Sachin Khajuria and Brendan Ballou – Private Equity: Profit or Plunder? (EP.331)

27:04Looking at this as an outsider, the general model, two in 20, suggests that generally you're entitled to 20 % of the profits, but you get 100 % of the fees, obviously. And what I'm a little concerned about is, does that create an incentive where you get 20 % of the upside if the company does well overall, but 100 % if you extract money through fees, whether or not that helps the company in the long term? Sachin? I have a reasonably clear view that fees are not the reason to be doing deals. If the total return on the deal is rescued by the fees and the performance is terrible, That's not a good outcome for investors.

27:43And I would urge investors to think very carefully about whether that's a sustainable or even correct outcome for them going forward. It certainly doesn't feel like one, does it? But I'm also very happy to say that A, I haven't seen it at all, but B, I haven't seen it as a motivation on a transaction, which is we're not entirely sure about how we're going to end up here, but let's just charge a load of fees and say this fee for that, this fee for that, and so on. The industry is much bigger. And 2 % is an industry benchmark. I think you've got to ask and say, really, what is that fee? Is it to genuinely retain great staff, put money into the IT, into the big data, expand your network of experts, paid advisors, all those important aspects of having a library of intelligence, good compensation, all those things.

28:37I think those are fair questions to ask for investors. And I think it's also fair that given some of the biggest firms are publicly listed, you only have to listen to an analyst call or look at any analyst presentation. One of the big attractions for equity analysts is, well, look, this is a big firm. It generates a lot of stable fees. Let's put a higher multiple on that than the incentive fees, because we don't know whether they're coming or not, or they may be lumpy, or they're less predictable. A secure, stable earnings stream that's growing seems to be valued at a higher valuation than an earnings stream, which could be big, but also could be small.

29:12And that's not something you can necessarily guarantee. I think that if the firm is performing and the stated band of outcomes on the deals is in accordance with what they're selling, whether those deals are placed in one kind a vehicle or another, it seems to be that, well, they're doing their job. They said they'd get you a net one and a half times, two times money, whatever the multiple invested capital happens to be. They told you off front, they're going to be charging you 100 basis points, 150, 200 basis points, whatever the fee happens to be. And they've delivered what they said. So that's fine.

29:51If of course the performance is below the performance hurdle, it could be a percent and you're not getting the performance that you were hoping for and doing the hypothetical exercise, which is always fun in hindsight, of what would have happened if I put that capital into treasuries or the stock market or something, and you find that that firm and that fund is not performing, it's very fair to say, well, why would I trust you to do it again? I think what you see with the winners in this business, and I think there's going to be a thinning of the herd. I think there's going to be a slimming now that the conditions are tougher.

30:27I think you'll find that those who are not able to perform consistently will find that issues such as this, am I getting good value for money by putting my commitments with you, will impact their ability to raise money. And conversely, those who are able to consistently demonstrate an outperformance against the market, the S &P is generally delivering you this over this period. We're generally adding 100 basis points, 1 ,000 basis points, 5 ,000 basis points, whatever it happens to be. They will get more allocation. So I look at this question as, well, what are you getting for that active management they're doing?

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32:01So leave the days of disjointed deal management behind and define your future with SRS Aquium, the smartest way to run a deal. Learn more at srsaquium .com. That's S -R -S -A -C -Q -U -I -O -M .com. And now, back to the show. Sasha, I'd love to ask about the premise that private equity firms make companies better. There's really two lenses we could think about, right? There's the financial part of it, which you're bringing in leverage. And then there's the operations, the ability to improve operations. whether that's growth or cost cutting. We just love your perspective from your experience on what actually happens on the ground with private equity firms and the companies they buy.

32:52So when you're talking about acquiring companies, significant stakes for the whole thing, there's a few things that the good ones do over and over well with a very diligent investment process. So first is focus. Now we may say, well, that's a function of the fact that it's a transaction. There's an exit horizon at some stage and you have to get a result, otherwise you failed. So there's amazing focus. And this focus you find in plenty of terrific public companies, but not all of them. And I would say that it's probably sharper and clearer in the private market situations that I've seen. And of course, that focus doesn't just mean from one person, It means from a team, a team, usually a relatively small team, a deal team of very focused individuals working together hand in glove with a good management team.

