You're Being Lied To About Private Equity | Truth Complex

When most people hear about private equity, it's usually in the context of a famous business that's in trouble. Private equity, often seen as the enemy of business, loading on a bunch of debt and slashing the workforce. No more fun and games for Toys R Us. Red Lobster has officially filed for Chapter 11 bankruptcy. But I really got interested in private equity when a chain of hospitals went bankrupt, a few years after it was bought and sold by PE investors. In less than 24 hours, two hospitals will close their doors here in Massachusetts. And then, basically the same thing happened in Pennsylvania. Enclosure Health is set to close in just a matter of days now. In both cases, hospitals went bankrupt after private equity firms sold off their real estate, which left the hospitals paying rent to keep using facilities that they used to own. I wanted to know how this keeps happening. Studies like this one find PE ownership of hospitals leads to higher costs and worse care. Whenever things go wrong with private equity, the industry points to its economic benefits. These investments don't just benefit ultra-wealthy people. They help workers with pensions, including firefighters, teachers, and nurses. For decades, the PE industry has marketed its funds as the highest-performing investments money can buy. And they use graphs like this to show that PE investments have performed way better than stocks. But experts I spoke with said that's not the full story. The whole chart is pretty much phony. Private equity is living on its past, past, past reputation. Yes, there was a time when they beat the market. But many of them are not doing that anymore. I spent months diving into the research to find out what's actually going on in this secretive industry. Private equity firms do a few different things these days, but this story is focused on buyouts. These buyouts are often compared to flipping houses, but instead of houses, it's businesses. They buy a company and try to increase its value as much as possible during a period of about three to seven years. Then they sell it, hopefully at a profit. Although, as we'll see, it doesn't always work out like that. But there's a key difference between a PE buyout and sprucing up a house. If I buy a house, I'll take out a loan from a bank to do it. And then I'll pay that loan back to the bank, plus interest. When a PE firm buys a company, they'll often use loans to do it. But those loans are in the name of the purchased company, and it's the one responsible for paying back the debt. So the company gets bought, but it now has a hefty debt to pay off. This is called a leveraged buyout. In the PE biz, debt is called leverage. That's what happened to Toys R Us when a private investment group bought it in 2005. After the deal, the toy company was billions of dollars in debt and paying about $400 million a year toward it. That meant it couldn't weather the storm when competition from Amazon and Walmart started to eat into sales. The company filed for bankruptcy in 2017 and began closing down hundreds of stores, eliminating thousands of jobs. In a court filing, the CEO blamed the company's huge debt payments. But for private equity firms, when a business they buy fails, it's just one of many in the portfolio. Each private equity firm manages multiple funds, and each one has roughly 10 to 20 companies in it. The firms put a little bit of their own money into a fund, but almost all of it comes from institutional investors. Those are typically university endowments, state-owned investment funds, ultra-wealthy families, and, interestingly, the pension funds of many middle-class workers. In the U.S., thousands of firms manage more than $3 trillion. That's bigger than the entire GDP of Italy. PE firms make money by growing those investments and by collecting various types of fees for their services, both from the investors who put their money in the pot and from the portfolio companies that they buy with that money. Those fees tend to be higher than what you pay a company like Vanguard to put your money in stocks and bonds. The average fee on a Vanguard mutual fund or ETF is less than 0.1%. Meanwhile, investors in private equity funds pay both management fees and a share of profits, which work out somewhere around 7 to 14%. So to recap, PE firms purchase companies using a mixture of debt, which they're not liable for, and equity, which is mainly other people's money. Then they collect fees from both the people who gave them the money to invest and the companies they bought with it. Pretty sweet deal, right? One study looked at four of the biggest PE firms in the U.S. and found that over a seven-year period, they made at least $16 billion in fees, almost as much as the $20 billion they made off their investments. Private equity funds also have ways of making money from the businesses they own, even if they aren't doing all that well. These include taking out a loan, which is then used to make a payment to the investors. This is called dividend recapitalization. It's controversial because it adds even more debt onto the purchased company and pretty much just exists to make more money for private equity investors. In 2019, the PE firm that owned Staples, Sycamore Partners, paid itself an eye-popping $1 billion using a dividend recapitalization that