Private Equity – Warning 4 bondholders!

Today's NY Times, had a great article on how private equity firms used "special dividends" to profit while bankrupting some of America's greatest companies. Simply put, do not loan money (through bonds) to companies owned by private equity firms.

This is how it works:

1. Let's say a company is for sale. A private equity firm decides to buy it for $500m. To finance the purchase, they will borrow $400m and will contribute $100m in cash. Since the company is generating free cash flow of $60m per year, this seems like a reasonable capital structure. Debt payments are $40m per year.
   
2. A few years later, the company decides to pay shareholders a "special dividend" of $150m. Since the firm is generating free cash flow of $80m, it can pay the $40m annual interest on the original debt + the additional $15m in new interest.
   

At this point, the PE firms owns 100% of the firm and has made at least $50m on the deal. Going forward, they are playing with the house's money and additional profit is a bonus.

Unfortunately, the economy has a downturn. Although the company generates $40m in cash flow each year, it cannot make its debt payments and it goes into bankruptcy.

While my example is simplified, it is very real. After the special dividend, the bondholders face all the risk of the firm. If the firm succeeds, the PE firm gets all the upside. If it fails, they bondholders face the loss.