Private Equity 401

Happily, I'm mostly out from under the thumb of Private Equity, at least for the time being.

But it's still quite interesting to me, to learn how it operates, and what influences it has on the world.

For example, why do shopping center owners set their rental rates at a level which leaves the shopping center 30%-50% empty? How can that make sense?

It's obviously quite interesting to others, as well:

• Retail’s Woes? Much More Than Online

  Private-equity funds have become involved in retail as developers and landlords. In an era of low interest rates, a business model predicated on higher, steady returns is an attractive use of capital.

  However, what works on a spreadsheet for distressed businesses doesn’t always translate into the commercial real estate space. Storefront businesses are limited to the rent they can afford based on the revenue they generate. Lease renewals with increases of as much as 100 percent from new private equity-funded landlords do not work. If the rent increase can’t be supported by the retailer’s revenues, they fold the tent up.

  It is too easy to blame retail’s woes on Amazon.com Inc. and other online merchants. The broader picture has to take in the enormous changes in how consumers behave. Retail has been very slow to adapt to this. The sooner the industry figures this out, the better.

• Putting on Developers’ Hard Hats, Private Equity Managers Break Risky New Ground

  Private-equity firms’ inexperience in construction and short investment horizons make them unnatural collaborators for contractors, he explained.

  In particular, Callahan said, private funds can run into trouble in negotiating the financial relationships that undergird large-scale construction. “A lot of the contracting world relies on surety credit, and the surety market space has been very suspicious of the private equity investor because [surety firms] build their relationships for the long term. The private-equity model is three to five years. That gives everyone a little cause for concern.”

  Pfeffer, the construction lawyer, also singled out financial arrangements with contractors as a source of risk for private equity.

  “Standard-form construction agreements benefit contractors and design professionals,” Pfeffer said. Typical contracts protect contractors against, for example, accountability for construction delays that could cost the developer tenants. “If there’s a waiver of construction damages on the agreement, the owner is out of luck collecting that big bucket of damages.”

• Real Estate Private Equity: Technology’s Next Victims? (Part 1)

  First and foremost, funds don’t have a strong incentive to invest in new capabilities and tools since things are not going too badly. In the short term, the glut of capital might even seem good: New money flows into the hands of the most established players and, for some, it feels like times have never been better.

  Second, funds do not respond because, strictly speaking, they aren’t allowed to. As you remember, private equity funds usually have a narrow mandate to invest in assets under a specific strategy and in a specific geographical area. What about investing in technology or acquiring new capabilities and expertise? That’s not part of the mandate. Keep in mind that the assets most funds currently manage were acquired 1–5 years ago with money that was raised from investors 2–7 years ago.

• Axios Pro Rata, Thu, Dec 21, 2017

  Private equity executives are largely pleased with the tax bill, but there are growing grumbles about how the change to interest deductibility isn't grandfathered in for existing loans.

  • This could be a particularly acute problem for highly-leveraged companies that are either unprofitable or barely profitable. In those cases, private equity sponsors may have to choose between pumping in new cash and crossing their fingers.
  • Going forward, expect leverage levels to decrease. Per one buyout big: "We use leverage as a tax shield, which is about to become much less relevant."
  • There is likely to be a decline in dividend recaps, at least in the short-term.
  • To be clear, private equity firms are still cheering these changes (at least from a portfolio perspective).
  • The longer-term hold period to qualify for carried interest is unlikely to prevent firms from selling before three years, in the rare cases when applicable. Just expect the funds to essentially defer the carry.

Viewed from their perspective, they are doing what makes sense: making a profit as effectively as they can.

But reread this quote, and think about it:

funds don’t have a strong incentive to invest in new capabilities and tools since things are not going too badly. In the short term, the glut of capital might even seem good: New money flows into the hands of the most established players and, for some, it feels like times have never been better.

This is not a good way for a society to organize its productive resources, even if "for some, it feels like times have never been better."

And the tax reforms passed this month did almost nothing to change the deep systemic incentives in the American tax code which encourage exactly this sort of destructive activity.

Sigh.