left the office supply company further in debt. Bloomberg reported that this let Sycamore recoup more than 80% of its original investment without selling the company, even as Staples was in financial trouble and laying off workers. Another maneuver is called a sale-leaseback. That's when the purchased company's real estate is sold off and the company has to lease it back to keep using it. The PE firm can use the cash from the sale to reinvest in the company and improve its operations. Or it can just pay itself more. That's what happened to Red Lobster when GoldenGate Capital bought it in 2014. The PE firm made $1.5 billion, selling off about 500 of the chain's properties. Red Lobster then had to pay rent for those restaurants it used to own while juggling other debt. GoldenGate sold off its investment in Red Lobster in 2020 and the restaurant chain filed for Chapter 11 bankruptcy in 2024. But between selling off the real estate and its shares of Red Lobster, the private equity firm made back its initial investment and then sold. One thing a lot of coverage glosses over. It's easy to think of these strategies as sneaky and exploitative, and they certainly can be. But remember, they are generally legal. Sometimes companies just make enough money to withstand a dividend recap. Ultimately, when a PE firm takes investor money, it has a legal obligation to act in the best interest of those investors. And that has been private equity's big selling point. University endowments and pension funds keep giving money to PE firms because they believe it'll get them the best possible investment returns. Even if getting those returns might involve some cutthroat business tactics. Some studies find companies are more likely to fail after they're bought by PE. One found bankruptcy risk is 18% higher after a leveraged buyout. There's typically more than one reason a company goes under. But famous brands like TGI Fridays, Party City, Payless, ShoeSource, Joanne Fabrics all went bankrupt after being bought by PE. When confronted about this, the PE industry will generally say if we have a higher bankruptcy rate, it's because we invest in risky businesses on the brink of failure. But they don't only invest in businesses on the brink of failure. Hard data on this is scarce, but some sources say as little as 1% of PE acquisitions are actually of businesses in distress. Meaning not making enough to pay their debts. So what explains the higher bankruptcy risk? One study found it might not be PE ownership itself, but the debt that tends to come with it that raises bankruptcy risk. If it were just chain restaurants and stores, that would be one thing. But PE is a massive force in other industries too, including healthcare. Let's start with nursing homes. It's a tough business with slim margins, but PE has been investing heavily in it for decades. Long enough that we had lots of studies about how that affects these facilities. One study of Medicare patients found that PE ownership was associated with an 11% increase in mortality in nursing homes, which translates to more than 1,000 additional deaths every year. We find that they cut back on staff, specifically on nurses. Nurses are the most important input, if you will, into nursing care. You would think that would save money, but the same study found Medicare spends more per patient at these facilities. Another study found PE acquisition of a nursing home is linked to higher costs, more emergency department visits, and increased hospitalizations. That study is interesting because it only looked at for-profit nursing homes, comparing apples to apples, and found that those acquired by PE still performed worse than for-profit nursing homes not owned by PE. I asked one of the authors about this. I think this may be largely due to the focus on short-term profits. PE firms tend to hold companies for less than 10 years, while the owner of a for-profit facility not owned by PE usually takes a longer view. They may be thinking more long-term and making investments to sustain the facility over time, while taking the impact of care quality and their reputation down the road into consideration. One complication. Many of these homes turn to private equity because the business is in trouble. With the baby boomer generation aging into these healthcare settings, they're battling increasing hiring and retention costs, and they're struggling amidst an increasingly tighter reimbursement environment. It's possible that without private equity investment, some nursing homes would simply shut down, and then there might not be a home to serve that region anymore. If you don't want private equity investment or other institutional forms of investment in there, and you don't want them selling off their facilities, you need to increase reimbursement. Nursing homes are somewhat unique in U.S. healthcare. 