Zero Interest
This week is all about one of our favorite topics - Private Equity!
Pensions
We have talked about the tricks PE firms use to acquire companies, load them up with debt to pay themselves fees, and cut costs to service those liabilities. If this creates an untenable situation, a firm might put its new acquisition into bankruptcy, abusing tax and legal codes to extract even more wealth from the business before tossing it onto the scrap heap.
For some firms, even that isn’t enough, because there’s still blood left in the corpse. Take the story of Friendly’s, a casual dining chain that expanded to over 160 locations in the Northeast before it was sold off to PE when its founders retired. What did the new owners do?
Among other things, the private equity firm piled debt onto the business, and required it to sell and lease back the property for some 160 restaurants, a move that made a quick profit but saddled Friendly’s with a new, unending obligation. Ultimately, Sun Capital pushed the chain into bankruptcy.
PE firms regularly employ this technique to create paper gains - selling valuable real estate, then locking in to expensive leases (more debt!) while paying shareholders and investors out on the proceeds. What happened next, though, is even more outrageous:
Under Sun Capital’s ownership, Friendly’s steered the case to Delaware—generally a favorable district for corporations—by chartering several subsidiaries there. Then Friendly’s lawyers successfully petitioned to expedite the bankruptcy process through a “363 sale,” in which the company’s assets—or the company itself—are auctioned off free of its prior debts. The process largely removes the discretion of the court and, in Friendly’s case, gave the chain greater leeway to choose who would buy it.
[…]
Sun Capital, through Friendly’s, proposed to sell the business to … itself. It was able to do this by becoming not just the chain’s largest owner, but also its largest lender, with hundreds of millions of dollars in unpaid debts. Sun Capital proposed to reacquire Friendly’s by forgiving these debts, a tactic known as “credit bidding.” Other potential acquirers were at a huge disadvantage, as they’d have to bid real money against the debts to Sun Capital, which were worth a fraction of their stated value.
The firm who drove Friendly’s into bankruptcy used legal chicanery to buy it back for a fraction of what it was worth, using the debt it foisted on the company in the first place as capital for the sale. Business!
Why go to all this trouble to ruin and buy a company back? Turns out, the objective was to fuck over the employees:
The answer was simple: pensions. At the time of bankruptcy, Friendly’s had $115 million in pension liabilities. By selling Friendly’s to one of its affiliates, Sun Capital reacquired its own company free and clear of those liabilities. These debts were pushed onto the Pension Benefit Guaranty Corporation (PBGC), a government-chartered insurer that rescues underfunded pensions, and whose work was paid for by other, more responsible, pension funds.
Wow. Sun Capital dumped Freindly’s pensions as part of a bankruptcy restructuring, saving themselves a hundred million dollars in future liabilities on the company they destroyed. They also closed a third of the company’s stores and fired those employees during the bankruptcy, for good measure.
Sun has used this trick in the past, ripping off retirees at Marsh Supermarket in the Midwest to the tune of tens of millions, and the Harry & David fruit retailer’s workers for $128 million in benefits. The PE industry as a whole has pushed more than 50 companies into bankruptcy and dumped $1.5 billion in pension liabilities since 2001.
We’ve discussed the lack of pensions in America, and how it creates extreme instability in what little retirement most people are able to cobble together. Now imagine you are one of the rare few with a pension, and some Wall Street scumbags come along, take over and bankrupt your company to pay themselves millions in fees, then vaporize a quarter of your pension. Pretty cool, right? It’s all legal!
Juice
We talk so often around here about food prices and inflation you may have grown weary of the topic. But! It will probably not shock you to learn that the private equity industry has gone on a food company buying binge in the last year and, thanks to rising interest rates, have been put in an awkward position as both their borrowing and raw materials costs have gone up.
What have they done in response? Raise prices, obviously!
Price increases are a key tool for private-equity firms to boost profits at companies they acquire. They also help cover the cost of debt the new owners use to pay for the purchases and, in some cases, to enrich themselves.
ZIRP stands for Zero Interest Rate Phenomenon. It has become a bit of a catch-all term for companies whose business models only work when interest rates are nearly zero and cash is extremely cheap to borrow. Think Uber, WeWork, crypto, things of that nature. The idea is that when investors can’t earn much return on traditional investments - bonds, etc - because rates are low, they may turn to risky investments like office leasing Ponzis, illegal taxis, and magic bean printers.
