My current working theory. Happy to hear from any of the actual PE people who are reading this.
1. As you can imagine, not everyone has the wherewithal to launch a PE firm. Only people who are well connected in the financial world will get access to the funds. People who have friends in the investment sector for instance. There's plenty of stories about how VC (which isn't the same thing) investment is hard to get a meeting for if you don't know someone in the firm. PE works in a similar way, certain people know the players and get the deals together. Of course a lot of it is a promise of future business.
2. When a firm is acquired, the M&A advisors that did the deal get paid. When a firm is restructured (from bankruptcy), the same happens. Lawyers as well. These people all get paid to make the deals happen. Part of what happens is the M&A people will talk someone in the lending department into doing the deal. And remember it isn't just one bank or one lawyer or one lender on each deal. The lenders will all take a piece of the debt, which can be sold on (eg packaged in various tranched products) to investors (pension funds etc). If you smooth out the poop enough it doesn't smell so bad.
That's what I can glean from my far corner of the financial world, while I do work in finance I'm pretty removed from PE.
It feels like most answers to “who is at the losing end of any transaction” is pension funds, which are guaranteed by the government. So by your theory PE firms are sucking in taxpayer money by fleecing pension funds run by financiers who aren’t smart enough to get into PE.
Basically until pension funds aren’t bailed out by the government this will continue.
I'm adjacent to the space and I'd disagree with this statement: "fleecing pension funds run by financiers who aren’t smart enough to get into PE."
Institutional Investment Funds (pensions, endowments, sovereign funds, etc) need returns well beyond inflation to ensure long term stability.
To do this, they will mix and match various different investment vehicles to minimize risk.
This means a fund will have a varying percentage of funds invested in stocks+ETFs, commodities+futures, cash in hand, real estate assets, IP assets, and greenfield opportunities.
Essentially, you are dealing with dozens of different financial instruments, and while you may have an above average understanding of how all these work, you won't have the resources, staffing, or ability to optimize returns on all these instruments.
This is why Funds end up having VC firms make VC investment decisions, PE firms (itself a loaded term because PEs specialize in different markets and sectors) making equity investment decisions, etc.
If you are able to specialize in one specific sector (aka have both the domain experience and the network of founders, operators, and managers) then at that point you may as well open your own firm and manage investments on the behalf of other institutional investors.
It's all about specialization.
Also, fund operating costs cannot exceed more that 2%. This means you can only really charge AT MOST 2% YoY on the entire value of the fund. That 2% will have to cover your entire expenses (salary, insurance, office space). This means most operations have to be extremely lean as there isn't much money to spread around.
And what do they accomplish with all that complexity and the absurdly large up-to-2% expense ratio? Any evidence that these funds deliver better than index returns after fees? Or is it just a jobs program for the spreadsheet set?
Some of the sovereign wealth funds like the Norwegian one and the Middle Eastern ones aim for a 10% annual return. They are extremely stringent about which funds they invest with, and in most cases they go for direct investments rather than passive ones. The funds from those are literally used to fund various welfare programmes for their citizens. They also hire some of the brightest, most talented traders and not some PE-rejects.
Just sucks that Western pension funds hire mostly second-tier folks with the right connections, with a few exceptions here and there, or some stupid union bosses, at least from my experience in PE.
Pension funds are investors in PE, they're not the debtors. In other words, if PE firms do well, their investors (pension funds) do well. They're also not stupid
This whole conversation about PE is non-sensical. It's all based on this naive notion that PE firms borrow money to buy investments and use that money to pay themselves, more often than not bankrupting the original company, and since it was borrowed money, they can come out unscathed.
But no one can answer, why would anyone lend PE firms money if it's a bad investment? Debt normally doesn't have an upside. Best case scenario is you get paid back what you're owed plus interest.
A lot of online criticism can't even get the relevant players right and relies on naive tropes like "they're greedy" or "corruption", as a hand-wavy way to explain complicated dynamics. And then they throw out theories that could be dispelled by reading the first few paragraphs on investopedia regarding PE firms. Why is the discourse in this particular field so poor on hacker news? Low quality conversations regarding technical topics would not fly on this forum. If someone mentioned Y2K and you made a low quality comment like "greedy corporations wanted to save money by not storing more than 2 digits for the year", you would get downvoted to hell. So why does this topic have such poor comments?
> But no one can answer, why would anyone lend PE firms money if it's a bad investment?
Remember the housing crisis? As long as you can align the debt with an appropriate tranche, institutional investors like diversification and risk (in that part of the portfolio).
Also, these types of debt can make money in the short term. My father in law bought a beach house with a KMart bond trade. After they emerged from bankruptcy, everything was great! (Lol)
I’m sure this won’t be a popular opinion, but I believe it’s basically class warfare at work. You have, here, a lot of upper middle class engineers whose egos are protected if they believe that the richer class is greedy and unethical.