33:42The other part of that focus, number two, is that they tend not to ditch the transaction if something goes wrong. They don't just quit their public company post and move on to another job saying, well, I was all too hard. The market was this, the market was that. They tend to stick with it. And if you think that you can just hop jobs from one deal to another, good luck. That's not going to work because people are going to want to know your track record and what you've done. And so there's a certain degree of commitment, tenure, to see it all the way through to the end. And I've seen that over and over at the best firms, being part of the GP now as an LP across many firms and funds.

34:22The third thing is, are they making it better? I think their chances of making it better are generally higher. That doesn't mean it's always going to happen. And their chances of doing it better are because just like in public companies, good ones, just like in good entrepreneurial settings or family -backed businesses, you have smart people. In this case, you have a great incentive. You have a lot of focus. You have alignment. And they have a lot of tools. Now, some of those tools are financial tools to provide discipline to the capital structure, to improve the efficiency of the capital structure.

34:58Does that mean sometimes using or often using debt as part of the capital structure? if it makes sense rather than equities using different instruments with different costs of capital. Sure. But acquisitive public companies do the same thing. Private enterprises do the same thing. LVMH Tiffany. I mean, take your gigantic international company that may have a family holding or may be publicly owned and look at the way it buys companies. Sometimes they have very similar characteristics to what private equity firms do. So there's financial tools. The most interesting are the operational tools, being able to use a bench of experts across the world to benchmark results, to bring people in as conditions change.

35:40These are things that tend to be harder for public companies to do to this extent. And I think it's not true to say, well, public companies just can't do that. They're typically buying within their focus area. They're not generalists. Let's just buy what seems to make sense. They're like a generalist investment fund. And so I think that they can rely on those operational experts, perhaps change that bench over time. And it's the combination of all those factors with obviously, hopefully the smarts of let's time the investment well on the way in, let's refinance it opportunistically and let's time the investment and structure it and price it well on the way out that mean that usually everyone wins where it's gone wrong is where of course some of those stars are not in alignment where things get out of kilter and then could you say that the risks are higher of it going wrong i'm not sure i'd like to say that the best private equity firms are very good at offense, they're exceptionally good at defense.

36:48So if something's gone wrong, they're like, well, we need to fix this. This is our mess. And there's usually a tremendous bearing of the teeth where that happens. And when it does go wrong, I think the criticism is warranted as it would be for any acquirer. Brendan, curious what you've seen as you've looked across the industry. What's your sense of whether private equity firms are improving the businesses that they own? I really appreciate Sachin's model here. And I think that is sometimes what private equity is and what I hope through proper regulation, it can be even more. My concern is it goes back to the initial problems that we were talking about.

37:29The duration of focus, reliance on leverage and fees and insulation from liability means that oftentimes private equity managers' incentives are different from those of the portfolio companies and leads to bad results. We can go through some of the anecdotes that also is borne out at least in some of the sort of quantitative studies, suggesting, for instance, that private equity -owned portfolio companies are 10 times as likely to go bankrupt as non -private equity -owned peers. In the best circumstances where firms are thinking for the long -term, taking responsibility, bringing that focus that they need to bring, it can lead to positive outcomes.

38:06The example that I keep coming back to is when a firm bought a timber mill in Arkansas, invested for a decade or longer, used very little, if any, debt, continued to maintain investment even after it sold its majority stake and kept two board seats. Ultimately, they helped revive this plant and helped to revive a whole town. I think where things are going wrong is when people are applying their expertise, not necessarily to building better companies, but to using and growing the legal loopholes that we have surrounding these operations. One of the most important of these would actually be the bankruptcy code.

38:42To pull just one example, when Sun Capital bought Friendly's, the diner chain of the Northeast, they did a lot of the tactics that we were talking about, push the company into bankruptcy, but they were not just the largest equity owner in the company, they were also the largest lender. And so using credit bidding and a 363 sale, they were able to essentially flip their ownership structure and sell Friendly's from itself to itself. And in the course of that reshuffling, they were able to push off the pension obligations of Friendly's from the company onto the pension benefit guarantee corporation, essentially saying that's now the responsibility of this quasi -government agency.

39:19So my concern is that oftentimes private equity firms are less exemplifying the best of capitalism and more exemplifying the worst of the legal profession, in a sense. And I say that as a practicing lawyer and using these loopholes for their advantage rather than trying to build better companies for the long term. So Brendan, in an industry, as Sachin said, that's $12 trillion, how do you get your arms around the significance of this problem? There's always going to be good actors and bad actors in any industry. The anecdotes don't sound good, that's for sure. What's your sense of how pervasive this is?

