Private Equity: Your Ears Will Bleed  ## Metadata - Author: [[Stuff You Should Know]] - Full Title: Private Equity: Your Ears Will Bleed - Category: #podcasts - URL: https://share.snipd.com/episode/8bd1f06e-e76e-41b7-bea9-5aed6640028c ## Document Notes ## Highlights - **Question PE Promises Before Celebrating** - Be skeptical of private equity's promise: leaner operations often mean layoffs and cash extraction, not long-term improvement. - Consider who benefits: managers and investors usually profit far more than employees or customers. Transcript: Josh Clark Look it in the eye and say, you will not be boring today. And then do all that. All right. Okay, we can do it, Chuck. We're professionals. I'm glad you feel good about it. I do. And I'm going to make you feel good about it, too. Because what we're talking about today is no mere typical economics. And we're famous for having trouble wrapping our heads around economics. This one can be that way, too. We're talking about private equity today. We'll explain all about it. The reason it can be hard to wrap your head around is because it's so insanely unfair, the structure of it, that it just doesn't make sense. So you just kind of have to accept it on its face that this is actually how it is. Charles \\Chuck\\ Bryant Yeah, I would agree. Josh Clark It's nuts. So private equity, I guess we should probably start out with a little bit of a definition, Charles. It's an alternative investment vehicle. And essentially what it is, is it's a fund, a private fund. You have to basically be in the club to even invest in this, at least traditionally. They've kind of opened it up a little more. And private equity goes around and essentially either buys huge controlling interests in companies or just buys the companies outright, trims them down, makes them lean, mean, efficient, And ideally turns them around for a healthy profit, walks away, does it again. ([Time 0:01:55](https://share.snipd.com/snip/9adb6643-d700-4eb5-9995-b75718c86731)) - **Why Private Equity Stays Private** - Private equity investing is restricted to accredited or institutional investors due to high risk and low transparency. - Regulators allow that secrecy because these investors are deemed sophisticated or wealthy enough to bear losses. Transcript: Josh Clark Yeah. Yeah. They've actually gone to great lengths to make sure that it's much less transparent. One reason why the government, who is in charge of regulating stuff to make it transparent, like stocks and bonds and disclosures and all that, is that you or I or anybody could walk along, Open up a brokerage account, start buying stocks and bonds. You don't have to be savvy at keep it that way. To invest in private equity because of the risk, because it's just so different from traditional stocks and bonds and normal investments, the government says you're on your own. As a matter of fact, you have to register as an accredited investor, which says that you either know what you're doing so much that we don't have to worry about you losing your shirt, like You're going to just deal with it if that happens, or you have so much money, it's not really going to matter if you lose your investment. ([Time 0:03:49](https://share.snipd.com/snip/0c3ca70f-89d4-4bb5-9156-5a504a830e91)) - **The 2 and 20 Fee Engine** - Fund managers earn outsized returns via the '2 and 20' fee structure: 2% of assets and 20% of profits. - These fees pay managers even when the company later fails or lays off workers. Transcript: Josh Clark And usually they're institutional investors, right? Like huge, massive funds or college endowments or something. Charles \\Chuck\\ Bryant Yeah. And the people who really come out on top are the people that manage these. If you're a managing partner, there's a formula known as 2 in 20, where the company that you're managing, that you have taken over, they pay you 2% of the total assets of that company plus 20% of the profits above whatever threshold that you agree on, I guess. And then there's all sorts of other ways that they can make money, as we'll see, like selling the land that the business sits on, maybe to yourself, and then renting it back to that same Company at a higher rate. So yeah, we'll dig into all that. But they're, the people that are really getting rich are the people that are investing in these, but really managing these. ([Time 0:04:46](https://share.snipd.com/snip/639f8cdd-ef4e-4c12-afad-ef73bef33824)) - **Common Ways Firms Siphon Cash** - PE firms extract value through asset sales, related-party leases, and dividend recapitalizations that send cash to investors. - Those maneuvers can cripple a company's ability to invest in operations and survive downturns. Transcript: Josh Clark Yeah. I'll give you an example. We'll talk a little more about Red Lobster, but they got taken over in a leveraged buyout. And the company did exactly that. They sold off all of their assets, all of their restaurants, just sold them off. And then they sold them to a company who turned around and