Sunday, November 23, 2014

How to Become an Oligarch

WASHINGTON, DC – Let’s say that you would like to become one of the richest people on the planet, someone with enormous wealth and access to the top rung of political power. This is not an unreasonable aspiration for any fresh college graduate in today’s winner-take-all economies. But how realistic is it?

You could have a good idea for a new technology with potentially widespread demand. With the right credentials and some luck, you could attract investment from a venture-capital fund. Many such ventures do not pan out; but – particularly in the United States – such equity-financed rapid-growth companies are strongly encouraged.

Or you could issue a lot of debt. This might seem like a strange idea in the immediate aftermath of a major debt-fueled financial crisis, and with many homeowners still underwater on their mortgages (they owe more than the house is worth, even if they can still afford the monthly payments). In any case, to the extent that any recent American graduate thinks about debt, it is in the context of paying student loans.

But a new book, Private Equity at Work, by Eileen Appelbaum and Rosemary Batt, explains exactly how a few people have become immensely rich through the shrewd strategic use of debt.

The authors present a broad, detailed, and fair assessment of private equity – the business of investing in established companies through debt-financed purchases of controlling stakes. (By contrast, venture capitalists support start-ups almost entirely through equity.) And Appelbaum and Batt are careful to point out that many private-equity firms bring better management or other efficiency improvements to their portfolio companies.

But some of the largest funds – in fact, most of the brand names in the industry – use the clever trick of securing the debt they issue with collateral owned by the company they buy. This is a little bit like buying a house. A bank or mortgage originator lends you a large amount of money, which is secured by the house as collateral. In other words, if you fail to make your payments on time, the lender can foreclose on the loan and take possession of the property – as millions of homeowners have experienced in the last decade.

And yet there is a major difference between how private equity operates and how a family buys a home. Only a small part of the equity ownership acquired by any private equity fund comes from money provided by the partners who found and operate the fund. Most of it is raised from outside investors. (This would be like a family financing its down payment not from its own savings but from distant relatives about whom the family cares little.)

The fee structure in this overall arrangement is such that the people running the private-equity fund want to have as much debt as possible; this will increase the way upside returns are calculated, which in turn is the main driver of the compensation that the controlling “general” partners can receive. More debt, of course, also means more risk; but this is not a sector focused primarily on risk-adjusted returns.

If the company cannot make its interest payments, its assets will need to be sold or its activities otherwise scaled back. But, in contrast to the case of the struggling homeowner, not much of those downside costs typically fall on the general partner.

In addition, there are various other fees – charged to portfolio companies and to investors – that further encourage high levels of debt. The US tax code allows interest payments to be deducted as a business expense; there is no equivalent allowance for payments to equity investors.

Appelbaum and Batt document in impressive detail the way in which top-tier private-equity funds have been able to earn high returns and ultimately enormous wealth for their founders, while not necessarily helping the companies in which they invest. Interestingly, when returns are measured properly, the outside “limited” partners in private equity – including pension funds, insurance companies, and university endowments – also do not necessarily do so well.

However, before graduates flock to private equity, they should know that only the very big funds can use debt to skew returns for insiders in this way, primarily because only they can raise the capital needed to buy well-established companies that are rich in fixed assets, and thus in potential collateral. Smaller private-equity funds typically buy into younger, smaller companies without such fixed assets, and the leverage in those deals is commensurately less.

Regulators have recently woken up to the incentives for excessive leverage in this sector – and to the risks that such leverage poses to lenders and the broader economy. Not surprisingly, big private-equity firms seem determined to ignore or otherwise circumvent new restrictions. As the policy debate on this issue heats up, one hopes that all participants will become better informed by reading Private Equity At Work.

If the new graduate in your life has the connections to join a very large brand-name private-equity fund, the path to immense wealth, political influence, or even power becomes much clearer. Without such initial connections, however, it is very unlikely that he or she will become an oligarch. But you knew that already.

