Widget Maker & Private Equity Investor Scenario

Just finished reading The Economist special report on the rich and my head is buzzing with many nuggets to reflect upon. The report itself is very well put together and, as always with the economist, is an intelligent read with some witticism.

But the real strength of the economist lies not only in its publication, but in its readers. The discussions following an article are sometimes even better than the article itself. Jomellon‘s take on this report is one such example. I liked it so much I decided to quote it here under. Share the love as some say…

One typical scenario for the last 18 years:
January -
Private Equity Investor (PEI) has 20 million. He uses it as security to borrow 200 million from Bank1 to buy a company ‘Widgets’. Widgets is a solid manufacturing business with assets of land, factories, patents, a brand, good will and no debts.

March -
Widgets borrows 300 million from Bank2 – no problems, its a solid business – but here comes the bit where it all goes criminal, though not illegal…

Widgets pays out 300 million to PEI its owner as a dividend, who repays 200 to Bank1. Widgets has to pay 20 million in interest per year. PEI keeps 100 million.

July -
Widgets also sells its assets: land, patents and so on and leases them back for 30 million a year.
The sales bring 200 million which Widgets also pays out to PEI its owner. PEI now has 300 million.

August -
Widgets Pension Fund is ‘restructured’ bringing a liquid 150 million onto the balance sheet. Widgets has liabilities to its pensioners with little to back them. 150 million is paid out to PEI as a special dividend., PEI now has 450 million.

December -
PEI sells the business to a pension fund, for 100 million, less than he paid as it has a lot of debt, but it is a good business, at least in a bull market. PEI now has 550

Recap:
Widgets now has 300 million debt costing 20 million a year in interest, plus 30 million in leasing payments. It has pension liabilities and the pension fund is almost worthless. PEI had 20 million at the start of the year and now has 550 million. But the business is still viable, as Widgets can meet its payments.

5 years later -
Sadly hard times come. Sales drop, prices drop, costs are cut, people lose their jobs, including engineers, managers, the shop floor and the sales team who did real work for years, created real value, invented the patents, built the brand. It doesn’t help. The company has no stores of fat – it goes bust. The banks loans are sour. Everyone loses their jobs, the pensioners cannot be paid.

This happens 100 times so the banks are bust too, but get bailed out by the taxpayer (that’s those guys who lost their jobs and pensions at Widgets)

PEI lives happily half the year in The Bahamas with the 550 million which he ‘earned’ in a fabulous year of ‘value creation’ in which the assets were ‘really made to work’, all made possible by the power of free and light touch regulated markets. He lives the other half of the year in London, but does not pay British tax. With his cash bundle he is contemplating which assets he can pick up in the current firesale.

Recap: Widgets are bust, its employees are jobless, its pensioners are broke. It suppliers are going bust, the banks are bust, the public treasury is bust… PEI has 550 million.

Problem for very advanced economists, unemployed Widget makers, penniless pensioners and bright 3 year olds: spot the problems with organising the economy this way.