Some call it free-market capitalism. Sounds good to me.
How Private Equity Works reveals the reality of the current nonsensical political rhetoric, "Assaults on the private-equity industry really are attacks on economic freedom, because the private-equity process is nothing more and nothing less than free-market capitalism at work. Shame on all the people, particularly those who claim to be friendly to capitalism, who attack Mitt Romney because of his association with the U.S. private-equity industry."
The article explains in some detail how private equity functions, so those who want a quick briefing are encouraged to read the article and see what Jonathan Macey, Yale Law School professor, has to say.
Suffice it to say that ownership is ownership, pure and simple. If I start a hot dog stand and my neighbor puts in some equity capital as well, he's a venture capitalist. Both his and my "ownership" money are at risk of total loss. If someone else with money loaned me additional money (at a high rate of interest due to the high risk involved) to build the stand or buy the hot dog ingredients to be sold, then some of that borrowed money is at risk as well.
If my hot dog stand venture proves to be a loser, the lender will get paid first when the assets are sold. My neighbor's and my equity interests will be the last ones to be returned, assuming there's any money left after liquidating the hot dog stand and satisfying the creditors. But there most likely won't be.
However, if the hot dog stand is a winner, we'll be able to pay off the loan and keep the profits for ourselves. So taking a risk sometimes equals a total loss and sometime means a big payoff.
And whether it's a hit or a miss depends on how well my hot dog stand works out. Of course, that's largely up to how well I manage the stand and how many people elect to spend their money to buy the hot dogs I'm selling. That's the free market at work.
And a form of venture capitalism, too.
And if I'm successful with my stand, I'll consider buying out my neighbor, opening more hot dog stands or perhaps expanding the one I have. Then I'll hire more people to work at my hot dog stand or stands. And I'll have to invest more money to do so.
Perhaps a bank will loan me all the the money I need to expand and charge me less interest as I expand my business, now that I've demonstrated an ability to run a hot dog stand profitably. Maybe now I won't need a venture capital investor.
Nobody goes into business to lose money. But that's not always the way it ends up. Risk taking at work. Maybe reward or maybe loss. Time will tell.
The basic point, however, is that equity bears the greatest risk, has the greatest potential for reward or failure, and always stands in line behind creditors, who also are risk takers. They just don't take as great a risk as equity holders.
Now let's consider a house and its mortgage. If I buy a house for $100 and borrow $95, I put in $5 of my own money, or MOM. I guess it's a form of "private equity," even though it's not called that.
As a happy new home owner with a down payment of $5 in equity at risk, I have a real estate asset valued at $100. Although both the lender and I are at risk of losing a substantial part of our investment, my $5 in owner's equity is at risk of total loss.
In fact, the lender in this case can seize the house in case I default on the required interest and/or principal payments in an attempt to get his $95 repaid. In the meantime, even though I pay monthly interest on the loan to the lender, my $5 is always at risk until I dispose of the asset.
In the end, the realized when sold value of the asset is the key for the equity investor. That and the staying power capability of the owner or borrower to make interest and principal payments until the debt is retired or the asset is sold.
In the end, if the house is sold for $95 or less, I've lost my $5.
Now let's look at a commercial shopping center. The developer buys land primarily with borrowed money. He also builds the shopping center infrastructure and buildings.
The buildings are hopefully leased to successful and well managed tenants, such as grocery stores. These stores sell groceries to retail customers. From the proceeds, they pay employees and rent the facility. If there are no profits, the grocery store ceases to operate in the shopping center. Then perhaps the shopping center owner isn't paid his rent and if so, then the shopping center's banker may not be paid either. Of course, the shopping center's equity owners may lose their entire investment as they are last in line.
Let's put the hot dog stand, home owner and shopping center investor together.
If I sell lots of hot dogs, keep my job and the retail stores keep selling at a profit, we will be able to service our debt obligations. But if the hot dogs don't sell, I lose my job and not enough paying customers frequent the grocery store, we will probably all default on our debt.
We've lost our entire investment, but the lenders still have a hot dog stand and house that they can perhaps sell, along with a shopping center that they may be able to lease again. This troubled situation may be ripe for a private equity investor willing to take big risks in an attempt to make lemonade out of lemons.
