The New York Times has been busy over the last few months informing the general public of all that COVID-19 has done or stands to do in the deteriorating quality of life in our society, from air travel to dining to the overall well-being of the economy. Its writers have not hesitated to let readers know what, in their opinion, COVID represents, and, for that matter, its wider significance (or not).
The often sensationalist coverage may or may not have always been sincere, but it has been consistent. So it was not altogether surprising to read in a New York Times article by Sapna Maheshwari and Vanessa Friedman published last week that the pandemic alone was not to blame for the recent bankruptcy filings of iconic American retailers Neiman Marcus and J. Crew. No, COVID and the COVID-related lockdowns that took all customers out of their stores for two months (and counting) were not, in this case, the sole cause of their demise. Rather, the chains’ private-equity owners were accomplices. But this case is hard to sustain.
Underlying the article’s thesis is an oft-repeated misunderstanding surrounding private equity — that the investors and sponsors have already made so much in fees and interest out of the deal that it really doesn’t matter too much to them if a highly leveraged investment ends in bankruptcy. The thesis has been repeated so often that it is frustrating to have to constantly refute it. But its repetition has helped embed it in American consciousness, and it is the duty of those who value truth and basic financial literacy to keep explaining why this analysis is faulty.
To start with the most basic of basic principles, equity investors lose money when a company goes bankrupt, and therefore they have every incentive to help it avoid that fate. That a significant amount of the capital that goes into a leveraged buyout — an acquisition where a high percentage of the cost is financed by debt — is borrowed money is by definition true. But buttressing every debt investment (which is, after all, an infusion of capital into companies that desperately need it for their growth, repair, and survival) is a layer of protective equity — the skin-in-the-game money that authors of articles such as this don’t seem to take into account. The argument that those who, as a result of owning the equity (or a large portion of the equity), have a significant stake in the profit if the company in which they have invested does well are prepared to risk that upside by structuring the company’s capital in a way that jeopardizes its prospects or even its continued existence seems counter-intuitive.
Any commercial enterprise so careless with the future of the companies in which it invests will not stay in business long, will not draw investor interest for long, and would not even get meetings with companies it is pursuing for long. In short, it would not have much of a business. If my goal in life were the death of the private-equity industry, I would be rooting for it to structure more leveraged buyouts in which the investee company went bust. That would surely hasten the outcome for which I longed.
The cases of J. Crew and Neiman Marcus are nuanced, as is any private-equity investment. To understand why and how an investment was structured requires detailed examination of the investor, the investee company, and the deal’s terms and conditions. To say after the event that a “company died under the weight of its interest expense” is a tautology. All companies fail when their debts and ability to service them exceed their assets and ability to utilize them. I look forward to reading an article that says, “Company ABC dies after years of paying excessive taxes,” or, perhaps, that “after 20 years of 20 percent annual growth in health-care costs, company XYZ shuts its doors.”
I am not holding my breath. The vilification of private equity by politicians such as Elizabeth Warren and the likes of Occupy Wall Street has created the conditions in which this sort of analysis can prevail. In reality, Neiman Marcus and J. Crew were thrown a lifeline by their private-equity sponsors. In a free-enterprise system, decisions about what resources are needed to give investments the best chance to flourish are left with, you guessed it, those who made the investment. When reading of companies “burdened” with the debt put on them by private-equity owners, it’s wise to look a little deeper into what the purpose of the debt was, and what the alternatives to such debt may have been. Did the debt merely replace prior debt already on the balance sheet (usually; or at least a significant portion thereof)?
The writers of the New York Times article cited the oft-repeated nonsense that Toys “R” Us died because of $5 billion of debt put on it by KKR, Bain Capital, and Vornado Realty, but never mentioned that this $5 billion was a recapitalization of a mess of a balance sheet defined by leases that were beyond the ability of the company to pay. Before evaluating the debt put on by a private-equity investor, it is surely only fair to evaluate the debt such new debt was replacing, including the improved terms on which the new debt often comes.
But, for the sake of argument, imagine that the new debt was not an improvement in terms, that (say, and to oversimplify) it carried an interest rate of 7 percent, compared with the old debt’s 6 percent. Is that the end of the story? Not necessarily. What if the prior creditors had been about to seize that company, and the new recapitalization gave it the chance of a new life? It seems odd to throw mud at investors who gave a company the opportunity to survive, even if that rescue bid did not ultimately work out. The writers of the article take aim at private equity for not equipping Toys “R” Us to compete in a changing retail environment. “It did not have sufficient funds to invest in its stores and e-commerce business during a crucial period of growth for Amazon and Walmart,” they say.
The broader accusation is that private-equity companies are seduced by the big brand names of high-fashion retail and the cash flows these businesses are supposed to generate, while underestimating the costs of investing in their long-term development. Yet as noted in the article, it was private equity that believed in Neiman’s story in 2005, and then profitably sold it in 2013 to two new private-equity companies (and there was a little thing called “the great financial crisis” in between those two dates). Several private-equity sponsors put their money at risk in the company, managed its balance sheet and operations through a sustained economic recession, and sold it to new investors at a billion-dollar profit in less than a decade. Winners all around, not the least of whom were the employees and managers of Neiman Marcus.
But yes, the private-equity sponsors who made the 2013 purchase now face the unfortunate reality of bankruptcy for their failed investment. Of course, before this happened, they attempted to bring the company public (in 2015, the heart of the economic recovery). Public markets were not biting. The risk was held by private-equity companies, and the creditors who had extended them debt (and by way of a basic reminder of how capital structure works, the creditors are paid first; the equity holders are paid last). The underlying inference in the New York Times article and others like it is that private-equity companies should be funding their investments with more equity and less debt. But in this case, the article itself highlights that the most liquid and sophisticated equity market on Planet Earth — the American public-equity market — had rejected the proposition. Nevertheless, private equity continued to support the business.
Michael Milken famously wrote that “capital risk should vary inversely with business risk”: The higher the risk, the more capital that will be required.
Sophisticated investors understand this and, moreover, seek capital structures that work for their individual investments. If politicians, who are outside observers encouraged by journalists and academics (two more sets of outside observers), start to issue top-down rules determining the correct capital structure for companies in which other people are supposed to put their own money at risk, it will not only lead to grotesque misallocation of capital; it will eventually lead to no allocation of capital. Those leading and financing Neiman Marcus may very well have made all the right decisions over the years, and simply run into capitalism’s creative destruction, not to speak of the damage inflicted by COVID-19 and the efforts to combat it. Or they may have made mistakes, and the new capital injected and the new investments made may have been inadequate to compensate for those mistakes. Opinions will differ over what went wrong. But no one can be happy to see an iconic American brand succumb, not least of all the private-equity investors who had much to gain from its success, and much to lose from its failure.
We do nothing to aid the cause of workers, managers, vendors, suppliers, and consumers by pretending against all logic and economic sense that these companies would be guaranteed success if only it weren’t for greedy investors and lenders — the greedy investors and lenders who believed in them and gave them a second chance. If you want a world of more iconic brand bankruptcies, root for the world the New York Times and their allies are pushing for – of pariah private-equity companies either being bullied into leaving their checkbooks in their desks or being denied the sort of opportunities that would induce them to take them out. But if you want to see free enterprise for all it is and all it will ever be — a combination of success stories and failures driven by the realities of the marketplace in the pursuit of productive growth — then rejecting the demonization of private equity is a good place to start.