70% of them are for-profit, and a majority of their revenue comes from taxpayer-funded programs like Medicaid and Medicare. That makes them attractive to private equity firms, plus they tend to own some pretty nice real estate. By contrast, only about a third of hospitals are for-profit. But just like nursing homes, they often sit on valuable property. So let's talk about PE and hospitals. Recently, an acquisition of several Massachusetts hospitals became the poster child for concerns about private equity and healthcare. Cerberus Capital Management bought 11 hospitals in the state from 2010 to 2013, and rebranded them all as Steward Healthcare. While Cerberus owned Steward, the management teams arranged a sale-leaseback of the hospital's real estate, making more than $1 billion, selling the properties to a real estate investment trust. As part of that deal, Cerberus paid itself a hefty dividend. Bloomberg reported the amount as $484 million. The company bought more facilities in other states, eventually accumulating a chain of more than 30 for-profit hospitals, many of which were previously non-profits. It sold off its investment 10 years later, which is a relatively long time by private equity standards. But by then, many of the hospitals were in financial trouble, and there have been news reports of them being understaffed and not paying their bills. Nurses who worked at Steward-owned hospitals testified about this at a Senate hearing. This chronic understaffing has resulted in preventable harm and even death. The chain is now in Chapter 11 bankruptcy, and six of its hospitals have closed their doors. Obviously, each time that happens, people in the area lose care or have to travel farther for it. Cerberus says the hospitals will well run under its care, and claims that the problems began after its exit in 2020. But financial documents paint a different picture. By the end of 2019, the hospital chain already had a huge debt problem. Its liabilities exceeded its assets by more than $1 billion. The Wall Street Journal reported that over the years that Cerberus owned Steward, through fees and the real estate sales, it made $800 million, more than triple its initial investment. In a statement, Cerberus says these returns primarily benefited our investors, and highlights the pensions of teachers and firefighters. After this whole thing unfolded, Massachusetts passed a law banning sale-leaseback agreements in healthcare. Of course, not every P.E.-backed hospital fails. One study actually linked P.E. ownership of hospitals to better financial performance on average, but also reduced staffing, indicating a tradeoff. A similar story has unfolded at dental practices, with tragic results. In 2013, a U.S. Senate investigation found that hundreds of dental clinics owned by private equity had milked Medicaid for money. It said they performed unnecessary dental procedures on children, including root canals. Yet, four years after that report, a two-year-old boy received multiple root canals at one of the practices mentioned in it. He became unresponsive after the procedure, likely due to improperly administered anesthesia, and days later, he died. His parents sued, saying the practice over-treats, underperforms, and over-bills. In 2020, another P.E.-backed dental chain was in the news. Workers there said they saw unnecessary dental work performed on patients. I have watched them drilling perfectly healthy teeth multiple times a day, every day. Meanwhile, the percentage of dental practices affiliated with private equity doubled between 2015 and 2021, and research links this shift to higher costs for patients. P.E. investment is moving into more and more areas of health care. Right now, it's anesthesiology practices and gastroenterologists and pain clinics. Of course, heavy P.E. investment in these types of settings has brought a tremendous amount of scrutiny and bad press onto the industry. When asked about this, P.E. firms tend to say they're being scapegoated for systemic health care issues. Of course, P.E.'s failures tend to get a bit more media coverage than its successes. It's true that sometimes P.E. investment can help build up a business. Blackstone's acquisition of Hilton Hotels is a famous milestone in the P.E. world, sometimes called the best-leveraged buyout ever. During the six years Blackstone owned Hilton, the chain added more than 1,000 new hotels. After that, Hilton went public again. It raised $2.4 billion in its IPO, the largest ever for a hotel company. By the time Blackstone sold its last stake, it had made $14 billion, the highest ever in P.E. P.E. firms also point to what they say are the broader economic benefits of private equity, driving growth, making businesses more productive, and, of course, higher returns for people with pensions. Pensions are not as common in America as they once were. But many workers, including some nurses, teachers and government employees, still have them. There's over $27 trillion in U.S. pension funds. And nearly 90% of these funds have some investments in private equity. And that gives the industry a strong talking point. Pension funds across the country rely on private equity investment to strengthen Experts I spoke with said the industry leans on pensions when it's criticized for its other tactics. Whenever you would go and say, well, it looks like in hospitals you are doing, like, bad things with the patients, they would say, look, the industry has created tons of jobs, we give lots of good returns to the patients, this is what, you know, we are mandated to do, so we are just maximizing profit, we are good. People in the private equity industry say pension funds grow more quickly with private equity because P.E. offers better returns than the stock market. That is their big pitch to pension funds and other investors. Private markets has outperformed public markets for every single one of the