Key Takeaways
- • Private equity firms controlled more than $6 trillion in assets in the U.S., according to ProPublica, with about one-third of North American PE firms' $6.5 trillion in assets held as "dry powder" as of September 2020.
- • The standard private equity compensation model, "two-and-twenty," pays firms a 2% management fee on assets and a 20% cut of profits from exits, with the carried interest portion taxed at a preferential rate.
- • Leverage in leveraged buyouts has declined from roughly 90% debt-to-enterprise value in the 1980s to about 70% in the 1990s and 50% to 60% today, according to Steven Kaplan of the University of Chicago Booth School of Business.
- • Critics such as Sen. Elizabeth Warren and Eileen Appelbaum argue that short-term profit focus and debt loads destroy long-term value and harm workers, while defenders note PE provides financing when banks will not and that public pensions supply about a third of PE fund investment.
- • The 2005 $7.5 billion buyout of Toys R Us by Bain Capital and KKR illustrates how acquisition debt can erode a portfolio company, which ultimately closed.
Summary
Private equity funds are pooled investments, generally closed to small investors, that take controlling stakes in companies, work with management to increase their value, and seek to sell them at a profit after several years, either to another buyer or through an initial public offering. Firms typified by Bain Capital, Apollo Global Management, TPG, KKR and Blackstone differ from venture capitalists, who fund early-stage startups, and from public-market traders. Funds are typically backed by pension funds, sovereign wealth funds, endowments and wealthy individuals. According to ProPublica, private equity firms control more than $6 trillion in U.S. assets.
According to Steven Kaplan, a professor at the University of Chicago Booth School of Business, the top priority for firms today is growing company revenue, followed by cost reduction, refinancing debt and multiple arbitrage, which involves buying firms trading below intrinsic value. Firms also often offer equity to workers of acquired companies.
Compensation follows a "two-and-twenty" structure: a management fee, usually 2% of assets, plus 20% of profits from a sale, taxed as carried interest at a discount. Under this model, firms earn fees regardless of portfolio company profitability. A bill backed by Sens. Joe Manchin and Chuck Schumer would have extended the holding period required for carried interest treatment from three to five years, but that provision was removed after opposition from Sen. Kyrsten Sinema.
Critics, including Sen. Elizabeth Warren and Eileen Appelbaum of the Center for Economic Policy and Research, argue that the focus on quick returns harms workers and extracts wealth through leverage. Defenders point out that private equity lends to distressed companies when banks will not and that public pensions are responsible for about a third of PE fund investment, with the median North American pension investing about 6% of assets in the asset class.
Leverage has declined over time. The 1980s leveraged buyout boom featured deals at around 90% debt-to-enterprise value, falling to about 70% in the 1990s and 50% to 60% today. The Toys R Us collapse illustrates the risk: Bain Capital and KKR bought the retailer in 2005 for $7.5 billion, and its acquisition debt grew relative to revenue until creditors chose liquidation. ProPublica also reported in 2020 on a hospital chain whose private equity owner extracted $400 million in dividends and fees while facilities faced supply shortages.
According to Steven Kaplan, a professor at the University of Chicago Booth School of Business, the top priority for firms today is growing company revenue, followed by cost reduction, refinancing debt and multiple arbitrage, which involves buying firms trading below intrinsic value. Firms also often offer equity to workers of acquired companies.
Compensation follows a "two-and-twenty" structure: a management fee, usually 2% of assets, plus 20% of profits from a sale, taxed as carried interest at a discount. Under this model, firms earn fees regardless of portfolio company profitability. A bill backed by Sens. Joe Manchin and Chuck Schumer would have extended the holding period required for carried interest treatment from three to five years, but that provision was removed after opposition from Sen. Kyrsten Sinema.
Critics, including Sen. Elizabeth Warren and Eileen Appelbaum of the Center for Economic Policy and Research, argue that the focus on quick returns harms workers and extracts wealth through leverage. Defenders point out that private equity lends to distressed companies when banks will not and that public pensions are responsible for about a third of PE fund investment, with the median North American pension investing about 6% of assets in the asset class.
Leverage has declined over time. The 1980s leveraged buyout boom featured deals at around 90% debt-to-enterprise value, falling to about 70% in the 1990s and 50% to 60% today. The Toys R Us collapse illustrates the risk: Bain Capital and KKR bought the retailer in 2005 for $7.5 billion, and its acquisition debt grew relative to revenue until creditors chose liquidation. ProPublica also reported in 2020 on a hospital chain whose private equity owner extracted $400 million in dividends and fees while facilities faced supply shortages.
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