Greetings, everyone. Welcome to the Plane Bagel. I'm your host, Richard Coffin. Today, I wanted to talk about an area or a topic that's kind of become a bit of a dirty word over the years in the space of finance. It's an area that these days controls 13.1 trillion in assets under management globally and $3.5 trillion just within North America, having seen tremendous investor inflows over the past couple of decades, with their reach expanding to everything from restaurants to hospitals, with this group being none other than private equity. A space that's often confused with hedge funds, and they do have a lot of similarities, but seemingly even more despised, with many blaming a lot of current US problems on the space of private equity, ranging from the closure of retail stores, rising unemployment, the housing crisis, higher clinic and medical costs, and even more recently the bankruptcy of Red Lobster. Just tragic all around, but perhaps more ominous than the claims that this group has taken away the average person's ability to both

purchase their first home and enjoy endless shrimp is the fact that most people have never heard of these companies before Blackstone, the largest private equity company with over $1 trillion in assets under management, might be a more well-known part of the group, in part because people just keep mixing it up with the much larger BlackRock. But other companies like KKR, Carlyle Group, Apollo, and a number of other large players in the space have all managed to maintain pretty low public profiles, despite the fact that many of these companies each individually manage hundreds of billions of dollars, really contributing to this dark, ominous image of a secret puppet master corporation operating everything from the shadows. And with the area having grown over tenfold since the 2008 financial crisis, they've come to control some pretty prominent brands, including Baskin Robbins, Dunkin' Donuts, Michaels, and even Ancestry.com, which raises a number of questions. Who exactly are these companies? Are they really as evil as people say they are? Should I be concerned that they've been collecting

spit samples from over 3.5 million subscribers, and most importantly, should I invest in private equity? Because these days, there are services rolling out that bring private equity offerings to retail investors. Well, that's all what I'm going to try to sort out in today's video. And in the past, I have tackled the more conspiracy-esque theories around large asset managers secretly controlling the world or trying to destroy given companies. And indeed, private equity does come up often as a sort of filler villain for especially meme stock-style theory. But to be clear, that stuff sort of aside, the bad reputation around private equity is still pretty well-deserved, with one National Bureau of Economic Research paper even arguing that private equity ownership of nursing homes has contributed to over 22,000 additional deaths over a 12-year period. So, among other things, I'll also try to explain why it is that private equity can't seem to stop getting in trouble. Now, as you might know, when we talk about private

Equity. We're really referring to private equity firms or funds, which are groups that specialize in helping clients invest in these types of companies. Private equity itself is just an asset class or type of investment that encompasses all privately owned businesses. So, basically, any company that's not a publicly traded stock is technically private equity. And private equity or PE firms specialize in helping their clients buy these types of companies since doing so is a lot more complicated than just buying a stock on Robin Hood, with PE firms pulling client money together, employing teams of lawyers, analysts, operations experts to take over these companies, and then trying to employ best practices or what have you to make the business more profitable to earn themselves and their investors a return. Now, within private equity, there are a bunch of different strategies that a group might focus on. For example, there's venture capital, where you effectively invest in startups, but the most popular and controversial strategy is the leveraged buyout, which represents roughly 28% of all private market AUM, inclusive of debt-oriented.

strategies as of June 2022, with this typically involving the PE fund borrowing a bunch of money, typically 80 to 90% of the company purchase price, using that to acquire a usually mature business, saddling the debt onto the target company, and then trying to use the higher profits from the turnaround to pay down the leverage. Something that, when successful, can be very lucrative for investors given how little capital is being put upfront to try and own this business, which touches on why private equity has been such a popular asset class. Because in addition to this sort of high-risk, high-return strategy, they've often been presented as being a superior asset class in terms of return, given the illiquidity premium, the higher barrier to entry, which leaves more opportunities for realizing returns. And in addition to all that, they're argued to be less correlated to public markets, meaning they might not fall when everything else does, which offers a diversification benefit. And they're often presented as being less volatile, meaning they don't swing around in price.

