"Two and Twenty
By Sachin Khajuria
(Currency, 248 pages, $28)
Critics of private equity funds hate them for what they do and for the money they make.
What they do is buy companies, whip them into shape and sell them back to investors after a few years. Funds often borrow most of the money they use to acquire a company, financing the rest with debt that will be paid by the rehabilitated company itself. Any unexpected disruption creates a risk of default. The strategy for mitigating that risk? Frequently, layoffs.
What they make is 2% of the value of the assets they manage each year, plus 20% of any profits, a lucrative compensation scheme called "two and twenty." No matter what happens, the fund wins: The 2% fee brings steady income, even if the investment crashes, and the fund takes a large piece of the profits of each successful investment. The U.S. government boosts the payout further with a tax perk called "carried interest." Fund managers aren't taxed on the profits until the company or investment is sold, and they pay the very low capital gains tax rate.
Sen. Elizabeth Warren, standard bearer for private equity's despisers, excoriates the industry for going after short-term profits at the expense of businesses' long-term prospects.
The Stop Wall Street Looting Act she and co-sponsors introduced in 2019 and re-introduced last year would end the carried interest tax break, add employee protections and bar dividends from a target company for two years after an acquisition.
In "The Bonfire of the Vanities" Tom Wolfe famously satirized bond traders as "masters of the universe." In the current environment, it's easy to imagine a scathing expose of private equity as the new masters. In "Two and Twenty: How the Masters of Private Equity Always Win," Sachin Khajuria has written precisely the opposite of such an expose. For Mr. Khajuria, a 25-year private equity veteran who rose to partnership at Apollo, "masters" is an honorific, deployed without a trace of Wolfe's irony. Mr. Khajuria believes private equity deserves to be defended.
He's right about the need for a defense.
Some criticism of private equity is well-founded, to be sure -- funds do siphon out value, and 70% of the large corporate bankruptcies filed in the past few years are companies owned by private equity.
But the public caricature obscures the benefits of private equity. Private equity funds often improve the companies they acquire or invest in, and they make loans that banks can't or won't.
Mr. Khajuria's sanitized portrayal of the industry, however, won't persuade many skeptics. He relies on "fictitious sketches" of a private equity firm -- blandly identified as "the Firm," headed by a saintly "Founder." The Firm seems largely to be modeled on Apollo, and many of the deals resemble Apollo transactions.
Early sketches supply helpful information about the structure of private equity funds, which typically have three layers: the "analytical base," where young associates begin; midlevel employees; and the partners, or managing directors, at the top. A committee anchored by the Founder vets each potential acquisition or transaction proposed by a partner and his or her team.
The vignettes enable Mr. Khajuria to show the wide range of industries and transactions in which private equity now operates. The Firm invests in "TV Corp" during the 2008-09 crisis; buys General Insurance Group, an insurance company that ran into trouble when fellow insurer AIG collapsed; persuades the founder of Charlie's Cookies to sell the company to the Firm, then remakes it by adding healthier alternatives to its famous cookies. The Firm extracts value wherever it can, distributing $300 million of General Insurance Group reserves in a dividend and borrowing $1 billion to make more dividends when it concludes General Insurance can handle more debt.
Mr. Khajuria sands out the industry's rough edges. "Let's concentrate on our work, and growth and size will follow," Founder says (with a smile) to a partner who predicts the Firm is on track for $1 trillion in assets. "If there's one thing I can't stand, it's greed." If the investment committee's questions reveal flaws in a proposal, "the deal team will be the first to admit it."
Because the story is told through fictional sketches, readers unfamiliar with the industry won't learn who the leading figures and firms in the industry are, and how their strategies differ. Other than an early reference to Blackstone, Carlyle and KKR -- three industry giants -- actual names of individuals and firms are almost entirely absent.
Private equity's ruthlessness does occasionally peek through. When a young partner proposes that the Firm agree to $20 million of bank fees to help finance a $2 billion deal, since the fees "were tantamount to a rounding error," Founder reminds him that they need to press "for every cent." After agreeing to purchase part of a business, the Firm improves its deal by battling over every feature of the transition: "the period between signing a deal and closing it for a carve-out is the ideal time for private equity to drive a harder bargain."
To defend private equity, Mr. Khajuria points to the complexity of the transactions and the industry's success. He also has a convenient human shield: retirees. Public pensions are responsible for 35% of investment in private equity funds. The irony here is that public pensions are forced to seek out investments with unusually high returns -- such as private equity -- because they have overpromised with their pension benefits and consistently failed to set aside enough money for them. This enables Mr. Khajuria to say, as he repeatedly does, that private equity funds are making money for "pension funds and other investors."
For readers unpersuaded by Mr. Khajuria's claims that "in private equity, capitalism has perfected its version of a virtuous circle," he suggests that private equity is too big and has insinuated itself too deeply into American life to be stopped. That may be the book's most persuasive point.
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Mr. Skeel teaches bankruptcy law at the University of Pennsylvania Law School.” [1]
1. New Masters Of the Universe
Skeel, David.
Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 28 July 2022: A.15.
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