tl;dr- In some cases, not all, the private equity companies will conduct transactions that ensure they get their money back on the deal early on, but saddle the businesses they acquire with debt or unfavorable terms (See the Red Lobster example elsewhere), which leads to bad business decisions to repay the debt which is typically unsustainable.
I'll use the real world example of Remington Arms to help explain this. Remington Arms was a successful gun company. Then a private equity firm called Cerberus Capital Management came along. They wanted to invest in the sector, so they created a holding company which started buying gun companies, including Remington. The holding company then borrowed money, probably from hedge funds, and, instead of paying back the loans, issued paid-in-kind notes, another form of debt. The holding company had shares of stock, mostly held by Cerberus, so they started using the money they had borrowed to buy back shares of stock. So Cerberus is getting the money back from its initial investment in cash while the holding company is accumulating debt. Then they have Remington, as an operating company able to borrow independently from the holding company, borrow a significant amount of money which it then used to purchase the debt of the holding company. Now the holding company is whole, but the operating company has a large amount of debt. Since the operating company's debt was borrowed from banks and other lenders, it had to pay it back in cash, not in paid-in-kind notes.
At the same time, Remington was expanding their production facilities to Huntsville, AL from New York through a sweetheart deal (free factory, discounted energy, tax breaks) all of which was contingent on hiring workers at a good wage. Unfortunately, the workers explored unionization, which was antithetical to the company's interest, so rather than hiring permanent workers (who would become more skilled over time) they relied on temporary workers. As a result, the quality of their products went down significantly, their reputation and sales suffered and they weren't able to meet the payments on the crushing debt they had assumed to buy the debt of the holding company, which had been used to buy back shares from the private equity firm which created the holding company.
So Remington and related companies go bankrupt, the holding company is sold off, but the private equity firm made money overall on the investment.
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u/CrazyCletus Feb 14 '25
tl;dr- In some cases, not all, the private equity companies will conduct transactions that ensure they get their money back on the deal early on, but saddle the businesses they acquire with debt or unfavorable terms (See the Red Lobster example elsewhere), which leads to bad business decisions to repay the debt which is typically unsustainable.
I'll use the real world example of Remington Arms to help explain this. Remington Arms was a successful gun company. Then a private equity firm called Cerberus Capital Management came along. They wanted to invest in the sector, so they created a holding company which started buying gun companies, including Remington. The holding company then borrowed money, probably from hedge funds, and, instead of paying back the loans, issued paid-in-kind notes, another form of debt. The holding company had shares of stock, mostly held by Cerberus, so they started using the money they had borrowed to buy back shares of stock. So Cerberus is getting the money back from its initial investment in cash while the holding company is accumulating debt. Then they have Remington, as an operating company able to borrow independently from the holding company, borrow a significant amount of money which it then used to purchase the debt of the holding company. Now the holding company is whole, but the operating company has a large amount of debt. Since the operating company's debt was borrowed from banks and other lenders, it had to pay it back in cash, not in paid-in-kind notes.
At the same time, Remington was expanding their production facilities to Huntsville, AL from New York through a sweetheart deal (free factory, discounted energy, tax breaks) all of which was contingent on hiring workers at a good wage. Unfortunately, the workers explored unionization, which was antithetical to the company's interest, so rather than hiring permanent workers (who would become more skilled over time) they relied on temporary workers. As a result, the quality of their products went down significantly, their reputation and sales suffered and they weren't able to meet the payments on the crushing debt they had assumed to buy the debt of the holding company, which had been used to buy back shares from the private equity firm which created the holding company.
So Remington and related companies go bankrupt, the holding company is sold off, but the private equity firm made money overall on the investment.