The Private Equity Deception

Private equity firms are a risky place to invest and their reported returns can be misleading.

The Private Equity Deception
Credit: iStock.com/zimmytws

During the dog days of summer, August 7 to be precise, President Donald Trump signed an executive order that The New York Times described as aimed “to make it easier to include alternative assets like private equity, cryptocurrency and real estate inside 401(k) and related employee retirement plans. Together, the accounts hold $12.2 trillion in retirement savings.”

Let’s leave aside real estate as well as the topic of cryptocurrency, which economist Gerald Epstein has examined in a three-part article series for Left Hook Economics (see herehere, and here), and the financial benefits that the Trump family will receive from this executive order, as the family has its own cryptocurrency operation. (Did I hear the word "corruption”?) 

Instead, let’s deal with private equity. It is a risky place to invest and its reported returns can be misleading. Public pension funds, which hold and invest the retirement money of state and local government employees—schoolteachers and many others—are often big investors in private equity. Also, if the current difficulties of private equity continue to expand, they could generate a financial crisis and a severe economic downturn. 

(Full disclosure: As a retired state of Massachusetts worker, my pension funds are in the hands of a governmental investment company with substantial holdings in private equity, about 17% of the investment company’s $100-billion-plus holdings.)

What is Private Equity and Why It’s Risky

Private equity includes a variety of financial firms—hedge funds, venture capital firms, and firms that buy, control, and then sell other companies. What makes them private is that they take investments only from large investors, institutions like pension funds and endowments, and rich individuals. They do not sell shares on the public market, the stock market. 

Compared to public companies, which anyone can buy into, private equity firms are very lightly regulated. The rationale for light regulation is the traditional regulatory framework that maintains “more sophisticated investors are adequately protected with a less intensive disclosure framework.” The belief is that big investors—rich individuals and large institutions such as public pension funds—are “sophisticated investors” and can take care of themselves. They then have little need for the protection of regulation that requires more intensive disclosures. This rationale, however, ignores the damage that society as a whole can suffer from the actions of financial institutions, to say nothing of the fact that rich people and those who manage pension funds are not necessarily highly “sophisticated investors,” and pension managers may not be fully devoted to the interests of pensioners.

Here I am concerned only with the private equity firms that buy, control, and then sell other companies. These private equity firms buy companies with the ostensible purpose of improving the purchased companies’ operations and then selling them at a profit.

The lack of substantial regulation allows the people who own these private equity firms—the general partners—to operate them in a risky manner. Their business plan is to buy companies, mostly with funds from outside investors—who are called limited partners—and loans from financial institutions. Typically, about 1% of the purchase price comes from the general partners, about 70% is borrowed, and the remainder comes from the limited partners.

The firm—that is, the general partners—place the purchased company in a legally separate fund. They take large management fees out of the companies they control.  These fees can exceed the amount of money they put into the purchase. They also charge annual fees of 1%-2% to the limited partners. If they are able to sell the purchased company for a profit, they take 20% of the gain, even though they put in a tiny share of the purchase price. (The private equity firms are able to takes such a large share of the gains because, like hedge funds, they have convinced outside investors that they too will obtain exceptionally high profits.) 

If the purchased company fails, the private equity firm loses little, or maybe nothing (remember those high fees), and has no financial liability because the failing company is held in a legally separate fund. Instead, the limited partners (e.g., the organizations managing public pension funds) and the creditors suffer the loss from the failed purchase made by the private equity firm. 

While the possibility of big gains versus small losses contributes to the riskiness of private equity, an additional risk comes from private equity firms using a high amount of debt to buy companies (typically about 70% as noted above). When interest rates are relatively high, the purchased company may not be able to meet the debt payments. Indeed, public companies with a similarly high level of debt also fail at a relatively high rate.

The list of reasons for failure goes on. Private equity firms often purchase companies in trouble, which is why a private equity firm could see them as ripe for improvement. That trouble, however, also makes failure more likely. And, further, a private equity firm can see quick profits from “bleeding” the purchased company—that is, for example, by selling off the company in pieces or cutting its workforce. The “bleeding” can also take place as it did with the infamous Steward hospitals case in Massachusetts. The private equity firm that bought the hospital chain Steward Health Care sold the actual buildings, bringing in a large amount of cash and burdening the hospitals with rent payments. The private equity firm also took substantial fees from the sale but avoided incurring costs when Steward failed. (Poor care and deaths at the hospitals have also been attributed to the “bleeding.”)

For the outside investors—the pension funds and others—private equity is, then, relatively risky. While estimates vary, it seems that the failure rate for companies held by private equity firms is at least twice as high as the rate for publicly traded companies. Yet, in his 2023 book, Plunder: Private Equity’s Plan to Pillage America, Brendan Ballou reports, “Roughly one in five large companies acquired through leveraged buyouts [i.e., with a large amount of debt] go bankrupt in a decade. This is vastly more than the roughly 2 percent of comparable companies not acquired by private equity firms that do.”  

Risk and Returns

It is, then, easy to understand why private equity investments are relatively risky for outside investors, the limited partners, and creditors. Yet, high risks might be justified if, overall, private equity yields high returns.

But are the returns from private equity investments actually so high? This question will be taken up in part two of this article series.

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