I believe this to be the case also. In the UK we have lots of cases cropping up of PE being the bad guys, but the current owners being to blame for buying these companies in unstable positions and allowing the sellers to make fortunes. It does often seem like it is Pension funds making these poor investments. I am also really happy to see this line of questioning on HN, as it has been lacking in previous discussions.
Wrong. PE investments today make a small portion of the overall portfolio of a pension fund (varies from state to state). In widely swinging markets a PE form that does not speculate in the market but buys and flips with a lot of expertise a private company, and often generates higher and more sustainable returns. This is a reason why PE investments by pension funds are increasing, but they still make a small portion of the pie. In addition, pension funds are not funded through tax money but through portions of ones wage. And not all pension funds are from the state (e.g. CalPERS), most of them are run by pension fund specialized corporations or if big enough by the employer itself.
Regarding 2, the still requires you to believe that either Banks or Pension funds are fine with hemorrhaging millions or billions of dollars buying PE debt and haven't figured it out over the course of a half century.
I think the real answer is more unsettling for some. PE debt has volatility but is on net a profitable investment. You can smooth out volatility with volume and by spreading it around.
This is the only explanation that doesn't depend on a source of dumb money that can never learn buying this debt.
I'd be willing to change my opinion I came across data showing that PE debt has net losses over a multi-decade time scale.
That's certainly a possibility, but I wouldn't put it at the top of the list without ruling out the possibility that they actually make money.
Where does the claim that PE debt is a loser come from?
According to one of the top links on google, state pension returns from PE investments is almost twice that of their stock investments if you look at 2000-2021 (11%/yr vs 6.9%/yr)
Those returns are completely different. Private equity assets cannot be easily sold. Try realizing that 11% return and you will quickly see it does it not exist. You need to take a substantial haircut to sell.
> This is the only explanation that doesn't depend on a source of dumb money that can never learn buying this debt.
No it isn't. A simpler explanation is that the people making the decision aren't the ones paying for the failure. I see this all the time at the executive level in finance -- people will knowingly make bad deals if it gets them their bonus.
> the M&A people will talk someone in the lending department into doing the deal.
According to the standard narrative, lenders have been repeatedly duped into throwing billions into bad PE investments for decades.
If you had a friend who asked for a thousand dollars every month, always promised to pay you back and never did, how long would you continue to give him a thousand dollars each month?
If "talking" alone can accomplish this, I think we need to start considering the intervention of supernatural forces in these deals.
It's the agency that causes the issue. And a little bit of financial engineering.
Say you have a friend who often can't pay back his debts. But he can pay 80% of them.
You have another friend who wants to lend to safe debtors. Why not get that safe tranche, the bottom 80%? He needs to show he's safe so he can take more risk. He loves going out to dinner with you.
Another guy wants to take some risk. You give him the 20%, but you also let him into some other deals that you have, so that he doesn't always lose. In fact, it turns out this guy isn't paid on the returns, he's paid on assets managed. And he's not even going to be around that long, he'll be onto the next role long before the bond is up. And they're in a bag of other stuff anyway.
Turns out you're not even the guy lending the money. You work on a transaction basis. Your next job might be as one of the friends. Or on the PE side.
So you and your buddies keep skimming a bit of the money off each year, well mixed with other stuff that you are managing.
Everyone knows fraud exists, yet fraudsters continue to flourish; they are good at leveraging new technology and tropes to rebrand themselves.
Consider the frequent complaints about scammers marketing substandard products on Amazon; the issue is well understood, the markers of scammers are well identified, but Amazon does nothing about it because the lesses from disgruntled customers are less than the revenue from shapeshifting scammers.
1. Connections talk, but money talks even louder. The companies they buy are also trying to sell for top dollar and rarely court just one buyer.
2. CLOs are definitely problematic, but the current rate of default is vastly overstated. If private credit defaults at the rate people seem to think it does, we'd be looking at a GFC-type situation. I can't say if there's systematic risk in CLOs a la MBS, but any possible risk hasn't materialized yet. The biggest PE firms today rarely default. Blow-ups such as Toys-R-Us are newsworthy for a reason.
See my comment below for more information. I'm not in PE, but I am very familiar with how the sausage is made.
1. As you can imagine, not everyone has the wherewithal to launch a PE firm. Only people who are well connected in the financial world will get access to the funds. People who have friends in the investment sector for instance. There's plenty of stories about how VC (which isn't the same thing) investment is hard to get a meeting for if you don't know someone in the firm. PE works in a similar way, certain people know the players and get the deals together. Of course a lot of it is a promise of future business.
2. When a firm is acquired, the M&A advisors that did the deal get paid. When a firm is restructured (from bankruptcy), the same happens. Lawyers as well. These people all get paid to make the deals happen. Part of what happens is the M&A people will talk someone in the lending department into doing the deal. And remember it isn't just one bank or one lawyer or one lender on each deal. The lenders will all take a piece of the debt, which can be sold on (eg packaged in various tranched products) to investors (pension funds etc). If you smooth out the poop enough it doesn't smell so bad.
That's what I can glean from my far corner of the financial world, while I do work in finance I'm pretty removed from PE.