Friday, September 21, 2012

Private Equity Privilege Even Works When You Lose

Private Equity Privilege Even Works When You Lose

Yesterday our private equity guru doubled the value of a $100 million investment and made a tidy profit for himself, which more than covered one of those pricey invites sent by a Democratic US Senator or Republican Presidential candidate.

Today, our little company runs into a rough patch.  If the selling price falls below $60 million those pension plans and endowments lose all their money – remember the $60 million bank loan has to be paid off before the investors get their money back.

Fund Flows (1999)

So if the business is sold for less than $60 million the investors are wiped out, and the private equity manager loses the $1 million he invested as well (he can deduct the loss against other investment gains).  If the price falls below $60 million the bank also starts to feel some pain because the loan won’t be repaid.  But not everyone loses.

The bankers (think people, not the institution) who arranged the loan and advised the private equity firm on the deal will still make millions from the fees long before the business goes bad.  So if you are soliciting campaign contributions keep them on your list.

The private equity firm, having failed to make any money for its investors, will still come away with $4 to $6 million in management, director and/or monitoring fees.  Obviously they’ll have some expenses associated with running their private equity business and ordinary income tax to pay, but they’ll still take home $3 to $5 million, while only losing the $1 million they actually invested in the failed business.  Isn’t this a great business model?

Now there are two important lessons.  First if you continually make bad investments your investors will not continue to back you.  So you’ll get to keep the place in the Hamptons, but your plans for the south of France will have to go, and you might not get the prime table at the fundraiser for the Metropolitan Museum of Art.  In other words, to keep this game going private equity does have to deliver some winners to its investors.

Second, private equity and hedge funds don’t necessarily back Republicans.  Contributing isn’t about ideology; it’s about money – their money (making it and keeping it).  Remember, the industry backed candidate Obama in 2008.  So don’t be surprised if President Obama doesn’t start to get a slug of cash if he continues to lead in the polls as November approaches.  And even if the private equity folks fail to write the big checks to the President and his party before the election, there’s always the Inauguration Committee, which will gladly take their money.

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