leased them to Red Lobster, right? The Red Lobster was paying an estimated $16 million a year for just a 1% property tax on its locations, all of them, $60 million. Now their leases amount to $158 million, right? So these are just terrible, terrible business decisions. And the reason why is because anytime a big influx of cash comes in, it gets divided up among the investors. They get tons of money. And it's not just like from selling properties, Chuck. One of the other ways that investors get their money back, they get a return on their investment, is they'll take out more loans from the company. After the company's been bought and has all this extra debt, they'll take out even more loans. And when that money comes in, rather than spending it on the company, they'll divide some or all of it up among the investors. ([Time 0:11:40](https://share.snipd.com/snip/00549817-58cd-45f2-8bf0-bf397e42d21d)) - **KKR's Early Leveraged Buyouts** - KKR used leveraged buyouts in the 1970s and 1980s to buy firms with very little equity up front. - They saddled acquired companies with debt and collected management fees while installing new leadership. Transcript: Charles \\Chuck\\ Bryant The first leveraged buyouts, though, came after World War II. There were some dudes from Bear Stearns, Jerome Kohlberg, Henry Kravis with a K, and George Roberts. So they were KKR. They got together. They started, you know, with this idea of leveraged buyouts for small companies like, you know, family owned businesses. This is in the 1960s. And in the mid 70s, they formed Colbert, Kravis and Roberts, the KKR business. And their first big success story for them as far as making a ton of money doing one of these was a machine tooling company or a tool company rather called. Is that Holdale? Whodale? Whodale, maybe? Whodat? H-O Industries. It was in 1979. They bought it for $380 million, of which they paid about a million bucks. Once again, as we've already learned, the company was saddled with debt immediately covering the remainder of that money. And they got a new CEO. They said, hey, we're going to pay you double what the previous CEO got. And we're going to start raking in these fees as the fund manager. Josh Clark Yeah. And so Hudale, which at the time of this purchase was doing really well, it had been around since I think the 19-teens. Was fat with cash. ([Time 0:19:25](https://share.snipd.com/snip/96541387-b259-491c-a155-3a078a67832d)) - **RJR Nabisco: A Cautionary Deal** - The RJR Nabisco buyout became a symbol of 1980s excess and led to thousands of layoffs. - That deal showed how leveraged takeovers could break up and dismantle major corporations. Transcript: Charles \\Chuck\\ Bryant If you've seen the movie Barbarians at the Gate with James Garner. I haven't. Have you? Josh Clark No. I've always wanted to. Charles \\Chuck\\ Bryant Hey, it's out there, buddy. Josh Clark Okay. That's not a Tom Wolfe book. I'm thinking of a man in full, aren't I? Charles \\Chuck\\ Bryant Yeah, I think so. I can't remember who wrote the book, but the book was called Barbarians at the Gate, colon, The Fall of RJR Nabisco, because it's about RJR Nabisco, and there is no more RJR Nabisco. No. There's RJR and there's Nabisco, but that company ceased to exist after that leverage buyout. Josh Clark Yeah, and I think 2,000 people lost their jobs as the company was sold off in pieces, and then finally, like you said, the whole thing went down. And at the time, this is 1989, I think you said, 2,000 people losing their job because some corporate raiders came in and screwed up a good thing. That was enormous news. And that really kind of put a period on the end of what had become almost like the Wild West. Like these people were, in some cases, like outlaw folk heroes who were just coming into corporates and taking everything, people getting laid off and then they go off 50 times richer Than they were and do the whole thing again. ([Time 0:21:36](https://share.snipd.com/snip/0d47eab7-41fc-4358-b00b-1edcc3a0e537)) - **Toys 'R' Us: Nostalgia and Collapse** - Toys R Us was taken over by private equity and later collapsed, costing about 30,000 jobs. - Nostalgia and mass layoffs made it a high-profile example of PE's social cost. Transcript: Josh Clark So the news says, here, read this. One of the big ones that I remember was Toys R Us. And this is another thing. It will also make news if like a beloved nostalgic brand just gets torn apart by corporate raiders. And Toys R Us definitely fit that bill. You know, most people our age have memories of going to Toys R Us and it being like, how does this place exist? This is the most amazing place on the planet. In addition to that, even more importantly than that loss of nostalgia, is that 30,000 people lost their jobs because of a private equity takeover of Toys R Us that eventually ran it Into the ground. Yeah. Charles \\Chuck\\ Bryant I mean, it makes some of those earlier ones where, you know, 1,000, 1,200 people lose their job seem quaint. Yeah. Josh Clark 30,000 people