In the meantime, I've lost my equity upon the hot dog stand's failure or the home mortgage foreclosure. And the equity investors in the shopping center are in deep trouble as well. None of of us is likely to see our money returned, let alone earn a profit.
One more example will tell the rest of the story.
Let's look briefly at Kodak and Rochester alongside Intel and Silicon Valley. Kodak Didn't Kill Rochester. It Was the Other Way Around is a story of the boiled frog phenomenon at work.
For those unfamiliar with the boiled frog story, think of putting a frog into a pan of boiling water. The experience will be most unpleasant, and the frog will react instantly and remove himself from the pan asap.
Next place a different frog in a pan of lukewarm water. He'll relax and become most comfortable in his warm and friendly surroundings. Maybe he'll take a swim. Then gradually increase the heat of the water. The happy swimming frog will never see the danger coming and will perish with a smile on his face.
The boiled frog metaphor, of course, suggests that quick reactions are preferable to ignoring reality and gradually getting too weak to react. Private equity often results in saving frogs by placing them in a pan of boiling water or even turning up the heat very quickly in a pan of lukewarm water.
In any case, drastic action is at least worth a try, because the alternative is that the business closes and all of the company's workers lose their jobs.
Besides, if the company then survives and the "frogs are saved," the private equity venture capitalist earns a big profit for its other investors, including pension funds who invest on behalf of "regular folks."
Kodak and Rochester are the warm water frog, and Intel and Silicon Valley represent the boiling frog. That's the way capitalism works, too. Leverage or borrowing isn't inherently good or bad. It's just another piece of the investing process at work.
In other words, equity investment, whether by an individual or a corporate entity, a privately owned company or a company traded on the stock exchange, is merely a piece of the firm's overall capital structure, no matter whether or how much debt the firm may have.
The more risky the investment, the greater the potential rewards for investors and the greater the potential for total loss as well. Meanwhile, the debt holder has a much better chance of not losing his investment but has a lesser chance at realizing a huge gain.
Let's quote from the article:
"Kodak's problem wasn't blindness. Rather it was that film was a fatally attractive cash cow. Even in its decline, the company's film business produced outrageous profit. That cash paid for Kodak's forays into digital, but the result was that Kodak's digital cameras never learned to run on their own two feet. Trust-fund babies seldom do.
Kodak's other structural problem is geography. When you study the history of great American companies that stumbled and failed, or only partially recovered, you see how difficult it is to overcome the mindset of your immediate surroundings. Businesses located in places where success is the norm, and innovation is built into the ecology, have a better chance of fixing themselves.
Intel almost bit the dust in the mid-1980s but came back to greater glory. Like Kodak, it faced ruinous Japanese competition. Intel didn't hesitate. It shed its memory-chip business and bet the ranch on microprocessors. That was a big bet and it was ruthless. Memory-chip factories were shuttered and people were laid off. That was, and is, easier to do in Silicon Valley, where the laid-off can more readily find new jobs, than in a small city like Rochester, whose population is now at 210,000 plus.
Paralysis can infect cities and regions, and not just small ones. It is still a mystery how the entire Boston-area-based minicomputer industry could fail so suddenly in the early 1990s. Digital Equipment, Data General, Wang, Apollo—all went poof. Each fell from the top of their industries to death in less than a decade. . . .
IBM also nearly died during the early 1990s. But unlike the companies in Boston, it retooled and recovered. Why? I would argue that IBM, being a New York City company—okay, a suburban one—had a healthy disrespect for the status quo and zero tolerance for omerta. Tough-talking Lou Gerstner had no qualms about shedding a couple hundred thousand jobs.
What Mr. Gerstner did was difficult. It would have been infinitely harder to do in Rochester, because the impact on a small city and the multiplier effect of lost jobs, axed all at once, would have been a civic disaster. Of course, Kodak's slow bleed has turned out to be a civic disaster anyway.
The world might be flat. But innovation and adaptation remain local."
And that's why capitalism works. And why ignoring reality only prolongs the inevitable.
Our American choices don't include preventing anything unpleasant and enjoying unlimited prosperity. The government, like the emperor, has no clothes.
We're on our own and our own individual and collective equity (emotional, intellectual and financial) is all we need. It's all we've ever needed.
Let's remind our political "leaders" and neighbors of those few simple facts.
Thanks. Bob.
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