39:57As Sachin said, it's an enormous industry and it's growing in the sense that the quote -unquote private equity firms do so much more than private equity, whether it's credit, infrastructure, hedge funds, insurance, and so forth. And in some sense, they have, in my observation, sort of supplanted in importance the investment banks of a generation or two ago. We lawyers have this incredible ability to invent a flawed business model every 20 years. Right now, I would argue that it's in large part private equity. 20 years ago, it would have been subprime lenders. 40 years ago, it would have been SNLs.

40:2960 years ago, it would have been conglomerates. 100 years ago, it would have been trust. Oftentimes, unfortunately, as a result of a crisis, but sometimes not, in the case of conglomerates, we have managed to improve our laws to hold firms more responsible for their actions and align the incentives of the various parts of our economy. So I think that there are actions that our national legislature, Congress could obviously do. There are things that federal regulators, the SEC, Treasury, Federal Reserve, and so forth could take on. There are also things that states and localities could do, famously our laboratories of democracy to say, okay, if a firm acquires a company in our jurisdiction, we're going to place some reasonable limerence on the amount of leverage.

41:14Or we're going to say that if something goes wrong in this company, ultimately, if you had operational control over it, you should bear some of the responsibility. And with those sorts of changes, I would argue we can make private equity a much more positive and productive force in society. Brennan, I want to push on that. With your knowledge of the legal system, what's practical? In theory, we could say there are all these things that all the states and municipalities and the federal government could should do to make this better. What can we actually do? This is, I think, a very fair rejoinder, which is at some level, is this a insoluble challenge or it's existed for all of time?

41:57Can we ever change it? My rejoinder, again, it's a bit of a straw ban argument, not necessarily what you said, is that this is a legal issue that is a relatively recent creation. And if we created, we can solve it. And I would say that it's really interesting. People that are passionate about these issues in specific industries have actually been enormously successful. So we were talking earlier about the case of nursing homes. Activists have been enormously successful, for instance, in pushing rulemaking to establish minimum staffing criteria in nursing homes. And rulemaking is going on at HHS right now on that.

42:31When we're talking about prison services, which is an area where private equity is particularly active, I'm really astounded. A handful of passionate people were able to pass legislation starting in a few cities, then in the states. So Connecticut, I think, was the first state to pass legislation establishing cap fees for prison phone calls. And just last year, there was national legislation that was passed on the issue. A certain amount of pessimism is completely understandable. I think it would be irrational to think that the legal challenges that we've got can be solved in a moment. But I think we have demonstrable instances in our recent history where we've had progress.

43:09Sasha, I'd love to turn to some of your thoughts about the impact of private equity. A bunch of different constituents involved, and maybe we start at the top of the food chain with the investors in private equity funds. It's true, I think, that you cannot meet your obligations as a retirement system, a pension provider, probably even as many retail investors, if you rely on just one way to save and invest. The impact of and the impact on the institutional investors in particular, because they're the biggest ones historically, they're still the biggest ones today, has been that they're able to fund more of their retirement obligations.

43:54They're trying to get to a 7%, 8%, whatever the annual target is. Their understanding of the methods which are used to generate these returns has improved and increased. In other words, they're part of this democratization of knowledge. And let's remember that the industry has changed from institutional investors going into funds with perhaps less involvement to now co -investing alongside funds at more attractive terms to some very large institutional investors having their own direct investment teams, often staffed with people who used to work at private equity firms to take a cut of deals or even, if not lead, then co -lead transactions as if they were a private equity firm themselves.

44:45And therefore, they're trying to skin the cat various ways and say, well, look, this much money in our balance sheet, we want to allocate to private markets. We're going to put this much into a bunch of funds that are charging us X and Y. And we've got this much, we're going to manage ourselves in our direct investment team, whether we're based in Abu Dhabi or in Qatar or in Canada or Australia, wherever. And we're actually going to get better economics off that because we're learning ourselves how to do it in a way that suits us. So we're getting closer to the action, to the transactions, but not necessarily taking over the role, I think, to some intermediating private equity.

45:22And so I think those are some of the impacts we've seen. I think the other impact that's very important to me is that the more the LP base reflects more of society, the more society focuses on the industry. So it's not just high net worths and large institutions that don't have a website, as it was resembled quite some time ago. Issues of sustainability, of social justice, of diversity, all these things come to the fore because of what's happening in society, but also because of who's investing in private equity. The kinds of things they invest in, one hopes, are not only driven by which investors are sensitive to those end industries, but you don't see many private equity firms going into tobacco, the arms industry.

