PE - Does the Industry Actually Create Value?

Hey guys -

First-year PE analyst here. Something I've been grappling with over the past year is the question of whether or not my colleagues and I are actually improving our portfolio companies/contributing positively to the US economy more broadly. Obviously, I don't think I'm doing God's work by choosing to work in finance, but I sometimes worry that the PE industry is value destructive in many instances. When I have spoken to friends/family members outside finance, it's clear that the industry has a very negative reputation among the broader public. Between the fallout of failed LBOs (Toys R Us, J.Crew, Hertz to name a few..), the controversial nature of recaps, and just general outcry at LBO financial engineering, it seems like the industry has no shortage of detractors. 

Would love to hear some more senior members' opinions on the state of the industry - do you feel that your funds (and PE in general) are adding value to the businesses that you acquire? Is PE a necessary part of the financial ecosystem, or is Elizabeth Warren right when she says that we are a "vampiric"/unnecessary part of the economy? I'm assuming there's some gray area here, and it probably depends on the fund, but curious to hear everyone's take on this based on their own personal work experiences.

Comments (47)

 
  • Associate 2 in PE - LBOs
Feb 20, 2021 - 8:08pm

It creates liquidity in private markets, returns for their institutional investors, and (hopefully) growth for the portco. No PE firm buys to run it into the ground (like Toys 'R' Us), that's not a viable value creation strategy (leaving out technical defaults a la Blackstone), and the PE firms are the bagholder end of the day (being the equity portion of the cap stack). 

Not everything is great, and the chips are heavily stacked in your favour, but its not inherently evil like some people portay it. You're not some pirate entering a company - quite the opposite actually. Clearly, efficiencies do get streamlined and manufacturing capacity might be outsourced, but overall PE ownership net-net creates jobs through acceleration of the trajectory of its PortCos - although be it in a much more focussed manner than the more lassez faire like a lot of other companies are run.

 
  • Analyst 1 in IB - Gen
Feb 20, 2021 - 10:10pm

The flaw in this response is that you don't define "viable value creation strategy," which I think is actually the crux of the question that OP is proposing here. How do you define "value creation?"

If creating value equates to creating value for shareholders (i.e. a traditional Friedman Chicagoan economics), then yeah, I bet private equity creates a lot of value. Moreover, if you believe that creating value for shareholders has positive benefits on the rest of society, then I think you can argue that PE creates value for society.

However, what constitutes "creating value" and particularly, for whom, is debated endlessly. For example, on a recent acquisition I've worked on with a sponsor, much of the thesis was driven around automating manual human labor functions. Is this inherently valuable for society? For shareholders-- most certainly. For the people getting laid off? Probably not. Defining what constitutes "value" is the question here.

Also, much of the current intellectual argument pushes the belief that shareholder focused practices (e.g. just letting the supply/demand curve dictate our decision making) have negative externalities from a societal perspective.

 
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  • Associate 3 in PE - LBOs
Feb 21, 2021 - 4:38am

Let's be a little clearer on value... your response is still a little gray. I'll go first. Value to society is forward process wrt innovation and increasing levels of production per unit of labor (ie, making everyone work 24/7 would not constitute value). Under my definition, I'd argue that PE creates LT value even if it causes temporary pain for layoffs in obsolete fields (fields that can be automated). To say it destroys value, you'd need to assume that the laid off workers never retool and find another way to contribute to society, pretty damning to their abilities. If total output for society is the same or increased due to automation and laid off workers go on to do something else, are we not moving forward as a society with a higher level of production per unit of labor? Does the increased productivIty per unit free is up to spend more time outside of work? Just my definition, open to takes from others. The whole innovation displacing workers arguments = bad for society has never resonated with me. It's pretty short sighted and easily disproved with just a little bit of historical context. Are we still crying about the icemen that lost their jobs due to refrigerators? What about the newspaper printers and delivery boys? What about the telegraph operators? What about the accounting teams that relied on paper ledgers? We probably were at some point, but we've since moved on. Would we be in a better place as a society if we protected these jobs?

 
Feb 20, 2021 - 11:42pm

Interesting question and debate. I think the general public opinion is too negatively biased.

I have benefitted from seeing both a MM PE fund as well as a PE asset allocator. 

The value creation thesis for the MM PE fund I worked at focused on applying "best practices", helping the founder take money off the table (which allows increasing the risk tolerance of the business e.g. to launch new products, sustain losses to expand into new geographies) and creating a more corporatized business. This would often lead to a) increased EBITDA and b) benefit from multiple expansion because the businesses were bigger and more corporatized. Having said that there were times when despite the best intentions the changes just didn't work and the businesses went backwards (occasionally into bankruptcy). 