just, sorry, you don't have a job anymore. ([Time 0:24:58](https://share.snipd.com/snip/4adc86bf-d72e-46f3-939f-aea39919f305)) - **How Sears And Kmart Were Stripped** - Edward Lampert used loans, buybacks, and asset sales to extract value from Sears and Kmart after the merger. - The firms closed thousands of stores, cost hundreds of thousands of jobs, and Lampert personally profited massively. Transcript: Charles \\Chuck\\ Bryant Iconic brand, iconic brick and mortar store. I would say there's some nostalgia tied up in Sears for sure. Sure. And a guy named Edward Lampert is someone who may not be on your radar unless you follow this stuff a little more closely. Kmart files for bankruptcy in 2002. And Ed Lampert comes in. He was a Goldman Sachs guy. And he, I think, former by this time. Right. But he buys up a bunch of the debt from Kmart. They come out of bankruptcy. And then he has a hedge fund, ESL Investments. And they were the largest shareholder. And so thus he becomes the chairman and can then run the show. Josh Clark Later accused of devaluing Sears so that he could buy it through Kmart for cheaper. Regardless, Kmart bought Sears and they formed the Sears Holding Company, which was this huge, massive retailer. Kmart was not doing very good. Sears was doing amazing. Tens and tens of billions of dollars in sales every year. And for the first couple of years, things were going pretty well. But Edward Lampert, being a corporate rating private equity guy, again, this is his firm. So he is directly taking hundreds of millions of dollars, that 2% of the assets every year, plus that 20% when he gets above performance goals. So by juicing this company and like boosting the stock price and the value of all this stuff, he's getting huge percentages of that every year, right? The problem is these bad management decisions. This is when it goes bad, and this is when you end up reading about it. One of the big things they did was a stock buyback, right? And if you have a bunch of stock out there, a bunch of shares out there on the market, just by like the laws of supply and demand, they're worth less than if they're scarcer. So you go as the company and buy those shares back. And because there's fewer shares on the market, your share price can increase, right? So if you're holding shares in the company, your share price goes up. And you make the company buy the stocks back. It's not like you're out there doing it yourself, right? The better thing to do traditionally for if you want your business to keep running is to use that money to keep your business running. But instead, they took six billion dollars and bought stock back to raise the share price. And they only spent, I think this is over a couple of years, they only spent half of that on capital expenditures, like keeping up your properties, maintaining your buildings, stuff Like that. And so the company just almost immediately started to just falter. Charles \\Chuck\\ Bryant Yeah, so things start faltering. This is around 2007 or so. And ESL, which again was Ed Lampert's company, they and some other firms then loan money to themselves, almost $2.6 billion. And so they're now also collecting interest and fees on that. So about $400 million in interest and fees to the big loan that they gave themselves. And Sears continues to sort of tank, or the Sears holding company continues to tank. That's when they break it up. They spun off, they start spinning off different divisions. ESL is buying shares in most of those smaller divisions as well, once they break it apart. And then in 2015, Ed Lampert founded a real estate company called Seritage Growth Properties. They bought 266 Sears and Kmart buildings and then rented them back to themselves. Right. It's like robbing Peter to pay Peter. Yeah, it's just sounds like such a obvious policing. It is. And grift. Josh Clark And it's totally legal. That's the thing. They're not breaking any laws. All of this is completely legal. It's just despicably unfair. So obviously, after a fairly short time, seven years, this company, Sears Holding, filed for bankruptcy. And again, bankruptcy doesn't mean like, oh, that's it, I'm out of money. It means like, hey, I can't pay my debts back. So I'm going to negotiate with all these people and hopefully reduce it by two thirds. And then I can manage that. So I'm going to come back out of bankruptcy and try to continue on. That was the result for Sears holding. But part of this restructuring was that they started slashing costs. And the first thing you do to slash costs if you're a corporator is fire people. They closed stores, Chuck. They had 3,500 Sears and Kmart stores when those two companies merged. OK. By seven years later, they were down to 700. And today there's eight. Eight. Eighty? Charles \\Chuck\\ Bryant Eight. 