46:12I think some do alcohol in one form or another, but not all of them do. Most of the major firms have pretty sharp focus these days on the environment, climate change. All of those things are a result of the democratization of the LP base. And I think that is set to continue. We may find, and this is probably not the ideal solution Brendan is looking for or is hypothesizing or is part of the mix, is actually as that process continues and the industry continues to grow, we're going to find that any mistakes that are made in the investment process and results actually are an even greater focus. Because the people whose money is at risk and whose money is being spoken for, their names are on the line.

47:00Their reputations are on the line when you buy into a school or a nursing home or what have you. They don't want to see price gouging in drugs, as we saw a few years ago. Hopefully, no private equity firms are doing that. They don't want to see any of these other bad things happen. If they do happen, And they hopefully want them to have lessons learned and moved on. Brendan, thoughts, good or bad? I think that's right in that in an interesting way, I think that there's more leverage for social good through pension funds than there would be, for instance, through publicly traded companies where power is so much more dispersed.

47:33So I definitely think that that's an avenue. I continue to be concerned about the level of education of pension fund leaders, not the technical experts, but often political appointees and so forth. Do they understand the nature of these investments and the fees that are involved and so forth? But I agree. I think that that is a potential leverage point for change. I'd love to get your thoughts on risk. Brendan, you made a comment that private equity -owned firms are 10 times more likely to fail, undoubtedly having something to do with increased leverage on their balance sheet. Part of investing is the balance of risk and reward.

48:08So we'd love your understanding of how does this fit together? as Sachin said, the diversification for some of these pools to meet their spending needs might require the higher returns. To get the higher returns, you have to take risk. And you're looking at the aggregate. So just would love your thoughts on whether the failure rate by definition is a bad thing, or is that just part of the process? In a sort of perfectly competitive market, you'd have a sliding scale of risk that everybody can choose their point along the curve that they want to stick to. I don't think that there's an inherently right amount of risk in our economy or to take for given companies.

48:49I think my concern is more that in a lot of different industries, we've set up an area where the firms can take risky actions, but can essentially walk away if things don't work out. And to use a different example, for instance, private equity firms have gotten very active in the insurance industry, investing in them, buying them outright. There's very interesting reporting about then selling those assets to offshore affiliates that have lower capital requirements, which potentially increases the risk for the insurance companies and for the policyholders. And that is within the legal right of the private equity investors or owners.

49:24The challenge that we've got is if these insurance companies fail, the responsibility for paying the continuing obligations will essentially default to the state guarantee corporations in which the insurance companies are incorporated. So if you have an Iowa insurer, for instance, that goes bankrupt, it'll be the Guarantee Corporation, which is funded by other essentially more responsible insurers that'll be responsible for picking up the tab. Whereas the private equity firm that owns the insurer will likely be able to walk away. In that sense, it's not about what is the right risk level, what percentage of companies should go bankrupt in order to have a functioning economy, but rather are the people who are making the risk decisions going to be held responsible for the consequences?

50:13Sachin, any thoughts? I think you have to start by looking at the consequences. Are we seeing increasing levels of bankruptcy problems, just like you'd look at credit card loans, auto loans, and consumer corporate measures of problems? If we look at all those kinds of KPIs, are we seeing big upticks in this as the industry is growing as a proportion of the deals happening? I don't think we are. And we're also not seeing the sort of systemic issues that we saw with some of the other bedfellows. We heard earlier that Brendan said, well, you got subprime X years ago, you got private equity Y years ago.

50:54Those other examples that we're talking about were often systemic problems. We're not seeing systemic problems with private equity. the very few that go bust. And I think not just because of the corporate veil point, but I think also just the way their own risk management is set up. It's inherently very conservative. I think what is fair to say is that do the regulators fully understand the risks that are being taken? Do policymakers fully understand those risks? I hope so. Does there need to be much more education at a practical level. So not necessarily by academics, although their input is great, or journalists, because their input is also great, but as practitioners, of course, I've written a book, but I mean, there's hundreds of different ways you could do it.

51:47No nonsense, plain, blunt English, direct understanding. Because if there was a big issue, you would imagine there might be people sitting in front of some committee, Congress, saying, well, you know, tell us about this, what happened here, what happened there. You don't want it to get to that point. I don't think we see the measures of risk as in problems getting worse. I do think that it is important to continue to mitigate that risk by engagement, education, and collaboration. And that doesn't mean saying it's either perfect or it's terrible, as we've seen so much of our lives these days. Politics is either perfect or terrible.

