How does that work exactly though? Loans from whom? Lenders watch Goodfellas too. They know the game here. Oh, a private equity firm wants to take out loans on the future earnings of this company they just bought. That sounds like it must be very profitable! Let's call off our due diligence.
A loan at an 11% interest rate pays for itself in around six and a half years. The general concept is that even if the PE firm runs the company into the ground, it only needs to exist (and make loan payments) for 6.5 years to get your money back.
For a company like Toys R Us, there is still value in that brand name. You can reduce the quality of the store and coast on that recognition for a little while before people change their shopping habits. Put another way, how many bad meals would you have to have at your favorite restaurant before you stopped going? I bet it's more than one or two, as long as the experience isn't super terrible.
So for a lender, the questions you ask yourself are:
1. With cost cutting and other measures, how long do I think this business can last?
2. Once this business reaches bankruptcy, how much am I likely to recover on my loan? This involves figuring out how much in assets the company has.
3. What are the chances this business is able to be turned around?
There are situations where even if the company goes bankrupt, the lenders still made money.
Lenders aren't dumb. They know the reputation of the PE performing the buyout. If that particular firm has a terrible track record money to lenders, the lender will want to be compensated for that risk.
Ultimately, the people that "pay" for this are shareholders (who get zeroed out in bankruptcy) and consumers (who get degraded product/service quality for the same price; that's how the company stays afloat in the short term).
In this case the PE firm would have been better off not getting a loan to begin with - it would have kept the interest payments to itself.
This looks a lot like selling some bad assets to some sucker investors. But the question a lot of people seem to ask in this thread is: when will the world run out of suckers? (Maybe this question shows how naive I am? Maybe some people know how to find these suckers one after the other?)
>In this case the PE firm would have been better off not getting a loan to begin with - it would have kept the interest payments to itself.
That assumes the PE company can predict exactly how long the expect the business to survive after takeover. They can't.
Both sides (the lender and the PE firm) are evaluating the company being purchased and the plan set out by the PE firm. The loan terms are set such that both sides feel they can make money on the deal.
The fact that PE doesn't make money on every deal indicates that they can be wrong.
>> Lenders aren't dumb. They know the reputation of the PE performing the buyout. If that particular firm has a terrible track record money to lenders, the lender will want to be compensated for that risk.
That's not a bust out then. If the lenders get compensated for their risk it's just a business decision.
The accusation was "The company has a bunch of loans it will never be able to pay off (sucks for the lenders)".
The accusation was that the lenders were in fact dumb.
I mean, the view I have is that at the time of the LBO nobody knows for sure what will happen.
The PE firm knows what they plan to do. The lenders know in a general sense what the PE firm plans to do, along with the track record of that firm's other LBO's and loans. Even if the outcome of bankruptcy is fairly certain, it's hard to predict how long it will take until that happens.
The point I'm making is that if you only look at the failures, LBO's look like a bust out. But I don't think the entire concept of an LBO is a bust out, which is why I don't think the lenders are dumb for underwriting these loans.
How does that work exactly though? Loans from whom? Lenders watch Goodfellas too. They know the game here. Oh, a private equity firm wants to take out loans on the future earnings of this company they just bought. That sounds like it must be very profitable! Let's call off our due diligence.
Said no lender ever.