The Private Equity Illusion (2024)

Blackstone CEO Steve Schwarzman made almost a billion dollars last year. In 2022, he made even more than that. To consistently make this kind of money, he must be producing something of great value right? Not really.

A lot of my work clients (institutional investors) invest significant sums of money in private equity (PE). So I spend a decent amount of time talking with them about the risk and opportunities inherent in the space. A previous firm I worked at was also acquired by a PE firm, so I saw firsthand the leverage, cost cutting, and profiteering that happens afterwards with little regard for the needs of the people doing the actual work.

How PE firms really make money

PE firms make money by taking public companies private. Theoretically, they then improve these companies by making them more efficient and productive, ultimately reaping their just rewards for these improvements when they either take the company public again or sell it to the highest bidder.

In reality, PE firms target cash-rich companies with little debt because these companies have a high capacity to borrow. This borrowing capacity is then used to finance a big portion of the acquisition cost (i.e. the cost to take the company private). It’’s similar to when you buy a home — a PE company can just put up 10% of the money needed to take a company private. The other 90% is borrowed.

But here’s the critical difference. With a mortgage, I am liable, meaning that my credit will be ruined and I will lose my house if I don’t keep up with payments. In PE, the soon to be private company’s cash flows and assets are what’s used to secure the debt. This protects the PE firm and is a huge advantage — if things go south, creditors can try to seize the private company or conduct a fire sale of its assets, but they can’t touch the PE firm. The PE firm gets to walk away with its money mostly intact (it suffers a loss on the equity it invested, the 10%). And unless its portfolio is filled with duds, it doesn’t even take a reputational hit from this bankruptcy — folks expect the companies that PE firms invest in to fail due to the high leverage…