Ever Wondered How the Private Equity Industry Works?

The New York Times has the story for you. (Thanks to a reader for pointing it out to me.) Yves Smith has a summary of the juicy bits.

The game is basically this. Thomas H. Lee Partners bought Simmons in 2003 for $327 million in real money and $745 million in debt. But that’s debt issued by Simmons, not by THL. To buy the company, they needed to pay the previous owners $1.1 billion in real money. The previous owners didn’t care where the money came from, so as long as THL could find banks or bond investors willing to lend $745 million to Simmons, the deal could go through. Since THL put up 100% of the equity in the new version of Simmons, they owned 100% of the company.

In 2004, Simmons borrowed more real money (by issuing new debt) and promptly gave $137 million of that real money to THL as a special dividend. In 2007, Simmons borrowed $300 million more in real money and paid $238 million of it to THL. So THL got $375 million in special dividends in exchange for its $327 million investment (plus an additional $28 million in fees). Simmons is now going into bankruptcy, unable to pay off all that debt, a casualty of the collapse in the housing market (houses => beds).

Now, there’s nothing illegal about this. If I own 100% of the equity in something, I can do whatever I want with it (subject to any covenants imposed by lenders). Since THL was the sole shareholder in Simmons, it was perfectly justified in pulling cash out of the corporate treasury, and I’m sure it told Simmons’s creditors that this is precisely what it was going to do with the 2004 and 2007 bond proceeds. They were just maximizing value to the shareholders — themselves. And they did it using their core competency — at every chance they got, they prettied the company up for the debt markets and convinced investors to lend it even more money.

So why doesn’t all of American capitalism come tumbling down in an orgy of shareholders raiding their own companies’ bank accounts? Two reasons. First, most companies have widely distributed ownership, which means that the managers call the shots, not the shareholders. Managers are unlikely to destroy the companies that pay their salaries, and it’s also harder for managers to raid their own companies’ bank accounts (that’s called executive compensation, which has to be justified to someone). Second, most of the time, a company is worth more as a long-term going concern than as a piggy bank to be broken open. So even if there is only one shareholder, the rational thing is to invest in the company’s long-term health, not to borrow absolutely as much money as possible and stuff it in your pockets. (THL’s returns on the deal, though positive, are far below what they would like to see from an investment.)

But what if there is only one shareholder, and the company is not worth more as a long-term going concern? Let’s say you know the market for your product is going to implode, and you know you can make more money by borrowing money to stuff in your own pockets than by running the company for the next ten years and then selling it. Then the rational, shareholder value-maximizing thing to do is precisely to load up on the debt and pay yourself off.

So, two final points. First, this is one reason why I don’t think all corporate evils can be ascribed to managers not acting in the best interest of the shareholders. Because acting in the best interest of the shareholders, in a time of crisis (or simply given inside information that the bond market doesn’t have), can lead to what Yves Smith, following Akerlof and Romer, calls looting.

Second, the theoretical “solution” to this problem is that the creditors should never have loaned Simmons the extra money in 2007. But it’s possible that they will learn, since it is the creditors who are being taken to the cleaners in bankruptcy. Had Simmons been too big to fail, then this would have simply repeated over and over again.

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