as much I'll we get to those points later. Now, the asset class does have its drawbacks. Some of the strategies are higher risk. It can be pretty illiquid, meaning that it can be difficult to get your money out of the investment, with some funds being able to gate or otherwise block investor withdrawals. And the superior return they offer does come at a pretty hefty price, with most funds charging 2 and 20, meaning a 2% annual fee based on the value of your investment, plus 20% carried interest or a performance fee that pays out 20% of profits above a given threshold. But despite this, private equity has continued to be a pretty popular strategy, which is why the investors who ultimately own the $1.13 trillion being managed here include the likes of pension plans, endowments, and even country sovereign funds. Which all sounds pretty good, but then what's the problem? Well, there are a few, and they typically involve other stakeholders. But even investors in PE funds face a number of

issues with one of the more public problems being the layoffs that typically follow a PE acquisition. Uh, with this seemingly being a favorite tool in the Arsenal PE firms to try and squeeze more profits out of the companies they acquire. And in fact, one 2021 paper that looked at 6,000 buyouts from 1980 to 2013 found that employment at Target companies shrunk an average of 4.4 percentage points in the first two years relative to a peer group when omitting post-buyout acquisitions and divestures, with the retail sector in particular receiving the short end of the stick here, with the area expected to have lost 600,000 jobs as a result of PE firms and hedge funds taking over companies over the last 10 years. Now, layoffs can make sense when a company is overstaffed and could use further optimization, but these layoffs and other cost-cutting measures are often blamed for hurting the quality of products and services offered by these Target companies, which sucks when your morning honey cooler isn't as fresh as it used.

to be but is particularly concerning when it comes to the other more critical industries that private equity has gotten involved with, most notably healthcare, with private equity having come to own 8% of private hospitals and 5% of total nursing home facilities, with one ASP study finding that private equity investment in the latter resulted in a 12% relative decline in RN hours worked per resident day. And as you'd expect, it's had some negative impacts, with private equity-owned private hospitals seeing a lower CMS star rating and nursing facilities seeing a 14% increase in their deficiency score index, lower overall inspection and staffing ratings, and even, as cited earlier, a higher mortality rate among residents. Now, in addition to healthcare, private equity has also caused a ruckus with real estate for managing funds that exclusively go around and buy up single-family properties with the goal of renting them out to tenants, which, as you can imagine, during a real estate affordability crisis, is not cool, man, with advocacy groups arguing that not only are private

Equity firms taking inventory from other buyers, but that they also have a tendency to hike rates, evict tenants, and overall neglect their properties more than other ownership types in the pursuit of profits. So already, you can see why some people aren't all that fond of private equity. But perhaps the most frustrating aspect here is that despite the layoffs and the deterioration of the products and services they offer, the companies that these firms promise to turn around still fail pretty frequently. Whether it be Toys R Us or again the more recent bankruptcy of Red Lobster, private equity's high-risk approach has a pretty high failure rate, with the space accounting for 16% of U.S. bankruptcy filings in 2023 and the first four months of 2024. In one study even suggesting that companies held by leveraged buyout firms have a 20% bankruptcy rate in their first 10 years, 10 times higher than that of a control sample, which is actually part of what contributes to the high unemployment.

that seemingly stemmed from private equity activity, and as you can imagine for, again, those critical industries, these sort of bankruptcies and failures can have pretty severe implications for many other stakeholders, which all brings us to the question: why are private equity companies seemingly so reckless and aggressive? Don't they want to have a better rate of not failing? Well, part of it is that private equity firms tend to have a pretty short time horizon of anywhere from 3 to 7 years, meaning that they often have an exit strategy that focuses on short-term profitability rather than long-term sustainability. For example, a pretty common strategy for private equity firms is to take all of a company's real estate holdings and sell it to the market, only to then rent back those positions so that the PE firm has access to a sudden pool of capital, even though long-term that just forces the company to now pay rent in addition to trying to pay down their massive debt balance. But a more controversial aspect here is that private equity firms don't inherently need their companies to

