In The Buyout of America, Josh Kosman, a financial journalist at The New York Post, believes he has found the cause of the next financial crisis - billions of dollars worth of high yield bonds that come due around 2013-2014. Whilst it is hard to believe that you can set your watch for the next financial crisis, the impact of private equity on the global economy is a hot topic in the UK right now, following the recent fortunes of Cadbury and Manchester United.
Private equity (or PE) refers to the practise of buying private companies (whose shares are not traded on the exchanges) or to buying publicly listed companies and taking them private. PE firms raise funds primarily from institutional investors, endowments, pension funds, or very rich individuals. Once a fund has been raised, it usually takes five to ten years for the investors get all of their money back. Private equity firms often buy mature companies using a technique referred to as a leveraged buyout.
It is this practice that Kosman most objects to. He believes that this type of financing makes it difficult for businesses to survive in the long run. When a private equity firm embarks on a leveraged buyout, they typically borrow up to 85 per cent (and sometimes more) of the purchase price from banks. This debt is transferred onto the balance sheet of the acquired company. The company's profits are then used to pay the interest and principle on the debt. Because this can be a risky proposition, the banks can transform their loans to the company into high-yield bonds, sometimes called junk bonds.
Kosman's argument in The Buyout of America, is two-fold. First, he believes that the burden of a lot of debt on the balance sheet of a company puts the business in a position where it is difficult to grow in the long run. Management is under pressure to reduce overheads in order to service the debt. This means fewer employees, less money on quality materials, and a lower priority placed research and development. Second, even if companies can continue to prosper with fewer employees and inferior products, they are unlikely to be able to repay the huge sums of debt once it becomes due. The private equity industry grew substantially between 2005 and 2007. The loans which financed these transactions typically had an eight to ten year maturity. It follows that most of these loans will be due for redemption around 2013. Kosman thinks there's a good chance they won't be repaid. Most of the debt will be in the form of bonds, sitting in the savings accounts of individual and institutional investors. The realisation that they won't be repaid could cause a collapse in the markets.
Kosman's book is easy to read but his reasoning is hardly compelling. He offers no defence of the private equity industry in Europe or the United States, despite the evidence that it creates jobs by investing in underperforming companies, which then perform better than publicly listed ones. Kosman fills his book with tales of the deals that went wrong but leaves out the examples where both employees and investors benefitted. His theory that all of the loans will come due at once ignores all of the ways that companies can restructure their debt; from initial pubic offerings, to extending the loans, to selling assets to pay the loans. The Buyout of America amounts to little more than a brazen attempt to trash a credible industry.