Inside the Private Equity Game (2009)

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What surprised me most about this story is the degree to which private equity touches our lives in ways that we're not aware of. You know, a shopper Albertsons probably doesn't know that it's private equity owned, or someone who eats at Outback Steakhouse would have no idea. There's really no way to tell. Outside of financial circles, many people don't realize the scope and influence of the private equity industry.

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The number of brands is astonishing, and what most people don't realize is we- all of us, in one way or another- actually are invested in many private equity deals. When I was in business school, there was nothing sexier in this entire world than private equity. It's exactly where you went if you wanted to one day own an island, and one of my classmates just bought an island. But what is private equity?

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How does it work and what happens to the businesses that fall under its control- businesses like the Simmons betting company, which has recently announced its filing for bankruptcy and will emerge with yet another private equity owner. I think the best way to think about private equity is to think of somebody buying a home, try to fix it up and then selling it. The only distinction is that typically, the buyer is often playing with other people's money, money that could come from your pension fund, your insurance company, a college endowment or large charity.

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So let's say, for instance, that you have a company that's been owned by one family for sixty years and the president is the grandfather and the vice president is his son, and you've got seven family members working in the accounting office. None of them ever went to business school, they have no idea what they're doing and they have zero debt. And you come in and you say: look, I'm going to buy you guys up for a couple million dollars. And they say: a couple million dollars, it would take us five years during. A couple million dollars, we'll do it right now. So they- and not only that, but we don't have to like deal running a company anymore. So you buy it for a couple of million dollars. The first thing you do is you go and you borrow as much money as humanly possible. You leverage, which means borrowing against something, every, every piece of machinery in the, in the joint, and then you take all that money and you use it to expand. You go into new markets. You go to China, you buy new plants. You hire a whole bunch of MBAs.

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You fire half of them because they don't know what they're doing. You get McKenzie to come in and do this big study and actually this works. Five years later you have a company that cost you a couple million dollars to buy. Now you've expanded all over the world and if the markets going up and you called things right, you can turn around and you can go public with it and once you share, sell shares to the public- you get to take all this proceeds or you exit some other way, by selling the company or something else. These deals really assume that a company, company's, revenues are going to go up because these are booming times and there will be more than enough money for everybody, including pain, down this debt. This is not the situation today. Cynicism- erican mattress company. It's been around for over a century. Its products and brands are ones that we use every single day.

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It was immortalized in a Cole Porter song. It's advertisements were included people like Eleanor Roosevelt. It's a big brand. It's an iconic brand. It's an American brand. It's a brand fits now until in a Wall Street version of flip. This house. Simmons has been bought and sold by five different private equity firms, each looking to make a profit, and is about to be sold again. You know the private equity. Their goal is to make money, clearly for themselves and also for their investors, which are pension funds and endowments all over the country. For the company itself, its goal is to survive, to thrive, to become operationally better, to become financially stronger- sometimes what you can see in these deals, though, as those goals aren't necessarily compatible.

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It's normal for a private equity firm to increase the amount of debt on a company. Some debt is almost always used by private equity investors when they buy a company in the first place, but for Simmons, each time it was taken over by a private equity firm, the amount of debt on the company doubled. So the private equity company that owned it has made a huge profit on its initial investment, but that profit translated into debt for the company over and over and over. Its fifth owner, Thomas H lee Partners, took out debt not just to invest in Simmons, but also to pay itself a dividend. It's leaving the company with a total of 1.3 billion dollars in debt, and that might very well pay off for the employees and for the private equity owners and for everyone else, but it does expose the employee to more risk, because there is now a new chance that your company's going to go bankrupt.

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Employees like these, who used to work at a Simmons plant near Atlanta, may not even know their company is being run by a private equity firm. They may not know that the new owners are looking to cut, which can mean plant closings, benefit cuts and layoffs. We're all from Simmons. Does you sit at this table here? We got 22 plus years working at Simmons company. Every time a new owner come in look like the company went backwards. To me, impression to produce became stronger and I believe I was due to the factor of some cutbacks. I couldn't out people's job. It put more pressure and stress on the person that was there.

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A lot of employees that have lost their job attribute the job loss to the decline in the mattress industry. I think a lot of them believe that the industry's sales are down, which is true, but I don't think a lot of them understand how much debt to this company has on its balance sheet and how that's actually a much more of a driving factor right now to what's happening at this company rather than anything that's happening with the economy. The company's debt wasn't the only thing that former Simmons factory workers did not understand, if you guys ever heard of Thomas H lee. Before they bought the company way from New York. I supported Thomas H. That's about the company, not right, Thomas? Actually they never heard. On September 18th 2008, as workers arrived for the day shift, they were called into a meeting due to a drop in sales. They were told the plant would be closed permanently. They were not allowed to return to the shop floor.