last 20 years. Private market outperformance is consistent. $1 invested in private equity is worth a whole lot more than $1 invested in public equities. There's just one problem with that. We don't actually know if it's true. This is a graph on the website of a professional group that represents the private equity industry. It's plotting state pension returns. You can see it has private equity returns beating stocks for every year studied by more and more as time goes on. I broke this graph down with Jeffrey Hook, who once worked in private equity before writing the book, The Myth of Private Equity. It can't be real that public stocks drop 20 and private equity goes up two. They're the same kind of companies. So, you know, that's obviously phony. And so the whole chart is pretty much phony. You also have to pay close attention to how P.E. measures the competition, meaning what indexes they use to represent the stock market. The chart uses a combination of the Russell 3000 and an MSCI index that doesn't include the U.S. Historically, both have performed much worse than the S&P 500. Here they use performance measures that deliberately understate the performance of the U.S. stock market. So that's another game that the pro-P.E. propaganda machine uses. Experts I spoke with said the P.E. industry picks highly convenient benchmarks. A 2020 paper called An Inconvenient Fact explores this idea. A University of Oxford economist, Ludovic Falopu, wrote it. He found P.E. funds have gotten about the same returns as public equity indices since at least 2006. At the time, this was a pretty shocking claim. And it's still controversial. If you tell them your performance is not that clear, then they go ballistic. And that's pretty much what happened with that paper. The paper includes rebuttals from the big four private equity firms, who disagree with Falopu and claim his analysis contained multiple errors. But he's not alone in questioning whether P.E. actually beats public markets. You have lots of very senior academics who have the same results in their papers. I didn't amend the data. It's not proprietary data. Anybody can go and check the numbers. More recently, a working paper from Harvard Business School compared P.E. returns to what you would have gotten if you'd put the same money towards similar public stocks over the same period. The authors found average P.E. funds have not actually outperformed their public market equivalents since the Great Financial Crisis of 2008. Eileen Applebaum, another economist, has written extensively about P.E. and echoed these sentiments. Private equity is living on its past, past, past reputation. There was a time in the past when investments in private equity funds beat the market. All of these advantages have been competed away over the years. Institutional investors like endowments have flocked to private equity. In under two decades, they've helped increase the cash flowing into the industry tenfold. This means more competition for deals. It's not that easy to find a company that is undervalued that you can buy cheaply, fool around with its books for a while and sell it for a lot more than you paid for it. It's getting harder and harder to find those companies. Yet the P.E. industry still says they consistently beat the stock markets. How can there be so much uncertainty here? Well, the first issue is a lack of transparency. Private companies don't have to share much about their businesses compared to public ones. And even private equity firms that are public companies, like Blackstone and KKR, aren't required to publicly disclose earnings for individual funds. There's been very little pushback from either the investors or the government, in part because everything is so mysterious and hidden and confidential. Some of the best data we have comes from public pension plans, which are relatively transparent about their returns. But the other problem lies in how you analyze the numbers. It's difficult to make a fair comparison between private equity funds and public stocks. You have to make choices, like which time periods you look at and what index you use to measure the public markets. U.S. stocks tend to perform better than the global average, so a global index will be a lower performer, while an American index, like the S&P 500, is harder for private equity to beat. Also, private equity portfolios contain much smaller businesses than those traded on stock exchanges. Falapu's paper says once you compare apples to apples in terms of region and size of the companies and subtract the fees paid by institutional investors, the supposedly dramatic gap between public and private equity basically disappears. Some of these experts might be seen as pessimistic on P.E. returns. Analysis from industry sources often supports the idea that private equity beats stocks, but even one of those recently changed its tune. This is BI reporting from March of this year. The investment firm Hamilton Lane issued a report showing that the MSCI World Index beat out P.E. returns for the first time since the dot-com bubble burst of 2000. Remember, that's the historically lower-performing index that the P.E. industry tends to prefer to use. And this time, P.E. returns couldn't beat it. So there's lots of uncertainty around the question of when P.E. stopped beating the stock market. Some people say in 2006, some people