From Project Syndicate by Simon Johnson:
Let’s say that you would like to become one of the richest people on the planet, someone with enormous wealth and access to the top rung of political power. This is not an unreasonable aspiration for any fresh college graduate in today’s winner-take-all economies. But how realistic is it?
You could have a good idea for a new technology with potentially widespread demand. With the right credentials and some luck, you could attract investment from a venture-capital fund. Many such ventures do not pan out; but – particularly in the United States – such equity-financed rapid-growth companies are strongly encouraged.
Or you could issue a lot of debt. This might seem like a strange idea in the immediate aftermath of a major debt-fueled financial crisis, and with many homeowners still underwater on their mortgages (they owe more than the house is worth, even if they can still afford the monthly payments). In any case, to the extent that any recent American graduate thinks about debt, it is in the context of paying student loans.
But a new book, Private Equity at Work, by Eileen Appelbaum and Rosemary Batt, explains exactly how a few people have become immensely rich through the shrewd strategic use of debt.
The authors present a broad, detailed, and fair assessment of private equity – the business of investing in established companies through debt-financed purchases of controlling stakes. (By contrast, venture capitalists support start-ups almost entirely through equity.) And Appelbaum and Batt are careful to point out that many private-equity firms bring better management or other efficiency improvements to their portfolio companies.
But some of the largest funds – in fact, most of the brand names in the industry – use the clever trick of securing the debt they issue with collateral owned by the company they buy. This is a little bit like buying a house. A bank or mortgage originator lends you a large amount of money, which is secured by the house as collateral. In other words, if you fail to make your payments on time, the lender can foreclose on the loan and take possession of the property – as millions of homeowners have experienced in the last decade.
And yet there is a major difference between how private equity operates and how a family buys a home. Only a small part of the equity ownership acquired by any private equity fund comes from money provided by the partners who found and operate the fund. Most of it is raised from outside investors. (This would be like a family financing its down payment not from its own savings but from distant relatives about whom the family cares little.)