How Buyout Funds Work

Taijitu

Let’s apply the Fourfold Problem-Solving technique of last week to an example in the microeconomics level of the economy. Let’s suppose you are part of the lucky 1%.

You manage  a buyout fund. A good opportunity comes your way. There’s a company in trouble, and you have the funds to buy it. Should you?

Here are four aspects of that question:

Buy                  Hold

Walk away        Flip

Villains and heroes

Many buyout funds buy with the intention of immediately flipping the property belonging to the company they’ve bought out. These are the ones who often get a bad reputation as plundering pirates. Like vultures picking at a corpse, they fire everyone, sell off everything they can, keep the patents, and dump what’s left. They trash companies more efficiently than any street rioters could ever do.

However, there are times buyout funds will hold and restructure a company. They do this in four ways:  (1) by creating direct contact between owners and managers, (2) increasing speed in decision-making, (3) keeping any restructuring of the company out of the public eye, and (4) focusing on the core business problems to get the business back on its feet. Source: “Managers buy in to buy-outs” Andrew Hill, FT 7/28/11 p10

The result of this approach can be a company that is profitable and provides something to the economy, just as the sea captains like Jack Aubrey in the Patrick O’Brien series protected trading ships back in the days of the Barbary coast pirates.

Now, the choice between playing hero vs villain may seem like a matter of morality, but it isn’t.

Some companies just aren’t worth much when the owners get done mismanaging them and/or simply have a run of very bad luck. Sometimes it’s best to tear down an old house that caught fire so a new one can be built.

And keeping some companies afloat may or may not turn out for the best. How many big banks did we keep in business through the Bush/Obama administration bailouts? Are we happy now that we kept them? Are we glad we taxpayers played the reluctant hero?

To buy or not to buy

OK, so back to your problem as a private equity fund manager. Do you buy or not? Obviously if the answer is not, you won’t need to face the the other two decisions. However, you can’t pass up every deal that comes your way. Your job is to buy and convert declining companies.

The thing is that before you buy, it would be a good idea to look and see which hedge fund role, “villain” (sell off and gut) or “hero” (protect and rebuild), you’ll be playing.

If we’re in an “up” economy for hedge funds, you may have more choices – you can flip or hold. In a “down” economy for hedge funds, such as the present, you may wind up having to hold what you bought.

In fact, you may not be able to sell any of the assets of the company you buy, even in order to streamline it. Even in order to make it a better company for someone else to buy. In that case, if you can’t accomplish either mission; you can’t be either pirate or sea captain, you shouldn’t buy the company. To decide, you’ll just have to “run the numbers”.

The current state of hedge funds

Hedge funds are privately-owned pools of investment capital that tend to focus on buying and selling financial investments such as the debt or equity of distressed businesses. Like banks, hedge funds are still far from their glory days of the pre-2008 financial crisis. Some buyout funds are even lowering their fees in response to calls to do so from their large investors.

In an entrepreneurial world like that of the 18th and 19th century sailors or the world of hedge funds in the 20th and 21st centuries, those who aren’t lucky and/or quick enough will certainly pay a hefty price even if they are playing with other people’s money and not their own.

There seems to be an art to running a hedge fund or a buyout fund. Some of the 1% have it and some don’t. And in fact, as a buyout manager, you’d have to make the above fourfold decision, not once, but often as you manage your businesses. Likewise only a few hedge funds and their managers have made it to the very top. The other thousands of private equity funds in the world are much smaller. Those are the ones who are failing just like the banks failed, because doing what they do isn’t easy.

According to The Hedge Fund Implode-O-Meter, “Since late 2006 at least 117 major funds at 71 outfits have imploded”. While this Internet site has clearly been updated to 2011, it was copyrighted in 2007-2008. For some recent stories of “Massive Hedge Fund Failures,” Investopedia is a good source. As it shows, hedge funds, like buyout funds, are sharks who can also be eaten by other sharks.

Who knows? Perhaps someday the person marching next to you in the streets will be someone from a failed hedge fund or buyout fund! Big banks too are laying off droves of employees right now. What happens to them? Do we ever hear? Who exactly is “winning” in the crazy system of gambling with money and lives we’ve evolved in this century?

Investing is a peri-mutuel game. It’s a contest of human knowledge and intelligence. One person pits their wits against another. That means the odds aren’t 50-50, as is the case in probability games that involve physical manipulation of inanimate objects. With peri-mutuel gambling, a “dark horse” can win the race, leaving as many as 99 percent of the gamblers tearing up their totes in its dust.

So I wonder, is this race we’re in right now just an aberration, a fluke, or is it because the winners, the 1 percent, know something the rest of us don’t?

For another practical example of Fourfold Problem-Solving on the macroeconomic level see my post, Citizens Concerned About Sovereign Debt Crises.

Follow Nancy Humphreys on Twitter @brucenomics

0 comments ↓

There are no comments yet...Kick things off by filling out the form below.

Leave a Comment