succeed to make money, uh, thanks largely to how their investments are structured. When a private equity fund carries out a leveraged buyout, as mentioned, they often saddle that debt onto the acquired business, meaning that there's a degree of separation between the fund and the liability for the debt they've taken on. If that company fails and is unable to pay back the debt, the fund is not often liable for the amount owed. So, beyond their initial investment, which again is often only 10 to 20% of the company's whole purchase price, there's not much financial liability that the funds face for their company's failing, with this lack of liability even sometimes extending to legal matters, with companies often able to dodge responsibility for the actions of the companies they effectively run thanks to their complex ownership structures. In fact, according to federal prosecutor Brandon Belo, we've even seen examples of PE firms abusing bankruptcy laws, using the mechanism to extinguish things like pension liabilities, which, mind you, represents money owed to employees, only to then reacquire the business after

bankruptcy under a different arm to ultimately end up in a better financial position. And while the investors of these PE firms might lose when the companies they hold go bankrupt because the private equity firms are often charging both their investors and the companies they manage fees, they can still benefit and end up positive while everyone else in the situation loses. With PE firms often criticized for benefiting from any of the cost-cutting actions they've carried out, regardless of how intense they are, while leaving their portfolio companies to deal with all the consequences. With Red Lobster, for example, in part failing due to its high rent payments, which it wouldn't have had to deal with if its private equity owner hadn't sold off all of its real estate. And while all this probably sounds pretty abusive and shady because private equity firms typically cater to higher net worth individuals and institutions, they have pretty minimal oversight from regulatory bodies who are really more focused on protecting smaller investors who most of the time can't even access private equity funds given that they usually

require you to be an accredited or qualified investor, often meaning that you need to have a minimum amount of money to invest with them. This has allowed them to remain pretty secretive, not just about the fees that they charge both the companies they operate and even their investors, but even their performance, meaning that investors of their funds might not even have a clear up-to-date picture of how their investments are doing. But surely it must be worth it, right? Why else would investors subject themselves to this sort of arrangement if they aren't seeing the returns to justify investing with private equity? Well, there it is a little difficult to assess the return of private equity because it's private, and the common measures of return such as IRR aren't directly comparable to public stock market returns. But regardless, some papers do suggest that private equity has seen superior performance over the last little while, with one 2012 paper finding that the average US buyout fund outperformed the market after fees by more than 3% a year. Likewise, a CIA study

found that the average annual performance of private equity held across state pensions over the past 23 years was 11%, compared to the Russell 3000, which earned 6.2%. However, there are some other conflicting arguments here, with another paper arguing that when performance is compared to other perhaps more appropriate benchmarks, private equity has performed about the same as public equity indices since at least 2006, with most of the benefit from these high-risk, high-return strategies seemingly going to the PE funds themselves rather than their investors, thanks to their high, obscure fees. In fact, the same paper, which is titled An Inconvenient Fact: Private Equity Returns in the Billionaire Factory, highlights that private equity has single-handedly added 19 billionaires, or more than one a year, over a 15-year period, supporting the notion that while private equity firms have gotten stinking rich from their approach, the returns seen by their investors have more or less just been fine. In fact, some firms have even been accused of abusing their investors thanks to their minimal reporting.

requirements and the valuation method of their holdings. Because in addition to their fees being obscure, so too are the values of the positions they hold. You see, compared to publicly traded stock, which because it's often traded by the second gives you a pretty good idea of how much money you can get for your investment, the value of a private equity investment isn't really known until the asset is sold. And up till that point, you can really only use estimates or appraisals to try and guess how the position has performed, which not only can lead to artificially low volatility since there's just less pricing taking place, but because appraisals are often done internally or through a company hired by PE managers, and because PE funds can charge a high fee when appraised values increase, it can create a conflict of interest. But there being a growing concern in the industry that PE managers are artificially inflating these valuations or otherwise delaying write-downs when the value of their assets have deteriorated to maintain the appearance of strong performance and to

continue charging high fees, with some going so far as to claim that private equity is in a bubble. With mass investor inflow into the space combined with its involvement in some troubled areas like commercial real estate, making it difficult for these funds to actually sell the assets they've acquired over time at a profit, leaving their investors stuck in these so-called zombie funds where they can't withdraw their money but are still stuck paying the fees. Now, this is something that the SEC has investigated and started charging some companies on, and we've seen them even attempt to improve disclosures and transparencies around fees and valuations with a recent rule change. But that rule change is actually something the Fifth US Circuit Court of Appeals ruled against recently after industry pushback. And if PE funds benefiting from lax regulatory oversight and lack of liability weren't enough to turn you red, it turns out that private equity managers even receive preferential tax treatment on their carried interest, that 20% performance fee, thanks to a tax