800? Zero. Eight. Yeah. There's eight of those left. It was, you know, again, tens of thousands of jobs and $11 billion in unpaid debt to creditors. And Ed Lampert ends up making about 1.4, personally, making about $1.4 billion from managing that fund. ([Time 0:25:54](https://share.snipd.com/snip/0c7d0930-b502-47ed-aec7-0d14eb7bb648)) - **Red Lobster's Real Estate Sell-Off** - Golden Gate Capital bought Red Lobster in 2014 and sold the restaurants' real estate to lease back at higher rates. - That sale pumped cash to investors while raising operating costs for the chain. Transcript: Charles \\Chuck\\ Bryant It feels like it was more recent. Well, I guess some of this stuff was a little more recent. But in 2014, Golden Gate Capital, a San Francisco company, bought Red Lobster, $2.1 billion. They said it was, an exceptionally strong brand with an unparalleled market position. And in order to pay for that deal, they sold, as you mentioned, they sold the real estate of 500 restaurants for about $1.5 billion. And a company called American Realty Capital Partners bought that land and then, once again, leased it back at a higher rate, like above market rates. Josh Clark Yeah. And again, that $1.5 billion, a significant portion of it just went right to investors. I'm not sure how much, but that's the playbook, right? I also have to say I worked at Red Lobster as a server for a little bit. Whoa. Charles \\Chuck\\ Bryant You and I have dined at Red Lobster before one time. It's probably the only time I've been there in the past 40 years. Okay. And you never, I don't think, disclosed to me that. ([Time 0:31:50](https://share.snipd.com/snip/3ed91eed-6c59-424c-be1f-922ace9728f4)) - **PE Ownership Harms Patient Care** - Private equity ownership in health care correlates with higher costs, safety issues, and worse patient outcomes. - Studies cited show higher infection rates and an 11% increase in mortality under PE ownership. Transcript: Josh Clark I mean, aside from people getting laid off, people being neglected in the hospitals they go to because they're owned by private equity firms. That's become a big problem in the 21st century and in the United States, too. Charles \\Chuck\\ Bryant Yeah, there's in 2024 alone, by one count at least, there were 166 leverage buyouts in health care just in that one year. And seven of the eight biggest health care bankruptcies that year were from companies owned by private equity firms or hospitals and health care organizations. Right. Josh Clark The private equity firm dental practices rose dramatically from the teens to the 2020s. Results in things like companies push. I read an article about a dental express in Ohio telling a mom that her three-year needed seven root canals. Charles \\Chuck\\ Bryant Yeah, for sure. And the same goes with hospitals. Hospitals, if they're owned by a private equity firm, they result in higher charges, more safety issues. There's one study that said there was a 25 percent rise in hospital acquired complications, like something you got while you were there. Josh Clark Right. And I think 38 percent more blood infections from IV ports. That's just from not having enough staff or inexperienced staff. It's just not good. And it gets even worse. They're also into hospices, nursing homes, and it just follows the same pattern that you would expect. A study found that private equity ownership increases mortality rates by 11% just because P.E.'s cutting corners to save costs. So that's a huge, huge issue. ([Time 0:42:34](https://share.snipd.com/snip/7d20b5a3-1722-4429-b587-af91be0064a5)) - **When Landlords Become PE Firms** - Large PE landlords like Blackstone own hundreds of thousands of rental units and tend to raise rents and slow maintenance. - That transforms housing markets and worsens tenant experiences rather than improving service. Transcript: Josh Clark I think Blackstone, which we mentioned, was founded back in the 80s. They're known as the United States' largest landlord. They own 300,000 units of rental housing in the U.S. As of 2023. And as you would expect when private equity comes along, rents go up. The maintenance people are slower to respond because they've been laid off, and just things kind of go downhill rather than get better. Like they're supposed to. That's the reason private equity is supposed to exist. It's supposed to take kind of slow lumbering companies that are in a position to do better than they are and make them do better. ([Time 0:44:41](https://share.snipd.com/snip/bb8713b1-3f95-47b5-9004-0945aff1b15b)) - **A Successful PE Turnaround: Hilton** - Blackstone's buyout of Hilton reinvested in digital and international growth, expanded rooms, and returned the company successfully to public markets. - This deal generated large profits while the hotel chain remained healthy and expanded. Transcript: Charles \\Chuck\\ Bryant Like, uh, one great example is Hilton, uh, the hotel chain. Um, there was a leverage buyout from Blackstone in 2007 of Hilton and the great recession, uh, you know, hit, uh, I guess it was like the next year in 2008. And obviously it's going to really affect the tourism industry. But they brought in a CEO from Blackstone, a guy named Christopher Nassetta, who actually made