Will Private Equity Be the Next Financial Meltdown? - TIME
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Four of the last eight Treasury secretaries currently work for private-equity firms. Is there anything we could do now to prevent this wave from coming?
Probably not much. Many of these companies will fall apart anyway. I did a study of the s, ideal economic times, and with 6 of the 10 biggest buyouts, the companies clearly were worse off 10 years later. In three cases the results were mixed, and in one case the private-equity firm improved the business. This decade, 6 of the 10 biggest buyouts are already considered distressed, according to Moody's. The core practice does not work and rips apart our economy. The danger is a recession is looming and interest rates could rise making it harder for companies to repay loans.
That is higher than the prior peak. Partially this is because Collateralized Loan Obligation CLO funds, similar to the CDOs which were instrumental in the meltdown of the mortgage market, have raised record amounts of capital and buy more than half of the loans. Every CLO consists of a little bit of debt from perhaps different loans, the idea being that if one of these pieces of debt fails, the others can make up the difference. Because financing has been relatively easy, companies in the last few years have aggressively pushed maturities out.
Companies are typically taking seven-year loans.
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Debt multiples too are as high as they were in the prior boon. To give an idea of what can happen in a worse case scenario, the leveraged loan default raise rose to That is they are not taking extra cash and paying their owners, but essentially taking second mortgages. That is more than the 24 percent during , and puts a greater number of companies at risk. The relatively good times for private equity firms are happening while a number of their companies, especially retailers, are going bankrupt.
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In December , the Financial Times reported that more than half of the 31 largest leveraged retail buyouts completed since had either defaulted, gone bankrupt or are in distress. The Wall Street Journal in this sharp and critical profile shows how private equity giant Sycamore Partners makes money by buying and carving up retailers often leaving the remains for dead. This great article from University of Pennsylvania academics shows how private equity run supermarkets like Albertsons have too much debt to compete against Wal-Mart and others while peers such as Kroger, which are not burdened by debt, can.
Meanwhile, change happens in many industries and private equity owned companies often have a hard time adjusting. Private equity firms buy companies the way that homebuyers acquire houses. They make a down payment, say 25 percent, and finance the rest. The critical difference, though, is while homeowners pay the mortgages on their houses, the PE firms have the businesses they buy take out the loans, making them responsible for payment. Much of the interest the companies pay on the loans comes off of taxes.
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Under the tax law that took effect in companies are limited to reducing only up to 30 percent of taxable income from taxes. The amount was unlimited.
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Bloomberg in November examined the tax change. A revealing study on how PE owned businesses paid much less in taxes than their peers came out after I finished writing the book. A article covered the same ground. Meanwhile, the carried interest loophole that allows private equity fund managers to have their profits taxed as capital gains, and not ordinary income was somewhat limited in the new tax bill. Now private equity barons will have to pay ordinary income for companies held less than three years, which represents about a quarter of their investments. Five of the last ten US Treasury Secretaries have joined private equity.
The reason: PE is where you make the most money. Great Washington Post story in July details how Geithner was now profiting from a predatory lender, after railing against the practice when he was Treasury Secretary.
Private equity crash could trigger next wave of financial crisis, Bank warns
No mention of how private equity firms collect fees that cover their investments, and then some so they take no risk. Or how the CEOs at their companies run their businesses so PE firms also provide limited sweat equity. In my book, consultants forecast, and I learned later that Treasury Secretary Henry Paulson feared, that private equity would cause the next great credit crisis. Largely, it has not happened because the low-rate environment allowed companies to re-finance their debt. Private equity, though, has caused the retailer credit crisis so the consultants were partially right.
Guy Hands from British PE firm Terra Firma in a June speech said the reason private equity firms have bounced back since the recession has little do with their own efforts. Instead, it is because the Government bailed out the banks through TARP and they, in turn, were able to refinance debt in PE portfolio companies.