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And he come out and do it like I did. You could have been a better, he could have did a better way. I think it really was a hostile ending. I mean anytime you close the plant and you bring police to the plant, I mean they brung in police like. I mean like we're gonna tear the place up. I think they set the plant because we were unionized. I think we were unionized and and they play, you know, and they paid people in our plant more than they paid people in an?

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I union plants, in a press release issued at the time, said: the decision to close our atlanta manufacturing facility is a very difficult one for us because of its impact on loyal simmons associates. Due to weaker-than-expected business conditions, we simply could not justify maintaining two manufacturing plants in the state of Georgia. The workload would be shifted to two nearby plants, neither of which were unionized, Fla closed the doors. The morale was low. I mean the morale went down. People, they know what they were going to do, where their next check was going to come from, where the meals are going to come from, how their mortgage and stuff was going to get paid. A bunch of us staying in contact, you know, just to see how, how each other's doing you know. But there's a lot of people still who don't have jobs. But whether this is seen as harsh treatment or an effective improvement on a company's bottom line can be a matter of perspective. For Simmons top management, working with private equity firms was a huge boom. They received all sorts of fabulous perks. The CEO, Charlie Idol, who was with the company from 2000 until just last fall, had country club dues fees paid. I had the captain of his yacht paid for one year received thousands of dollars in free mattresses each year, along with, you know, great salary bonus and equity stake in the company. A spokesman for private equity owner, Thomas H lee Partners, said, mr idols, compensation was in line with industry standards. The employees: the biggest perk that they sort of work for at this company was upon retirement they would get a free mattress set, and unfortunately, that perk was taken away last year. Sim was always gay and an employee that retired new set of bearings, so they also gave them $20 a year for every year service that they get that you was employed there. We asked them about the people that want to retire can every time, and would you still give them that mattress and their money? And they still said no, no, we will not give you nothing. What has happened is really the worst case scenario for everyone.

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Simmons is announced it's going to be going in to bankruptcy. When it comes out of it, it's going to have a new owner. The winners of the deal are clearly Thomas H lee Partners. They've made a profit of about 90 million dollars. They actually consider it to be a disappointment. They were looking for a return of two to four times their investment, which is in line with what previous private equity owners had made.

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They walk away with a profit, but it's small. They also, though, believe that none of this was their fault. They believe they've left the company operationally in better standing than when they bought the company six years ago, and they also believe that what happened was sort of the perfect storm, that what happened to the economy and what happened with consumer spending had not been seen ever in the bending industry history and was unforeseeable by anybody.

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The other winners in the deals probably Ares management, which is the new private equity firm. They've gotten this at a good price. The debt levels will be manageable for them. The losers are the employees, which have already seen the workforce cut by about a third, likely to have more more job cuts down the road. The bondholders lose big. Even the industry loses because there's questions about what happens to the Simmons brand. So why do companies just shift hands from one private equity group to the next private equity group, to the next private equity group? One of the really big reasons why is because of how the private equity industry is structured and how people- private equity professionals- get compensated. So let's say I'm raising a private equity fund, the Charles Duhigg fund, and I'm gonna raise a billion dollars.

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The way that I get paid is I get what's called two-and-twenty usually, which is 2% of the money that I have under management and 20% of the profits. But I only get that 2% once I've put the money to work. In fact, I only get the money once I found a deal to put it into. Otherwise it just stays with my investors in my investors bank account. So let's say that I've promised everyone that I'm going to put all the money to work by year four and it's now year three and it's a billion dollar fund and I've only put five hundred million. I've only invested five hundred million. Now I've got a year to put five hundred million dollars to work and what's more, if I don't do it within the next year, in some of the the agreements I signed with my investors they get to keep the money. They don't have to give it to me at all. So now I'm out there and I've got twelve months to put five hundred million dollars to work. It took me three years to put the other five hundred million dollars to work.

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I'm literally going to do any deal I possibly can, as long as it's not going to blow up in my face. I'm gonna look like an idiot if you bring me a deal and you tell me: look, the price we're selling it at it's going to be the exact same price three years later. I'm still going to do that deal because then I can go to my investors and I can say: look, I found a new deal they're going to. It's going to cost 300 million dollars. Now I get two percent of fees on three hundred million dollars. I don't have to give the money back. Everything is happy. So the question then becomes: why does the guy on the other end of that deal do the deal with me? Why does he give me the company for three hundred million dollars? The reason is because he's in year seven of his fund. Things are about to shut down in year ten and what he promised everyone was we will be exited out of all of these investments by year ten.

