Why private equity take-overs should be seen as a nail in the coffin of healthy companies

What is private equity and how does it work? Moreover, why should anybody working at a firm that is taken over by an private equity firm worry?

In the economic blogs, there have been many good articles about the private equity industry, especially in relation to Mitt Romney, who somehow claims to be a job creator because he was in a private equity firm.

To quote from a good introductory article by James Kwak of The Baseline Scenario:

A private equity firm is just a rebranded version of what were called LBO (leveraged buyout shops) in the 1980s, before they got a bad name. The classic transaction is to take over a company by contributing a small amount of equity and borrowing a lot of money.

As he states later in the same article,

The discussion of the power of leverage above should have reminded you of something: the credit bubble and financial crisis. Leverage means higher expected returns, but it also means higher risk, transaction costs, and the potential for looting. […]

When it’s easy to make money just by piling on debt and paying yourself hefty “dividends” and “fees,” why go to the bother of actually making a company better? In that case, it’s simply a case of shareholders (private equity funds) taking money from creditors, with employees left as collateral damage.

In another article on the links between private equity and ‘job creation’, James Kwak has this to say:

Private equity firms, in general, are buying shares on the secondary market (this is what “taking a company private” is all about), not contributing new capital. They are not increasing the amount of cash available for investment by companies. In fact, since they make money by paying themselves special dividends, they are reducing the amount of cash available for investment. In some circumstances this may be the best thing for shareholders, but it certainly has nothing to do with job creation—especially since we know that the dividends paid back to those private equity funds are only going to be used to buy more mature companies. The goal of a private equity firm is to make its companies more profitable: sometimes that means new products and new jobs, but it can just as easily mean the opposite (eliminating unprofitable product lines and fewer jobs).

Furthermore, the great Jared Bernstein states the obvious about the relation (and risk!) between the leveraged buyouts and the health of companies:

As I stressed here, because interest on their borrowing is tax deductable, debt financing and PE are locked in a symbiotic relationship that distorts incentives and leads to levels of indebtedness that can cripple otherwise stable companies.

(Obviously, for Europe this might be different, because the interest on debts might be less tax deductible than in the US, see Naked Capitalism’s piece on that here).
So, simply put, a private equity deal is a situation where a PE firm buys another company with a little own capital and loads of borrowed money. Their business is ‘buying and selling companies, all done with the goal of earning big returns for themselves and their investors.’ It does not necessarily have anything to do with making the bought company more competitive or upgrade its operations. The only goal is profit, profit – for the PE firm and the investors.
For the paper and board industry this is a nail in the coffin. There are many profitable paper and board mills in Europe (still) but the developments of the markets are such that profit margins will shrink (except for pulp, which is still in high demand in Eastern Europe and China. But for private equity firms these paper companies are interesting investment objects, since they usually have a fairly good cash flow and their capital intensity means that the value of the companies by itself is good, which means the PE firm can borrow a lot of money against the company. But as the NewPage fiasco has shown, if there is no understanding of the industry, then in the end the PE firm will somehow walk away from the debt, while having made a lot of money nonetheless.
So when Newark announced that it would divest its European operations to Phi Industrial Acquisitions, I naturally saw this as a very negative development, especially since according to Newark those mills are in a good condition and ready for the future – this indicates that there might actually not be so many options for improving the profit margin.
And yes, theoretically speaking, in a perfect world, private equity investment would be probably good for firms. But since they apparently need huge tax breaks, I have doubts about their usefulness.


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