One way PE firms are able to borrow so much money they can essentially buy companies for pennies on the dollar - loading them up with debt to cover the purchase - is because money is (was) so cheap. Firms play complex legal and financial games to put up very little equity and receive maximum return, and for years they’ve done that to raise the investor cash needed to buy said companies:
In leveraged buyouts, private-equity firms buy their targets with some of their own cash but primarily by using money borrowed by the companies they purchase. It can work just fine when the economy is solid, though the acquired companies must pay large annual interest expenses to stay current on their new loans.
When the economy falters and interest rates rise simultaneously, things can go sour fast.
Loans borrowed by private-equity-owned companies typically float, meaning their interest payments move up and down with interest rates set by the Fed. Interest rates normally drop when economists begin to fear a recession, cutting the cost of the loans.
Floating interest rates are great when interest rates are zero. When they are five or six percent and you’ve borrowed a few billion dollars to buy Toys 'R’ Us or whatever? Not so good!
In 2021, amidst a frenzy of PE buying fueled by the belief that supply chain constraints would make food companies ripe targets for wealth extraction, a French-based firm bought a majority stake in Tropicana:
Labor shortages, rail-freight backups and fruit inflation struck in 2022. Tropicana raised prices and delayed deliveries, prompting customers to cut orders.
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Tropicana had purchased financial contracts protecting itself against much of the rate increase, but its overall interest payments still climbed, which helped tip the company into negative cash flow, according to S&P Global Ratings. S&P cut its rating of Tropicana’s loans in January to single-B-minus, one of its lowest categories of junk debt.
A company that was doing just fine financially sold itself to a firm that used risky floating rate loans and - voila! - now one of the world’s largest juice makers is struggling, raising prices on its products to make up the gap.
There are many factors impacting food prices, but with PE firms tens of billions deep into the food industry, sitting on bad loans and debt payments as the Fed continues to raise rates, expect more suppliers to crash into bankruptcy or continue to hike prices to stay afloat.
Fishing
Sometimes, rather than simply take over one food producer, PE is able to capture an entire industry like, say, New England fishing:
Blue Harvest and other companies linked to private equity firms and foreign investors have taken over much of New England’s fishing industry. As already harsh working conditions have deteriorated, the new group of owners has depressed income by pushing expenses onto fishermen…
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Since it was founded in 2015, Blue Harvest has been acquiring vessels, fishing permits and processing facilities up and down the East Coast. It started with the self-proclaimed goal of “dominance” over the scallop industry. It has expanded into groundfish, tuna and swordfish, as well as becoming a government contractor, winning a $16.6 million contract from the U.S. Department of Agriculture this past February to supply food assistance programs.
Fishing has existed in New England (among white Americans) since the 17th century, and sustained hundreds of thousands of blue collar jobs along the coastline and inland. In a few short years a gaggle of investors have taken over and perverted the economics that, while probably not great for fishermen engaged in an incredibly dangerous job, had provided decent income for centuries.
Remember the PE food company binge of 2021? Well, that same ZIRP mindset helped fuel the buying spree in the Northeast:
In the first half of 2021, private equity firms, which often invest in privately held companies with the goal of ultimately selling them for a profit, accounted for 34% of mergers and acquisitions in the fishing industry, nearly double the 2017 percentage…
Firms didn’t just buy a few boats or one packing or processing facility, they bought all along the supply chain - fleets, processing plants, and the entire earnings economy of towns that rely on fishing:
Almost all fishermen in New Bedford (MA) are paid a share of the earnings from their catch. It’s an arrangement with origins in the 19th century, when whale oil made New Bedford the Dubai of its day. Whaling captains built the city’s historic mansions; the whale ships’ investors built churches and hospitals.
But today, companies like Blue Harvest take advantage of this pay structure to shift costs onto fishermen, reducing their income.
Ironically, the firms have been able to exert downward pressure on earnings thanks in part due to a 2010 law aimed at reducing the impact of overfishing on waters off New England:
Promoted by an alliance of conservation groups and some of the largest seafood distributors, the new framework sought to end decades of overfishing that had devastated species like the Atlantic cod while also helping American businesses compete with cheaper, imported fish by making the domestic supply more predictable.
The rare alliance of conservation groups and seafood distributors may have been well-intentioned, and it has helped revitalize fish populations in the area, but it created fragility by imposing caps on fishing that allowed investors to come in and capture significant market share, forcing additional costs onto fisherman and driving down wholesale pricing.
The ‘catch share’ system capped the overall amount of fish that could be caught during a season, and divided profits up amongst fishermen. But, those fishermen were required to sell to the owners of the handful of expensive quota permits, which consolidated wholesale fish buyers, allowing them to manipulate prices to their advantage:
In the early years of catch shares, many smaller fishermen sold out to the same New Bedford fishing magnate: Carlos Rafael, often referred to as “the Codfather.”