From an asset allocation point of view, PE still has a place in the portfolio of a pension/endowment/SWF because it has historically outperformed listed markets. In addition, as companies stay private for longer (admittedly this is a stronger argument for VC rather than buyout investing) then the PE allocation can provide access to those companies until they list. Given the fees associated with the asset class, if pension/endowment/SWF could either invest in a closely related asset class (public equities) with lower fees or try to internalize they would. On the latter, this has been tried with varying degrees of success (the Canadian Pension Funds have examples of where it has worked) but for the average LP they just can't internalize this and reproduce the same results.

 

 
Feb 21, 2021 - 12:11am

I believe that PE is generally good and creates value for the economy mainly through growing jobs and creating stability for those jobs.

Every traditional PE LBO relies on growth to achieve return thresholds either organically or through M&A. The number of jobs will increase in the majority of cases as the volume of sales increases  especially for services businesses. Do we look for ways to be more productive with less people through automation or other means? Yes, this can be the ugly side of the business. However, if we want to grow a business, odds are that the company will need to increase both direct and indirect headcount as the effectiveness of productivity improvements marginally decrease or the capex costs to capture productivity improvements do not have a beneficial ROI.

Remember that PE also fires 50+% of CEOs because the CEO and her/his management team are not able to achieve the desired growth plan or they put the company at risk of not generating enough cash to service debt. This puts company stability and ultimately jobs at risk. Don't forget that a significant portion of the PE debt investor base also involves many of the same pensions, endowments, mutual funds, etc. that also invest in PE funds and therefore depend on stability/growth to achieve lower risk returns.

 
Feb 21, 2021 - 12:49am

LMM PE 100%. I've seen some really wildly inefficient poorly run businesses doing as much as $100mm. Maybe not as widespread at large companies most of you guys work on but some examples:

-12 person accounting team. No software in use. Not even QB lol
-No mobile site on an e-commerce co doing 30mm+ (iirc)

-CFO that was quite literally doing nothing. As in, once he was fired there was zero noticeable impact on the company. The founder had hired him b/c he worked at GS before. Never bothered thinking through impact/output. 
-US based labor that doesn't need to be in the US routinely. Even by PE owned companies. There's a reason BPOs exist. 
 

Really all the byproduct of founders that are luckier than smart or lazy PE firms that are good at raising funds and not much else. 
 

Again, no clue if this holds up with chunkier companies. 

 
  • Prospect in IB-M&A
Feb 21, 2021 - 9:00am

The industry creates value to an extent for sure and saving bankrupt companies.

The nature of LBOs means it's virtually risk free for funds and long term incentives aren't aligned with the portfolio companies as funds are seeking maximum short term value extraction.

I think LBOs in healthcare definitely need to be more regulated. Just google KKR-Envision and more infamously the close of Hahnemann in Philadelphia. The number of lives lost and social detriment is astounding.

 
  • Associate 3 in PE - LBOs
Feb 21, 2021 - 9:29am

Please explain how an LBO is virtually risk free? Really interested.

 
Feb 21, 2021 - 9:59am

I don't work in PE and I don't plan on but I think I can offer a bit of critical perspective on the state of PE industry from an economics perspective.

Because buyers and sellers interact quite privately, there's a lot of information asymmetry in the private markets, a lot more so than secondary markets. What that means is that lots of people with less information are going to get screwed and people at the other end of the deal aren't going to care who's getting screwed and how much. This is not necessarily problematic because no market is frictionless nor perfectly efficient but the issue seems to be that the current PE industry is set up to perpetuate these assymetries and exploit them.

This can be dangerous in 2 ways 

1) It creates large distortions in the market and the correction will happen less often than in public markets. Corrections are more likely to be larger than that of the public markets, which can be a very devastating blow to the economy if the Private markets aren't properly decoupled with other markets.

2) Information asymmetry creates winners and losers. It's not a zero sum game and the losers might not figure out they are losers for a while but the impacts are still real. If the loser is just another PE firm getting screwed than it might not be that big of an issue, but if the loser is a company that could've created much more value then quite obviously this is bad for growth.

 
Feb 21, 2021 - 10:07am

It's about increasing value for shareholders. They do that by "managing up" a business either by capitalizing for growth, cost cutting, or both. Their objective may be to make a boat load on liquidity events while earning good returns for their investors. Nothing wrong with that as the way to do that is by increasing portco value (either in tact or in pieces). Those liquidity events provide ample resources for new investment in new ventures. As someone upstream pointed out, layoffs can't be viewed in a vacuum. If those people move on to something else (which many if not most do), they are not ceasing to create value, it's just value somewhere else in the economy.

