Yesterday on Fresh Air (a daily public radio show) Terry Gross interviewed Joshua Kosman, the author of a new book called The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis. While his hypothesis about how private equity is about to cause the next great credit crisis much in the same way the housing and mortgage crisis came about is an interesting one, what I mainly found interesting was his explanation of how private equity firms worked.
In b-school, private equity and venture capital are probably two of the sexiest areas that almost everyone wants to work in (and the sooner the better…this alone should give you a good idea of the profile of a typical b-school student). Private equity and venture capital represent power and money all in one — investing lots of (other people’s) money, choosing who gets it, and making lots of money for yourself in the process. Actually, I never really understood why you’d hire anyone who didn’t have a successful track record as an entrepreneur to work in these areas.
Up until I heard the interview, I had always assumed private equity firms were expert investors who excelled at identifying underperforming businesses that could be turned around, purchased them, used their business expertise to make them better, and sold them later on for a nice profit once the turnaround had been completed.
As Kosman explains, private equity firms in many cases use leveraged buy-outs (LBOs) to purchase companies, making them profitable mainly by squeezing or cutting down assets, focusing on short-term profitability and saddling them with so much debt in the process that they have little likelihood of surviving (and which could lead to a huge credit crisis if these firms all collapse in unison). LBOs were infamous for their boom and bust in the 1980s, and Kosman seems to be suggesting that something like it may soon occur again.
I admit I was somewhat skeptical of Kosman’s point of view about both the crisis and how private equity firms often destroy value because he comes across as fairly one-sided, but a series of videos on how private equity firms work put out by the New York Times seems to support his views. The video entitled “Getting Paid to Do Deals” in particular goes into more detail than Kosman does on why private equity deals get done the way they do. The saddest part is how many of the employees of these companies being bought by private equity are negatively impacted without realizing or understanding what’s going on.