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    1. CommentedAndrewLaird Turner

      Sir: Your crack about private equity being like financing from distant relatives about whom a family cares little was both unfair and gratuitous. As a co-founder of a small private equity shop, the money we took in was from ourselves, friends and family, and long-time business partners. We gave our handshakes and our word as bond that we would do everything in our power to make them money first and ourselves second. And yes we expect to make some; we aren't doing this for free. Your other barbs (e.g., not focused on risdk-adjusted returns) are spoken from a distance as if by a man who has never, face-to-face, accepted the fiduciary duty of investing someone else's money and promising your best - let alone understood the life changing pressure to perform that creates. Yes, there is unbridled greed in private equity, as in politics, or for a certain kind of power in academia, and it is deplorable. But my experience is that most in private equity take their responsibiity very seriously indeed. To impugn them all in such a backhanded way is really quite offensive. Your tone reminds of the fashion reporter assigned to cover a boxing match. The boxers should do this or that, and could've, would've, or should've done something else - when you've never stepped in the ring yourself, been knocked flat and had to get right back up again because you had given your word. Consistent with Theodore Rooseveldt's observation, It's easy to criticize when you've never stepped in the ring. There are real problems with some private equity transactions, with the nature of incentives, and especially with performance measurement of private equity deals, which if done correctly, would expose the use of leverage. But your column does no service to the discussion or offer solutions when you play on clear stereotypes and serve up backhanded slights in the guise of scholarship.

      Andrew L Turner, Ph.D.
      CEO, WHV Investment Management

    2. CommentedGerald Silverberg

      Besides the deductibility of interest charges in general, Johnson fails to mention the other implicit subsidy of private equity: the lower current "carried-interest" tax rate - 24% - on private equity capital gains versus the usual 35% rate.

    3. CommentedZsolt Hermann

      Let us play with the idea a bit.
      Let's say someone follows the advice, gets it right and becomes an oligarch.
      He/She has money, position, even political power...
      ...and what?
      If we read the news day by day, it is hard to see why anybody would actually want it.

      Ok, I could have a yacht, several properties in several places, could attend parties, occasions for "only very important people", could take selfies with world leaders or sport superstars, or even they would want to take selfies with what?

      Do these people actually look happy?
      Do they not use drugs, search for the most twisted pleasures, get depressed, exhaust themselves and then arrive to an elderly age without actually living life, even commit suicide before?

      Moreover more and more everybody is blaming them for the crisis, for the general suffering and their positions are getting increasingly insecure from multiple sides. The "Barbarian hordes" are already at the gates of the great empire that is falling apart anyway.

      What is life? What is the purpose?
      Is it truly money, power, influence?

      Natural sciences, even psychology do not think so, public polls do not think so.

      We could make a social, or even a family experiment, just switch off the toxic media brainwash for a week, disconnect and then re-evaluate what is important, what is it that we truly desire, without others professionally injecting desires in our minds.
      We could even find we already have everything, moreover we have much more than we need.

      Let us disconnect from the "Matrix" and try to find what naturally gives us happiness, contentment, one that remains, that is sustainable.
      Connections to others, mutual cooperation, complementing each other.

      Do not take my word for it is scientifically proven over and over again.

      Our only free choice is choosing what environment influences us, everything is based on that.

        CommentedEdward Ponderer

        You've reminded me of the poster, popular on college dormitory walls in the 1970s (if I may date myself :-) ). Neil Armstrong or Buzz Aldrin was standing on the moon -- by the planted US flag as I recall, with the LEM module or perhaps Earth rise in the background. The picture was as a front page newspaper photo, the headline reading, "So What?!"

        Do we think, struggling for artificial, perhaps resource draining and destructive goals, as to what social forces and internal egoistic forces drive us. Are these drives truly our real selves, or are we their slaves? -- When do we begin to think about our true state and cry out like the Israelites prior to the Biblical Exodus?

        Like the 1965 Burt Bacharach and Hal David song, "What's it all about, Alfie? Is it just for the moment we live? ..." Perhaps we should be living in the moment, rather than for the illusory moment of truly satisfying accomplishment. What areour relationships? What do we accomplish for others--something beyond our little organic shells of bodily self before it decays as a wretched joke back into the earthy material from whence it came? When will we be happy, truly creatively give to our greater, lasting self?