In this fascinating long read, Matt Stoller tears into the Private Equity industry given the heavy indebtedness amidst the pandemic driven economic depression exposes the industry’s vulnerability and how the industry is using political capital to engineer a bailout yet again. The newsletter traces the PE industry’s origins to the 1980s junk bond boom and highlights the consequent similarities in the ‘business models’ involving leveraged buyouts. As a build up to the current issue, Stoller starts off with a riveting recap of the Michael Milken era of junk bond driven corporate raids even using the Goodfellas ‘bust-up’ model for analogy, something most of us back home in India would be far too familiar with – the promoter-banker-politician nexus which inevitably comes at the expense of shareholders, creditors and taxpayers.
“In 1993, economists George Akerloff and Paul Romer wrote a paper on the conjoined two crises of 1980s finance. The first was mass junk bond defaults late in the decade, and the second was the savings and loan crisis of deregulated banks going bankrupt en masse as they engaged in an orgy of self-dealing and speculation. The paper was called Looting: The Economic Underworld of Bankruptcy for Profit, and in it, they described how financiers can profit by destroying corporations, using a particular strategy. “Our description of a looting strategy,” they wrote, “amounts to a sophisticated version of having a limited liability corporation borrow money, pay it into the private account of the owner, and then default on its debt.”
What Akerloff and Romer were basically talking about was a legal version of the bust-out scene from Goodfellas. In that movie, mobsters took an ownership stake in a restaurant they often frequented, and then used the restaurant’s credit to buy liquor, which they would move out of the back and sell at half off. When the restaurant’s credit was all used up, they burned the restaurant to the ground to collect the insurance money. It was an intentional bankruptcy, a theft from creditors by those who had control of the restaurant and did not care what happened to the asset in the end.
A bust-out requires the ability to borrow from someone, so that you can steal from the people lending you money. This is also true for its white collar cousin. So the trick, for both the mobsters, and the white collar looters described by Akerloff and Romer, is to find a way to borrow money. I’m reminded of this paper, and the bust-out scene in Goodfellas, because I’ve been trying to understand what is happening with private equity as the Coronavirus induces a massive, if short-lived, shock to our economy.”
The reason I’m reminded of this paper is because private equity is a business created in part by junk bond takeover specialists in the 1980s, who were the topic of Akerloff’s and Romer’s paper. What’s interesting about junk bond specialists is that they had a more insidious plan than the mobsters in Goodfellas. Mobsters just stole from the bank, which did not know that the restaurant had become an object to be looted. But financiers of the 1980s actually captured control of the bank.
Akerloff and Romer showed that both savings and loan executives and junk bond kings were making loans they knew could not be paid back, because they were often self-dealing. They would lend to entities in which they had a stake. And since they were lending money that was not theirs, they did not care if the loan went sour, as long as some of it got transferred to their own pockets. In other words, the best way to get a lender to lend you money is to put an agent in charge of the bank who doesn’t care if that money is paid back. Bill Black, a bank regulator in the 1980s, later wrote a book about this time with the memorable title: The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry.
…Between the 2008 financial crisis and the pandemic, it had been smooth sailing for private equity firms, who had in turn gotten more and more aggressive. Pension fund investors have thrown more money at PE firms, and debt investors, hungry for anything with a return, have also gotten more hungry for higher yields. PE firms have even launched their own debt funds, meaning that they are both borrowing money to buy firms and lending money to support takeovers. Basically, there’s now an entire shadow banking system of private equity giants and their various captive institutions lending and borrowing from each other, and buying and selling each others’ companies.
Private equity is undergoing what the great theorist Hyman Minsky pointed out is the Ponzi stage of the credit cycle in capitalist financial systems. This is the final stage before a blow-up. As Minsky observed, a period of placidity starts with firms borrowing money but being able to cover their borrowing with cash flow. Eventually, there’s more risk-taking until there’s a speculative frenzy, and firms can’t cover their debts with cash flow. They keep rolling over loans, and just hope that their assets keep going up in value so that they can sell assets to cover loans if necessary. To give an analogy, in 2006, when people in Las Vegas were flipping homes with no income, assuming that home values always went up, that was the Ponzi stage.
Now, what happens with Ponzi financing is that at some point, nicknamed a “Minsky Moment,” the bubble pops, and there’s mass distress as asset values fall and credit is withdrawn. Selling assets isn’t enough to pay back loans, because asset prices have collapsed and there’s not enough cash flow to service the debt. Mass bankruptcies or bailouts, which are really both a restructuring of capital structures, are the result.
I think you can see where I’m going with this. PE portfolio companies are heavily indebted, and they aren’t generating enough cash to service debts. The steady increase in asset values since 2009 has enabled funds to make tremendous gains because of the use of borrowed money. But now they are exposed to tremendous losses should there be any sort of disruption. And oh has this ever been a disruption. The coronavirus has exposed the entire sector.”

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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.

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