HOUSE FLIPPERS & PRIVATE EQUITY FIRMS: WHAT'S THE DIFFERENCE?

Have you ever had a bunch of credit cards with zero balance and then thought about doing a cash withdrawal for the maximum amount on each one, and then walking away? If you have then you've got the heart of a private equity fund manager.

In this excellent video interactive "How Private Equity Dealmakers Can Win While Their Companies Lose" (which is divided up into 1-2 minute segments) the NY Times presents a nice introduction to private equity markets that could also be called The Roots of Debt & Wealth Extraction in America

In a few words, private equity fund managers are individuals who manage money provided by wealthy market players. They then purchase (invest in) a firm with the idea of improving the company's performance and/or market share. As the video points out, the idea is similar to someone who purchases a house, with the goal of selling (flipping) it within a year after they've made improvements.


For example, in the housing market we know that there are many house flippers who took out cash advances on their credit cards, or borrowed against the value of their primary residence, to make home improvements. The idea was to enhance the value of the homes they bought. On a general level, this mentality is not only good for the individuals involved, but for markets too. But then greed and stupidity raises it's ugly head.

In the housing market, house flippers are losing big time today because they got in over their heads. Simply put, most were under-capitalized borrowers betting they could make a killing and get out before the market collapsed. President Obama's $75 billion bailout for homeowners acknowledged this, and excluded debtor-speculators and Ponzi-like house flippers from gaining access to federally-backed bailout funds.

Their mistake was that they should have become private equity fund managers, rather than house flippers. Here's why.

Unlike individual house flippers private equity managers don't have to pay back what they borrow. Pivate equity fund managers not only get paid for making a purchase but they work out arrangements where they can receive "special dividends" before the company they purchased shows any improvements or new profits.

What makes special dividend payments (which run into the millions) especially odious is that they are usually paid out with money borrowed from banks who helped fund the purchase, or takeover, of a company. As a point of reference, think about what Danny DeVito's character did in the movie, "Other People's Money" (1991).

For you romantics out there think about Richard Gere's character in "Pretty Woman."


For a modern version of how Devito and Gere's characters operate see today's NY Times' article on the Simmons Mattress Company here. According to the NY Times article, "Simmons owes $1.3 billion, compared with just $164 million in 1991, when it began to become a Wall Street version of 'Flip This House'." Over this period the various private equity owners of Simmons have made about $750 million in salaries, bonuses, dividends, and fees. You do the math.

Simmons' performance was improved so much during this period that it is now declaring bankruptcy.

If this seems a bit confusing think of it this way. Imagine that you purchase a house that you want to flip within a year. Then imagine that you max out the credit cards you have because you can legally tie the credit card debt into the house you are going to sell (legally, you can't do this, but play along here). You borrow more and pay yourself big "management" fees, but only make superficial (if any) repairs on the house. You then declare bankruptcy, or sell the house to someone else who might also declare bankruptcy (for the tax write-off). Under both scenarios you walk away richer, and debt free.

Now imagine that you can do this over and over again. In many respects, this is what the private equity market players have done over the years.

At the end of the day, when we bailed out the banks we were also bailing out the deals and bets that were made by private equity firms who destroyed firms like Simmons by dumping hundreds of millions in debt on the company. When President Bush and President Obama pushed for and guaranteed trillions of dollars for the financial and banking sector they propped up the debt creating deals of private equity firms. In effect they sanctioned the activities of a small group of financial parasites who do little more than extract rather than build wealth.

What a racket.

- Mark