52:29The media is either perfect or terrible. Private equity is either perfect or terrible. It just doesn't work that way. And I worry that in the environment we're in, where there are some people really gunning for this industry, which I don't agree with, and there's also people who say, well, this industry is perfect, which I'm not sure is true either, that we have enough of that collaboration and education. And the more plain speaking there is, the more understanding there is the people who are setting the regulation, people who are making the policies, I think that's healthier for the industry.

52:59I think it's healthier for the investors, and I think it's healthier for society. Brendan, I know there are some other pieces that have come out of such and mentioned that are trying to say private equity is bad. Are there other arguments that have resonated with you, either in your work or others, that you think pose challenges for private equity? I do think that there is some evidence to say that private equity investments are riskier or have higher bankruptcy rates than non -private equity investments. But I think the broader point is well taken. In terms of other issues to be concerned about, I think it's a more meta, almost political concern in that I think private equity firms have been uniquely successful in lobbying and not just using the rules of the game, but shaping them.

53:47Every industry lobbies. It's certainly not a crime or anything like that. But I think that there is something about both the amount of money spent and the people private equity has managed to attract to work on its behalf that has made it much more effective than some other industries. For instance, it's well known the lobbying stories around the carried interest loophole since back when Barack Obama was a senator was campaigning around this. He worked on it when he was president, failed. President Trump was opposed to the carried interest loophole, was unsuccessful in changing it. President Biden was as well.

54:15I think that story is well known, but there's also a thousand smaller stories, for instance, lobbying around surprise medical billing, which was really crucial to some of the business models of the few private equity portfolio companies. They were successful installing legislation for a number of years. And then when it was passed, blunting the force of some of it and accepting from the scope, some key sub industries. So I worry in that I think sometimes private equity firms through a concentration of assets under management, and then bringing in some of these really, really big names from government, have managed to not just play the rules, but also to make them.

54:52Sachin, thoughts? Are private markets firms fundamentally better than other American businesses in lobbying politicians and other decision makers? I'm not sure. I think if you look at the biggest lobbying budgets, it's reasonably diverse of sectors, industries, companies, public, private, whatever. Often it's things that touch us every day. It's consumer goods, it's household names. To address directly carried interest, is it a loophole? I think you have to ask, is the spread between carried interest taxation and income taxation, because that spread has changed over time. Is that at the right level, given the needs of society, given the size of the industry, given the fiscal needs of society, given the need to incentivize and so on?

55:47Those are fair questions. I think it's important to take head on all of Brendan's points about these three presidents looked at changing this and it didn't happen, but it has also changed over time. So I think it's a question of really looking at, has it changed sufficiently? And it sounds like the outcome is that more people or those who take these decisions think it has changed sufficiently rather than insufficiently. But I think it'll continue to be an area of focus, particularly as our society needs taxation revenue and all those things. But I would say that at its core, private equity is about taking principle decisions.

56:27They're not consultants. When they don't behave like principals and things go terribly, well, there's no carried interest to make any return. So I think that's worth bearing in mind. Certainly not smart enough or knowledgeable enough to be able to say the right level for the next five years is going to be X. But I do think it's changed over time. I personally think it's important to maintain an incentive. The question is the level of that spread and the level of that incentive. And I don't think that lobbying is so by implication, so out of control that it has to be reined in for this industry versus either reined in in general or looked at from a broader perspective.

57:08I'd love to ask each of you a closing question. And Brendan, why don't we start with you, which is what's your biggest investment pet peeve? I feel like I'm so not knowledgeable about personal investing. And as a government employee, I should not be either receiving or getting investment advice on a public podcast. I appreciate the question. Sachin, what's your favorite aspect of private equity? The focus and alignment. When it works out, I've seen really transformational change at companies for everybody. Life -changing events, improvements in personal circumstances, and not just financial, learning, career prospects.

57:58I've seen it. I've seen the people who never thought their industry would get beyond X or Y, and it's gone all the way. I've seen people who never thought they'd be able to afford this or that. And through a transaction, they've really been able to make big personal changes. And I'm talking about people who never thought they'd be able to buy a house and they were a mid -level employee at a company and now they can comfortably because they worked in a couple of buyout situations. That is the most satisfying I've seen. And I have seen it over and over, but of course it doesn't happen all the time.

58:31I hope we see more of it. Sash and Brendan, thanks for sharing your perspectives on private equity. Thank you so much. Thank you. Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators .com where you can access past shows, join our mailing list, and sign up for premium content. Have a good one and see you next time.