say just in the last two years. But it seems like that huge gap between the lines on the chart we looked at is looking more and more implausible. All this suggests that pension funds might not be getting as good a deal as they think they are. I mean, Warren Buffett thinks so. Just listen to this clip. If I were running a pension fund, I would be very careful about what was being offered to me. We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that, well, they're not calculated in a manner that I would regard as honest. Three economists I spoke to said one of the key numbers P.E. firms use when pitching their funds to investors is easily manipulated. It's called the internal rate of return. It's a complex formula that can be used to predict future returns based on expected cash flows over time. It's very sensitive to the timing of those cash flows, which means you can gain this number by timing sales strategically. They're always selling their best investments first. P.E. firms are usually fundraising for their next fund before the last one has been totally sold off, using figures based on the strong early sales and guesstimating the value of the companies still sitting in the portfolio. The problem is that the unsold companies are probably not worth as much. Their buyout funds have aging companies in them. Well, they sold the good ones early, so these have to be the dogs. If we haven't sold them, are they worth what we say they're worth? It's almost 100% on the honor system. Experts I interviewed said there are also incentive issues here. There's a lot of people who benefit from pretending that the private equity funds all do well. If you're paid to manage a pension fund, for example, you're expected to have an advanced investing strategy. Investing in a classic 60-40 mix of stocks and bonds probably doesn't justify your salary. Not to mention, you might be thinking about your next job. There's a revolving door from public pension funds into private equity. So you want to be on good terms with private equity because that's your next job. This points to a system where even if some of the players here suspected P.E. doesn't dramatically beat stocks, you'd have little incentive to speak up. One important side note. Even if P.E. investments merely match the stock market or even slightly underperform it, it wouldn't necessarily be the end of the industry. Theoretically, it could still have a place in diversified investment portfolios. Perhaps the strongest indicator that investors are worried about what lies ahead for P.E. returns is the fact that some, including pension funds, are trying to get out. The same is true for university endowments. In April of this year, Reuters reported that both Yale and Harvard were exploring sales of their P.E. interests. The universities could simply be looking for cash as they face federal funding cuts. But it's also possible they've been disappointed by the returns on their P.E. investments. Yale, which pioneered the endowment model, saw a 5.7% investment return for 2024, which was among the lowest performers of the Ivies. And that's not the only change to this industry coming down the pike. Pensions and endowments have been a massive and reliable source of funds for private equity for about two decades. Even if those investments scale back slightly, it'll have a big impact on the P.E. business. So now, the P.E. industry is looking at other funding sources. One way it's doing that is by gradually working its way down the income ladder. Until fairly recently, if you couldn't write a $10 million check without linking, you couldn't invest in private equity. But they wanted to get the, you know, near wealthy and the merely very rich into private equity, and they designed products for them. Right now, private equity investments are typically only available to institutional investors, like endowments, and people with ultra-high net worths. But for years, the industry has sought access to retail investors, essentially meaning regular people. And it scored a big win during the first Trump administration, which removed some of the barriers to having private equity in Americans 401ks and IRAs. Proponents say it's a way to make a lucrative form of investment available to more people than just the ultra-wealthy. I always said, why is it the richest people in the world get the greatest assets and the average person that needs it the most don't? Others, like Investopedia, interestingly, say this would create significant dangers for mainstream investors who might not understand these opaque, high-risk, and expensive investments. But there are some big hurdles before investing in PE goes mainstream. Private equity investments are highly illiquid, usually 10-year commitments where you can't get your money out. There's also the issue of convincing people to pay high fees. Despite all that, the nation's second-largest retirement plan provider and power announced this May that it was opening up private market investing to its 19 million plan participants. The company is teaming up with PE giants like Apollo Global Management to make this happen. And it says the fund is designed to provide liquidity protection and reduced fee exposure. Vanguard also teamed up with Blackstone and another asset manager to launch a fund for retail investors that would include a mix of stocks, bonds, and private markets. By