The Codfather ended up in prison for doing a bunch of crimes - obviously, with a nickname like that - but his operation and those of his rivals were bought up by companies like Blue Harvest, forcing its fishermen to sell their catch at sub-market rates.
Basically, fisherman on Blue Harvest boats are required to sell to Blue Harvest at their chosen rate, in exchange for having a boat to fish - boats and permits have become prohibitively expensive for independent fishermen. However, Blue Harvest now charges its fishermen for the maintenance of the boats, eating into their earnings. Fishermen allege the company runs boats way past their prime, which leads to more repairs, etc.
Listen, the fishing industry was not a shining example of ethical behavior or good work practices when the PE firms came in, but regulators should not allow conglomerates to come in and cartelize entire swaths of it, forcing fishermen into poverty while executives in New York and Amsterdam line their pockets.
Climate
Let’s talk greenwashing - when a company claims its making environmentally responsible investments or decisions or whatever, but is actually simply hiding its carbon footprint in creative ways. Private equity’s aggressive pursuit of profits means you’ll quite often find its hands in some of the world’s dirtiest, most dangerous (and profitable) industries.
Carlyle Group is one of the largest PE funds in the world, and has felt the need to declare itself a climate leader within the industry. I am sure you know where this is going:
The research calculates the multinational’s 10-year greenhouse gas footprint to be roughly equivalent to the “carbon bomb” that Alaska’s Willow arctic drilling project is to emit over its decades-long operation, and would take an estimated 4.6 billion new trees per decade to remove from the atmosphere.
Nice! Carlyle has an unusual level of asset disclosure since it is publicly traded - most PE firms are privately held, with many of their investments shrouded behind legal spiderwebs. Carlyle claimed it has made significant investments in renewables since 2019, and was the first major firm to pledge it would produce net zero emissions by 2050 (for some of its portfolio).
However, with oil prices where they are:
For every dollar invested in renewable energy sources like solar and wind, Carlyle invests $16 in fossil fuel operations like pipelines, oil and fracking wells, and power plants, according to the consortium of researchers—who told the Guardian that their calculations were based on “conservative emissions estimates” disclosed by the company.
Duh! Carlyle has a fiduciary duty to its investors and shareholders to maximize profits, and the best way to maximize profits right now is to invest in oil, and pipelines, and fracking. If the oil dried up, Carlyle would put that money elsewhere, but there is scant financial incentive for any large asset manager to heavily invest in green energy, because there simply isn’t that much of it. What they can do is put out statements in favor of reducing emissions, and make a bunch of greenwashed claims that fall apart under the tiniest bit of scrutiny.
PE firms use the same techniques to acquire dirty oil companies as they do food producers or restaurant chains - identify valuable investments, saddle them with debt, and extract maximum profits with little concern for sustainability. It would be nice if they decided to run all the oil companies into bankruptcy to help reduce carbon emissions, but unfortunately for the planet oil is still a wildly profitable commodity.
In fact, the most likely scenario when PE has wrung what money it can from mining and oil production follows the standard script - declare bankruptcy, and leave the abandoned toxic mines and oil wells for someone else to clean up.
Short Cons
NYT - “In court documents, prosecutors said Mr. Barzman, 45, of North Hollywood, had admitted to helping create between 20 and 30 fake artworks and then marketing them for sale as if they were authentic Basquiats.”
Institutional Investor - “With deals slowing, private equity firms are putting their resources into making the companies they already own more profitable, or what they like to call, “value creation.” Now, consultants want to catch up.”
WSJ - “The nation’s spy chief, a longtime college president and top women in finance. The circle of people who associated with Jeffrey Epstein years after he was a convicted sex offender is wider than previously reported, according to a trove of documents that include his schedules.”
Gizmodo - “The Biden Administration says they’ve found evidence that a small number of companies have joined together to exploit the H1-B lottery by entering foreign employees’ names numerous times to increase their chances of getting selected…”
Semafor - “"Southwest has resumed operations after temporarily pausing flight activity this morning to work through data connection issues resulting from a firewall failure," the spokesperson said. "Early this morning, a vendor-supplied firewall went down and connection to some operational data was unexpectedly lost."”
WSJ - “After the first fraudulent withdrawal, Mr. Zhong created new accounts and with a few hours of work stole 50,000 bitcoins worth around $600,000, court papers from federal prosecutors show.”
Know someone thinking of purchasing a beloved restaurant chain so they can drive it into bankruptcy and drain its pension fund in bankruptcy court? Send them this newsletter!