things better. He said, hey, let's invest in emerging markets. Let's invest in the future and like digital strategies like apps where you can check in and get your hotel key through an app and things like that. Just, you know, instead of just shuttering things like actually investing, reinvesting in the company. And it turned out to be really, you know, all these things were really popular moves and Blackstone sold Hilton back to the public market after it had been yanked out of the public market. They sold it back in 2013 and sold out of their stake in 2018, made a ton of profit, $14 billion over 11 years. But the company itself, Hilton, was doing great and continues to do great. Josh Clark Yeah, they doubled the number of rooms today that they had in 2007 when they took over, when Blackstone took over. ([Time 0:45:28](https://share.snipd.com/snip/bcfb5d58-e01b-4e0a-8c00-78b2e22d1642)) - **Pension Money Fuels Private Equity** - Many pension funds and endowments allocate significant capital to private equity despite the risks and secrecy. - That channels public retirement money into opaque deals that can benefit managers more than workers or communities. Transcript: Charles \\Chuck\\ Bryant But you also mentioned earlier that like pension funds like 401ks are where a lot of this money comes from. And like, do you have a choice whether or not the 401k that you invest in ends up being a part of this thing? Josh Clark Yeah, I think you can also invest your 401k now, which for a long time was off limits because that's your, you, the non-accredited investor who doesn't know what they're doing with private Equity, that was off limits. But now you can if you want, although they say that's probably not a good idea unless you know what you're doing again. Charles \\Chuck\\ Bryant Well, 89% of public pension funds have some of their money in private equity. I think 13% average of 13% of their assets is the average, sometimes more than 25%. But that's almost 90% of public pension funds. It's a lot. Josh Clark Yeah. And then I guess one of the other big things, so the reason why, well, another reason why people are like, this is so not right. All of that money that those people like Edward Lampert made, he made that $1.4 billion by running a huge venerated company into the ground. He paid at most 20% on those profits. Even though it was personal income for him, he didn't pay the personal income tax of like 37%. Instead, he paid 20% in capital gains tax because the fees that he charged are treated like gains from an investment rather than personal income, even though anyone would call those Fees personal income. ([Time 0:47:45](https://share.snipd.com/snip/4d0968ee-9881-48e3-bf88-b0292dc8217c)) - **The Carried Interest Tax Advantage** - Carried interest lets PE managers pay capital gains tax rates on performance fees rather than higher income tax rates. - That tax treatment reduces the public tax take on huge compensation from deal profits. Transcript: Josh Clark It just keeps going like that. Charles \\Chuck\\ Bryant Yeah. And they're like, no, no, no. But what about this? No, no, that's the best part. Yeah. So there's a lot of best parts. Josh Clark And one of the guys finally puts his fork down and stands up, hits the table and goes, bam. That's right. Charles \\Chuck\\ Bryant But you were talking about the carried interest loophole, right? That's what it's called. Josh Clark Yeah. Where your personal income is magically treated as returns on an investment and taxed at 20% rather than 37% or whatever. So if you make $100 million, you pay $17 million less taxes on that $100 million. And at that point, really, who cares anyway, right? ([Time 0:50:00](https://share.snipd.com/snip/513973f5-5a7e-48d9-b52f-14101392f591)) - **Grandmother Secretly Pays Dinner** - Listener James shared a story where his grandmother secretly paid a distant dinner bill by calling the restaurant with her card. - The family realized she had paid and celebrated her surprising generosity. Transcript: Josh Clark Done that for sure. Yeah, yeah. Charles \\Chuck\\ Bryant That's what you got to do. The best was when part of the family was in upstate New York for a triathlon. Sheila wasn't even there. Sheila's in Massachusetts. The bill came when dinner was over the night before the race. My father and my aunt reached for their card and the waitress said it had been taken care of. All the adults looked in accusation at each other and there was a long silence. And at the exact same moment, they all threw up their hands crying, Sheila. Josh Clark And all the way over in Massachusetts, Sheila went bam. That's right. Charles \\Chuck\\ Bryant My aunt had made the mistake of telling Sheila on the phone where we were going to have dinner. And our grandmother called the restaurant and gave her the credit card number. Josh Clark Beautiful. Charles \\Chuck\\ Bryant Thanks for all the pods. That is from James. James, that's wonderful. ([Time 0:51:50](https://share.snipd.com/snip/17c60baf-6ab5-4e1e-b947-f9107a5147bb))