private markets, they mean not only buyout funds, but also private credit, real estate, and infrastructure. Eileen Applebaum says investors should be very cautious. The fees are high. The returns are risky. You could be in one of the funds that doesn't make a good return, but they take your fees whether they make a return or not. Less experienced investors could be jumping into private equity right as new competition is transforming the industry. Here's one of the co-founders of KKR, the firm that pioneered the leveraged buyout. When we started the private equity industry, Jerry, George, and I, there was nobody doing it. Today, everybody and their brother seems to be in private equity. We got a room full of private equity people here. Another thing that's changed since the early days of PE is that the industry has shifted its focus to smaller companies in what they call the middle market. But experts I spoke to said there are signs PE dealmakers are struggling to find attractive businesses to invest in. In 2024, firms had record amounts of cash from fund investors that hadn't been put towards a deal yet. That's called dry powder. So dry powder is a problem because it means they kind of figure out where in the economy there will be opportunities to invest that money. Finding deals might be getting harder because so many sectors of the economy have already gotten the PE treatment. A lot of things have been kind of quote-unquote professionalized. They keep going down and down and down. Smaller companies, car washes, your roofing companies, Personally, I would have loved for them to do the car washes before the hospitals, but hey, maybe that's just me. So the industry famous for trimming fat might be running out of fat to trim. PE is a trendsetter. They may have started the trend of slashing costs, but it's now the norm in the U.S. economy. Given all these challenges, it makes sense that the firms are diversifying their own businesses. Major private equity firms like Blackstone, Carlyle, and KKR are not exclusively in the buyouts business anymore. They've expanded into real estate, infrastructure, and increasingly private credit. This is part of why these firms don't call themselves private equity anymore, opting for labels like alternative asset managers. Even the industry's main lobbying group changed its name from Private Equity Growth Capital Council to American Investment Council. This could also have something to do with the term private equity developing a poor reputation, but who knows. One thing seems clear. If they're going to get regular people investing in PE, they're going to need to get the word out. It's likely we'll see this historically private industry start to put more effort toward managing its reputation. We've already seen Blackstone start to run TV commercials for the first time ever. The days of PE firms operating in the shadows are ending. Now they want people to know what private equity is. And of course, to like it. Because PE firms stayed relatively under the radar for so long, I think many people might not have noticed just how big the industry has become. But in fact, this isn't a slice of the economy we can just lift out if we don't want it anymore. It's maybe not the foundation of the economy, but it's a weight-bearing pillar. Just in the U.S., private equity firms have investments in about 21,000 businesses, which employ more than 13 million people. Private equity is everything and everywhere, whether you like it or not, and they can't really be separated from what the economy is now. Even so, the industry is facing more and more scrutiny from regulators. One of lawmakers' main interests has been closing the carried interest tax loophole. This allows PE investment gains for people in the highest income bracket to be taxed at a marginal rate of 20% instead of the roughly 37% that they'd pay if the gains were taxed as income. A recent study looked at more than 10,000 funds and found that making this change could have raised up to $250 billion of extra tax revenues over two decades. The idea has had bipartisan support in the U.S. for quite a while. Well, one thing I do is get rid of carried interest. I've been in favor of getting rid of carried interest for years. But it never quite makes it over the finish line due to lobbying and pressure from the finance industry. In 2022, it almost made it into the Inflation Reduction Act, but one legislator pushed for it to be removed. That was Senator Kyrsten Sinema, an Arizona Democrat turned independent who happened to receive nearly $1 million that year in donations from private equity and Wall Street interests. Other proposed legislation would go even further than tax loopholes. If passed, it would hold the private equity firm accountable for the debts of the companies it buys. So the firms wouldn't be as likely to load companies up with large amounts of debt. This would be a foundational transformation of incentives in the PE industry. But the chances of that bill passing at present are slim to none. If anything has the potential to actually shake up what's so far been an untouchable industry, that would be institutional investors shifting their resources elsewhere. That is, if regular Joes don't pick up the slack. If you're wondering about the sources I used for this video, I made a reading list for you, and it's linked in the video description.