Tuesday, December 7, 2010 — “Wealth Creation” Private Equity Style

Skye Sepp sent me this inter­est­ing post from com­put­er virus and inter­net secu­ri­ty wiz Niko­lai Bez­noukov, who has impec­ca­ble first-hand knowl­edge of many finan­cial and indus­tri­al corporations:

Typ­i­cal sce­nario for the last 18 years:

Jan­u­ary -
A Pri­vate Equi­ty Investor (PEI) has $20 mil­lion. He uses it as secu­ri­ty to bor­row $200 mil­lion from Bank1 (of which he him­self is CEO) to buy a com­pa­ny we shall call “Wid­gets Co”. Wid­gets Co. is a sol­id man­u­fac­tur­ing busi­ness with assets of land, fac­to­ries, patents, a brand, good will, and no debts.

March -
Wid­gets Co., under “New” own­er­ship, bor­rows $300 mil­lion from Bank2 — no prob­lems, it’s a sol­id busi­ness — but here comes the bit where it all goes crim­i­nal, but not illegal.

Wid­get Co. pays out $300 mil­lion to PEI its new own­er as a div­i­dend. PEI then repays $200 mil­lion to Bank1. PEI now has $100 mil­lion cash, and has done noth­ing for it. Wid­get Co, how­ev­er, now has to pay $20 mil­lion in inter­est per year to Bank2. PEI now has $100 mil­lion cash.

July -
Wid­get Co. by direc­tion of it’s new own­er (PEI), sells its assets: land, patents and so on to anoth­er com­pa­ny (company2) con­trolled by PEI and incor­po­rat­ed in the Bahamas, which then leas­es them back to Widg­its co. for $30 mil­lion a year, with the pur­chase financed by Bank1. The sales bring $200 mil­lion which Wid­gets also pays out in div­i­dends to PEI its own­er. PEI now has $300 mil­lion in cash, plus that $30 mil­lion annu­ity gen­er­at­ed by the leas­ing operations.

August -
Wid­get Co’s Pen­sion Fund is ‘restruc­tured’ bring­ing a liq­uid $150 mil­lion onto the bal­ance sheet. Wid­gets has lia­bil­i­ties to its pen­sion­ers with lit­tle to back them. $150 mil­lion is paid out to PEI as a spe­cial div­i­dend. PEI now has $450 mil­lion cash, which he deposits into his accounts in the Bahamas and Switzerland.

Decem­ber -
PEI sells the busi­ness to a pen­sion fund, for $100 mil­lion. Far less than he paid as it now has a lot of debt, but, it is a good busi­ness. PEI now has $550 mil­lion cash. He deposits this mon­ey in the Swiss banks.

Recap:
Wid­gets now has $300 mil­lion in debt which gives rise to $20 mil­lion a year in inter­est pay­ments to bank2, plus $30 mil­lion in leas­ing pay­ments to com­pa­ny owned by PEI. It has pen­sion lia­bil­i­ties and the pen­sion fund is almost worthless.

Mean­while, PEI start­ed this lit­tle scheme with $20 mil­lion and now has $550 mil­lion in cash. But the busi­ness is still viable, as Wid­gets can meet its expenditures.

5 years later -
Sad­ly hard times come. Turnover drops, prices drop, costs are cut, peo­ple lose their jobs, includ­ing engi­neers, man­agers, the shop floor and the sales team who did real work for years, cre­at­ed real val­ue, invent­ed the patents, built the brand.

It does­n’t help. The com­pa­ny has no stores of fat, it goes bust. The bank loans sour. Peo­ple lose their jobs, the pen­sion­ers can­not be paid. The mon­ey they invest­ed is now in the hands of PEI who has no legal liability.

PEI then declares the sec­ond com­pa­ny (the one that bought the Widg­its Co assets) into bank­rupt­cy, as its assets are now exceed­ed by its expen­di­tures and can­not meet its pay­ments to Bank1. He sells off the Patents and oth­er assets for $100 mil­lion. PEI now has $650 mil­lion in cash. He then, being the own­er of Bank1, writes off the appar­ent loss on his tax­es, and is repaid by the Fed­er­al gov­ern­ment through the FDIC. The SEC refus­es to inves­ti­gate, as the pri­ma­ry inves­tiga­tive agency is staffed by his for­mer employ­ees at Bank1. He then resigns from Bank1 under a shad­ow of scan­dal relat­ed to the loss­es incurred by Bank1 in its deal­ings with company2, exer­cis­es $100 mil­lion in stock options, and is “offered” anoth­er $50 mil­lion as a gold­en para­chute to ease the dis­com­fort of being with­out work and as bonus­es for the increase in rev­enue to Bank1, which were gen­er­at­ed by his own busi­ness deal­ings with Widg­its Co.

This hap­pens 100 times so the banks are bust too, but get bailed out by the tax­pay­er (that’s those guys who lost their jobs and pen­sions at Widgets).

PEI lives hap­pi­ly in The Bahamas with the $950 mil­lion which he ‘earned’ in a fab­u­lous year of ‘val­ue cre­ation’ made pos­si­ble by the pow­er of free and light touch reg­u­lat­ed mar­kets. He pays no tax­es on the income, as the income was gen­er­at­ed by a com­pa­ny that is incor­po­rat­ed out­side the Unit­ed States.

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