It's ok if some get filthy rich in the process. That's capitalism.

 
  • Research Analyst in AM - Other
Feb 22, 2021 - 9:19am

My 2c: PE creates value for its investors and arguably makes the capital markets more efficient (this was certainly true in the 1980's, not so sure about today) but IMO it adds to systemic financial risk due to the use of debt to fund buyouts (corporate America is highly leveraged relative to history and the growth of the PE industry is a big driver of that). Also would argue that LBO'd companies are less likely to invest in LT growth (R&D that may not show a return for a few years, if ever) due to the need to service debt + show EBITDA growth to prepare the company for its eventual exit.

 
  • Analyst 1 in Risk Mnmgt
Feb 22, 2021 - 10:07am

On the leverage point, PE has also made debt a lot riskier for investors with how loose and borrower friendly most credit docs are (I don't think there's any maintenance financial covenants in any PE owned company for example.) Now part of this is on the law firms (looking at you K&E), but there's a definite trend of having unusual provisions and loose covenants that will of course leak into the wider market when CEOs wonder why their competitors have such flexible terms and why they don't.

 
  • Associate 2 in PE - LBOs
Feb 22, 2021 - 2:38pm

Did you even read the article?

"Our study found little evidence to suggest that competition from the public markets is likely to persist...There's little reason to believe that US equities will somehow break out of this pattern and sustain these double-digit returns over the long term."

 
  • Associate 3 in PE - LBOs
Feb 22, 2021 - 3:52pm

He's full of shit on every thread. Definitely not a bad boy.

 
Feb 22, 2021 - 8:14pm

Read my previous comment - the report isn't controlling for underlying debt and therefore isn't controlling for beta. Higher PE leverage by definition means that PE hasn't generated alpha for the past 10 years given equal returns. Even if public market returns decline, the argument for PE alpha generation is weak given it's a fundamentally high beta asset class. 

Levered Beta = Unlevered Beta * [1 + (1 – Tax Rate) * (Debt / Equity)]

 
Feb 22, 2021 - 3:56pm

Not this shit again dude you legit spammed up a "PE doesn't generate value" post a few months back with the same shitty studies and graphs that you didn't/can't read. I'd actually rather prefer a bleeding-heart "what about the poor children" argument for why PE is bad than your faux-intellectual bullshit. 

To live is to suffer, to survive is to find some meaning in the suffering.

 
Feb 22, 2021 - 4:55pm

First transition to institutional ownership - yes. Secondary buyout - situation dependent.

Here are some differences as our company moved to institutional ownership.

1) More accountability and increased operating pace. Formal board set up. Compensation committee. Equity incentive plans. Knowing there's been hundreds of millions of dollars invested. I could name dozens of other points as context. The point is that there more operating rigor. Our company was far from complacent or plodding along (the opposite mostly) and there was still a meaningful acceleration post-investment.

2) Better access to the capital markets. Institutional investors provide credibility to have greater access to capital.

3) Improved M&A/partnership deal flow. Announcement hits and now everyone in market knows you have access to capital and are pulling together serious growth/value-creation roadmaps. Increased deal flow means you have increased chances of seeing the more attractive opportunities. 

4) Better access to talent. Similar to capital markets access, operating talent becomes attracted due to credibility/track record of investor as well as signaling of opportunities for higher compensation (ex. option pool). Disclaimer: I think this exists more than personally experienced. We misfired on a couple headhunter lead searches.

5) Culture of ownership/transparency. This could be bucketed with #1. Deal transpires and now the employees know who owns the company (or portion of it), financial results are shared more frequently and across new areas of the organization, and financial targets become more common. Could go on more here, though I'll summarize as employees will think like they're helping drive value in a business more often if you provide them the information to do so. 

Have others to list though these are top of mind. I think a good portion of the above is taken out in the transition to institutional ownership. During secondary buyouts you could argue that all of this value previously existed. You then are left to figure out how to do it better.

 
Feb 24, 2021 - 6:29am

Your portfolio company is likely creating value however 'you and your colleagues' are likely not. In most cases PE is simply a capital provider and in todays market with immense availability of dry powder there is much less differentiation. Any guy in a blue shirt and vest can provide capital nowadays, which does have value as it allows companies to invest and grow, however the real value of PE is enhancing the wealth of the already rich. 

p.s. im a guy in a blue shirt and vest

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