This is the third in a series of articles about the rise of leveraged finance and private equity firms. To read the first in the series, "The Rise of the Ridiculously Rich," click here. To read the second in the series, "The Golden Age of Private Equity," click here.
Although the financial crisis and its nascent recovery brought much of the private equity world to a halt, it had little impact on the fortunes of the industry's founders. In 2011, the co-founders of Kohlberg Kravis Roberts
When the music stopped
Unfortunately, the same cannot be said for some of the industry's most notable takeovers. After the property market crashed in 2008, wreckage from Blackstone's Equity Office Partners deal was literally strewn across the country, from California to Texas to New York. The deal left many of the companies that bought pieces of the deal from Blackstone with punishing debt, properties whose values plummeted, and millions of feet of office space they couldn't fill. Some of the newfound owners simply walked away from skyscrapers, as if they were underwater subprime homeowners.
KKR and Goldman Sachs' monster TXU deal spawned a company that's now teetering on the brink of insolvency. Renamed Energy Future Holdings, it reported a $1.9 billion loss in 2011. Its retail business has lost about 17% of its customers over the last three years to cheaper rivals. And making matters worse is its prodigious $35 billion debt load, most of which was heaped upon it during the buyout. In his annual letter to shareholders, Warren Buffet highlighted Berkshire Hathaway's $2 billion wrong-way bet on the bonds of the company, calling it "a big mistake" and saying it was at risk of losing all of its value.
And a similar fate haunts shareholders of Caesar's Entertainment, formerly Harrah's Entertainment. Acquired by Apollo Global Management and TPG Partners in 2006 for $27.8 billion, the casino operator was taken public this past February in a ridiculously low-float IPO of just 1.4% of the company -- by comparison, Facebook has been criticized for releasing only 5% of its shares. The company is encumbered with $20 billion of debt compared to only $1.7 billion in equity. Its interest expense alone is almost $2 billion a year, eating up almost a quarter of its gross sales.
And the list goes on and on...
Is private equity good for America?
As in the days following the RJR Nabisco fiasco or Stephen Schwarzman's opulent 60th birthday bash in 2006, questions about the value of private equity have reemerged. This time it's been in the course of the Republican presidential primary, with much of the discussion revolving around the 13.9% tax rate applied to $20 million that Mitt Romney received as residual income from his days leading Bain Capital. Known as carried interest, the profits of private equity managers are often taxed as long-term capital gains and not normal income. In addition, it was recently announced that the Securities and Exchange Commission has begun a broad examination of the private equity industry, purportedly seeking information about the business practices of its most powerful firms.
Although the industry has its staunch defenders -- as you'd expect given the piles of money at its disposal -- it's hard to see the value it brings to the table. For anyone other than its participants, that is. Its main players trade multibillion-dollar corporations like 14-year-old boys trade baseball cards. And in doing so, they ravage their victims' balance sheets with debt, forcing them to lay off thousands of workers to meet the increasingly ominous interest payments -- some of which prove unable to do so despite the purge.
Foolish takeaway
Regardless of my reservations, of course, the private equity industry will go on.
As I see it, this presents the individual investor with two questions. First, should investors buy shares in the handful of private equity firms that are publically traded? And second, should investors avoid the debt-laden companies thrown off in their wake?
While each investor must answer these questions for him- or herself, I'd answer "no" and "yes," respectively. Quite simply, it's my opinion that these firms are far too opaque and risky for the average investor to invest in, and the debt-laden nature of their publically traded spinoffs, like Caesar's Entertainment, leaves them far too vulnerable to the market's inevitable swings.
What do you think? In the space provided below, please leave your comments and impressions about this lucrative but exclusive industry making up Wall Street's newest elites.
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