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Now let's say that this guy has exited out of no investments because the stock market is down and because he can't find any buyers, and because it turns out it wasn't such a great deal in the first place and he overpaid. What he's going to do is he's going to say: look, as long as I can find a buyer who's willing to like give me a price that isn't embarrassing, I'm going to get out of this deal, because then I can turn to my investors and say: look, what a genius I am. I got us out of this deal and, by the way, I did it before year ten, which means that we all get to keep the money and I get my percentage that I am promised. So you have a whole bunch of guys sitting in sort of a daisy chain and even though there isn't any economic value being created by handing companies around that daisy chain for the company itself, you're creating economic value for the professionals who are handing them around because they get paid to basically do deals.

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That's what happens on Wall Street: you get paid to do deals. There's a big question mark over what value the private equity firms bring. The industry has been trying very hard during this buyout boom to present itself as creating jobs, to present itself as improving operations. The private equity industry argues that its ownership results in healthier companies, more jobs and a stronger economy.

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Its companies can make decisions for the long-term free of public scrutiny and quarterly earnings reports, and their returns benefit large pension funds and university endowments. However, the industry still struggles to improve its public image. Before private equity was called private equity, it was really an LBO, a leveraged buyout. It was a term that people didn't really like because it talked about leverage. It talked about debt. He talked about adding debt on to the top of companies and became synonymous with firing people. I don't know if you recall the movie other people's money with Danny DeVito, amen, which really Illustrated what private equity was at some level. The villain is the private equity guy, but what he's really doing is he's coming in, or she, and saying: let's make hard choices that we should have made, that you guys should have made years ago. Now I'm going to force you to make them. I'm gonna take all the criticism, but I'm also going to get rich. When it's all done, take the money, invest it somewhere else. Maybe, maybe you'll get lucky and it'll be used productively and if it is, you'll create new jobs and provide a service for the economy and- god forbid- even make a few bucks for yourselves. As a nation, we basically say capitalism is a his destructive creation. We indulge the destructive part, and when you indulge the destructive part, a lot of people make a lot more money than some other people in private equity did that very, very efficiently and they were creating better markets. They created better companies. We made markets more efficient. There's a lot of good that comes out of the period from 2003 to 2007 was a golden age for private equity, and as the deals got bigger, so did the amount of debt used to make them happen. During the buyout boom, there was a new twist: companies would borrow even more money to pay their private equity owners special dividends, which allowed them to cash out well before they sold the company. More than a hundred and eighty eight companies that were owned by private equity companies issued this sort of debt to the tune of about seventy five billion dollars. So that means seventy five billion dollars went to private equity firms, but is now debt on these companies balance sheets that they're having to pay off. From a private equity investors standpoint, it was a great thing, and then they could. No, we got our money back, and then they may care about the company, because if the company does really well, they will make more money, but if it hits trouble, they're out. Keep in mind, the only way that you can actually do this is if you can convince some banker to loan you a gazillion dollars.

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The banker could very well say to them: okay, but you can't use it to pay yourself special dividends. You have to use it to actually build something, in which case they do. And if the banker doesn't say that, then it's not really the Tommy Lee's fault for making a buck. It's a bankers fault for being stupid enough to give them money that they weren't gonna invest in the company. And now is the fallout from that bubble. Just as you and I are struggling to pay for that house with the debt we can't afford, these private equity firms have created, they have built these companies up and have so much debt on these companies that are now worth so much less than they were a few years ago, once the credit markets contracted, once banks decided that they couldn't loan money anymore.

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The idea of private equity has actually disappeared in some ways, which is to say, the private equity can't buy businesses anymore with leverage. In the same way that the homeowner can't get the mortgage, the private equity guy can't get his mortgage either, and so the whole idea of this hot potato game of buying and selling these companies has come to a screeching halt, and so there's a big question about the future of this industry. There are a number of companies that are in Simmons position, hundreds of companies across the country that have a ton of debt that have been put on their balance sheet by their private equity owners and now, like Simmons, are struggling to figure out how to pay that debt and stay afloat. And what we don't know is what would have happened to this private, the companies without private equity? Would they have hit just as much trouble if they were publicly owned? We're on fairly delicate ground, and if there was a seismic shock, it could set off a wave of bankruptcies, and it's very difficult to recover from the bankruptcy. Now the world may change again and, as we're already seeing, there are investment banks like Goldman Sachs that are reporting these remarkable earnings, and so I wouldn't count these guys out just yet. There's a cycle to all of this. There was a period in the late 80s when people said the private equity was done with, and here we are talking about it right now. So

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