loophole that treats this amount as a capital gain rather than income, which means it's taxed at a better rate. Something that the industry has fought tooth and nail to keep in place with lobbying. So, yeah, you can see why there's really no love loss when it comes to private equity and why they've somewhat deserved some of their bad reputation. But with all that being said, of course, private equity is a very broad category, so it's not to say that all funds that operate in private equity are following a malicious playbook. And it could even be argued that in some ways these companies can offer benefits to other stakeholders. Venture capital, for example, while only investing a small amount in actual startups, has historically spent a good amount building out infrastructure for these businesses to help bring new technologies and products to scale. And it could even be argued that leveraged buyout funds, while risky, do fill a needed space in finance and at the very least are attempting to turn around otherwise failing companies. Well, Toys R Us is often brought up as an example of

leveraged buyout failures. There are examples of successes, such as Hilton Hotels, where private equity firms were able to replace problematic managers and genuinely improve company operations. I will also highlight that while there is data to support the notion that private equity is playing a role in some issues faced by the United States, that their role in these issues is sometimes overstated. Not too long ago, for example, there was a headline that private equity had purchased 44% of single-family homes in the third quarter of 2023. In reality, however, this was just a misinterpretation of a stat that investors as a whole, which includes individuals like you or me, represented 44% of purchases of property flips in the third quarter of 2023. Mega investors, which would include private equity alongside other investors with 1,000 properties or more, only themselves represented 9% of total investor buying activity in the second quarter of 2023, meaning that at the aggregate level, they only represented 2.3% of total

single-family home purchases a pretty ridiculous Far Cry from the 44% that circulated online and of course there are more convoluted conspiracy theories and the like about private equity secretly controlling the world to try and take down GameStop uh that don't have a whole lot of evidence to support them even still the lack of regulatory oversight the legal protections and just the clear conflicts of interest do present a lot of problems and have allowed for a lot of abuse in the space now the good news is that we have start to see investigations and more of a Crackdown in the space with private equity having drawn some attention from lawmakers especially for its role in healthcare and while the assets Center management for private equity has grown nearly 20% annually since 2018 Rising interest rates have since slowed the flow of money into private equity with fundraising declining 15% in 2023 versus 2022 we've also seen private equity ownership in areas like nursing homes go down and it's unclear whether private

Equity will continue to be as lucrative as it's been in the past. Not only will higher interest rates make leveraged buyouts more expensive and more difficult to pull off successfully, but investors crowding into the space has seemingly made it less attractive, closing the valuation gap between private and public equity, which translates into a lower expected return or effectively fewer opportunities for larger gains in the private space. Still, even with those caveats, the space managed to raise $649 billion last year, suggesting that it's going to be a pretty important force for the near term and something that we would hope over time sees smarter regulation to better align the interests of these private equity firms with other stakeholders or at least their investors. Anyway, that's the video. Thanks for watching. I hope you found this video helpful. If you did, please make sure to like, subscribe, all that good stuff. It does help the channel tremendously. Let me know your thoughts on private equity in the comments down below, whether you love them or hate them for taking away

your endless shrimp and the other stuff. Thanks again for joining. See you in the next one.

Why Does Everyone Hate Private Equity?

Investing and personal finance educational videos with a hint of economics, posted regularly.

I'm a CFA and CFP professional working as an analyst for an investment management company in Ottawa. I'm a huge finance nerd and am passionate about the field - I think people lack the resources they need to make educated financial decisions, and hopefully this channel helps with that!

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The videos on this channel are for education purposes only and do not constitute financial advice. Richard Coffin does not provide recommendations on The Plain Bagel - those looking for investment advice should seek out a registered professional. Richard is not responsible for investment actions taken by viewers and his content should not be used as a basis for investment trades.