Private Equity is neither private nor equity. It used to be called LBO and then it was re-branded.

It is perfectly legitimate to take on leverage to exploit some opportunity. That's what every startup funded by a loan does. It is a bit more difficult to fund such opportunities in established businesses.

It's would be rare that the parts are greater then the whole or that management is provably so bad you're almost certain to gain a return on investment simply by changing management.

It happens, but it is quite unusual for the markets not to exploit situations like that very quickly, long before it gets to PE or LBO.

So that why are LBOs and PE so common?

For one debt is a multiplier, invest 10, get 12, profit 2. Invest 100, 10 of those equity, 90 leveraged, get 120, pay back 100, profit 10. 10 is way better then 2.

But that's not all. There's also regulation, regulation gives lenders seniority in the bankruptcy process. First common shares are wiped out, then senior shares, then debt, then senior debt. In other words, all the share holders could be wiped out, but the debt holders can still get their money back.

And then there's taxes, debt is often favored in taxed.

So why wouldn't you prefer debt over equity? Debt is almost always better, except when you lose. If you invest 10 and you lose half, you have 5 left. If you borrow 90 invest 100, lose half, you're wiped out and then some.

To improve things, perhaps we shouldn't treat debt so much better then equity when it comes to taxation, and other regulation.

We definitely should have real bankruptcy, not tax payer bailouts.

And we definitely should keep an eye out for situations when the people in charge don't have their own wealth on the line. If they win - big bonuses, if they lose - at worst no bonuses. That's not the correct incentive system, that's a guarantee for disaster.

Concerning LBOs, the most interesting thing is not that the target firms investors may get hosed, but that these deals are profitable because they exploit the absurd vagaries in the US tax code. The fact that companies have to spend an enormous amount of time and money aligning their capital structure with business needs and tax constraints is not great.

Incentivized debt may be a problem in a country that seems to have problems with debt.

Link goes to video. Article (including video) on one page: http://www.nytimes.com/2009/10/05/business/economy/05simmons...

starts out rather polemic but really quite interesting, not to mention disturbing. A cautionary tale for mid-size firms that decide to seek private equity rather than an IPO.

THL was hardly alone in undertaking this sort of financial engineering, known as a dividend recapitalization. From 2003 to 2007, 188 companies controlled by private equity firms issued more than $75 billion in debt that was used to pay dividends to the buyout firms. Asked whether the 2007 dividend was too much for Simmons, Mr. Schoen of THL defended the deal. “That debt financing, which clearly spelled out to the market the use of the proceeds, was extremely well received. The securities were heavily oversubscribed,” Mr. Schoen said. “Not only did we think it was appropriate, but the market did as well,” he added.

:-|

I am afraid this is the predictable consequence of the Fed orchestrated monster credit bubble. These private equity players, through investment banking and other financial intermediaries are able to borrow close to the low Fed-orchestrated rate, while the companies they buy could not access the same cheap money, without which there is no basis for these deals. It was the "Age of the Financier" and every such age ended in mass misery. There is a reason all major religions prohibit usury, and in most traditional societies, making money on money is viewed with discomfort. After all, as the biblical story has it, Jesus chased the money changers from the temple.

The past 25+ years have been a mass redistribution of wealth towards the financial class, discouraging real capital accumulation in favor of playing games with money. This is not a free market at work, as some of these fraudulent "Wall Street Capitalists" would have you believe. Without an ever-accommodating Fed, , they would have been wiped out a long time ago.

That was an amazingly annoying interface for watching a video. There is a better link though: http://www.nytimes.com/2009/10/05/business/economy/05simmons...

It has text too!

Anyway, it's all about how great power and no responsibility is a bad combination.