If the sell-and-rent-back trick drives the chain into bankruptcy, it seems like they would still be in the hole for that amount. I can’t figure out why they would do it unless they thought that the chain could still operate at a profit (albeit a reduced one).