The Duality of Private Equity: How It "Bought" the World

Private equity, a contentious area of finance, controlling over USD 13.1 trillion in assets under management globally as of 2023. With a reach spanning multiple sectors, from restaurants to healthcare, it is not an exaggeration to say they have 'bought' the world.

What is private equity?

What do they do?

When we talk about private equity, we are more often than not referring to private equity firms. Since the beginning of the 21st century, trends have indicated that in developed countries, the private equity market has been growing at a rapid pace—nearly 20% per annum since 2018. With its roots in North America, primarily the United States, the markets in Southeast Asia and the Indian subcontinent are now ripe for the picking. Bain & Company, a prominent management consulting firm, claimed that Japan ranked among the top three developed markets for PE investment opportunities over the next 12 months, while India and Southeast Asia were identified as the two best emerging markets for investment opportunities.

A private equity (PE) firm is one of the various types of investment firms. They raise capital from investors to purchase stakes, or shares, in private companies, or they take previously public companies private by delisting them from public exchange markets.

The goal of a PE firm typically revolves around increasing a company’s value over time and selling their stake for a profit. This can be achieved by selling to another company (i.e., facilitating a buyout), an initial public offering (IPO) through a listing on the public exchange, or some other form of 'exit' strategy.

Their core approach of privatizing and flipping acquired companies for profit is not limited to any single sector. In fact, their reach spans various industries, including (but not limited to) technology, healthcare, consumer goods, financial services, education, real estate, and the industrial sector.

This means that from the clothes you wear, the food you eat, the school your children attend, the hospital you visit, to the house you live in, it’s likely that private equity had some role in the respective company providing the service. Investment across more sectors shows no signs of slowing down either. With a 'strong PE appetite,' firms are actively working to build up their 'pipeline of targets.'

One may also wonder where these firms generate the funds to acquire companies. The short answer is that PE firms accumulate capital from institutional investors and wealthy individuals.

Acquiring Firms

Using the aforementioned funds, PE firms employ two primary strategies when deciding to acquire a company. First, they identify which company to purchase, typically falling into two categories: an undervalued company with a steady cash flow or a company with a significant amount of underutilized assets.

The first strategy, known as acquiring a controlling interest, involves purchasing a significant portion of a company’s shares or voting rights. This usually gives the PE firm substantial influence over the company’s decision-making, including its operations, governance, and strategic planning.

The second method, called a leveraged buyout (LBO), is more complex than simply acquiring a controlling interest. In an LBO, a company is acquired using a significant amount of debt, with the company’s assets used as collateral for the loans. PE firms often use a high debt-to-equity ratio in these acquisitions, ranging from 60% to 90%, meaning the firm is only paying 10% to 40% of the company’s value with its own funds.

Increasing a company’s value

Post-acquisition, whether through a controlling interest or an LBO, the firm begins implementing measures to 'improve a business.' This generally means increasing a company’s profitability.

There is no one-size-fits-all method for boosting profitability. Typically, the process involves reducing overall spending, selling off non-core assets, restructuring management systems, and attempting to enhance operational efficiency. The ultimate goal is to raise the company’s value while simultaneously using profits to pay down the substantial debt over time.

The exit

Once the firm has increased the company's value and paid off a significant portion of the debt, it begins exploring an exit strategy. This could involve selling the company to a strategic buyer, to another private equity firm in a secondary buyout, or taking the company public through an IPO.

Examples to Private Equity

The impact of private equity firms is felt not only in the companies they acquire but also in the economy as a whole. They can benefit the economy through real-time effects, such as GDP growth, job creation, wage increases, and capital infusion.

In 2020, PE firms generated over USD 1.4 trillion in GDP in the United States alone. Employment and wages are positively impacted through job creation and capital investment. By 2020, almost 12 million workers in the United States were employed by companies backed by PE firms, generating close to USD 900 billion in wages and benefits. In fact, PE-backed companies create an average of 1.5% more jobs per year. Capital infusion refers to when firms provide funding to businesses, often leading to modernization and improved efficiency. As companies become more competitive, market competition is also stimulated.

However, when PE firms fail in an acquisition, the opposite effect is seen. If a firm is unsuccessful in transforming the company into a profitable entity, it can result in the company shutting down, causing economic downturns. Mass layoffs during restructuring lead to increased job insecurity, unemployment, and a heightened risk of homelessness.

To illustrate how private equity can make or break a company, I will explore the outcomes of two different acquisitions in the consumer food and beverage sector, both involving a strategy known as asset stripping.

The success of Burger King

3G Capital acquired Burger King in 2010, marking a critical point in the fast-food chain’s history. Their acquisition positively impacted the chain’s financial performance and operational strategies.

One of the first actions taken by the firm was overhauling the management, appointing 3G’s managing partners Bernardo Hees and Daniel Schwartz as the new CEO and CFO, respectively. While this move might seem like an imposition of power and influence, it was crucial for ensuring a swift turnaround.

The firm implemented aggressive cost-cutting measures across the company’s hierarchy. This included, but was not limited to, reducing corporate overhead, simplifying the menu to focus on their flagship product—the Whopper, outsourcing non-core functions, and enforcing strict travel policies.

A significant change that solidified the firm’s influence was the shift to a franchisee model. By 2013, over 90% of Burger King outlets were franchised, reducing the company’s asset base, minimizing operational risks, and generating a steady cash flow.

The results were evident soon after, with earnings increasing by almost 50% by 2012. That same year, Burger King went public, valued at USD 1.4 billion. Most notably, the chain merged with Tim Hortons in 2014 to create Restaurant Brands International.

The Failure of Red Lobster

In 2014, private equity firm Golden Gate Capital (GGC) acquired Red Lobster, an American casual dining chain. GGC’s acquisition significantly impacted the restaurant’s operational structure and financial capabilities.

Firstly, the acquisition directly increased Red Lobster’s debt burden. The agreement transitioned them into tenants of what was previously their land, imposing significant financial burdens that were not immediately evident but became clear over time. By 2023, rent obligations approached USD 200 million annually, accounting for approximately 10% of Red Lobster’s revenue.

The financial strain of the deal led to instability in management, with multiple CEOs attempting to turn the company around but ultimately achieving little lasting success. This instability hindered their long-term planning and execution.

This financial burden stemmed from the deal’s structure, characterized by high fixed costs and limited opportunities for cost reductions. By 2020, these financial pressures escalated to the point where the restaurant filed for bankruptcy.

Conclusion

In conclusion, we explored the scope of private equity firms and their responsibilities globally, as well as their impact on the companies they acquire and the economy as a whole. We also examined the extensive range of sectors that private equity controls, including consumer goods, food, healthcare, and education. Specifically, we discussed the effects of private equity in the consumer food and beverage sector. Successful cases, such as Burger King, experienced profit increases, while failed examples, like Red Lobster, ultimately filed for bankruptcy. These contrasting outcomes illustrate the significant influence of private equity on both companies and the broader economy.