I'm an Ignorant Idiot
Which is why I get to ask the following questions.
I read in PitchBook that private equity was limiting its borrowing to pay dividends. This has been a long-time strategy of private equity. It likely would not be feasible if the tax code did not have a carveout specific to private equity. This carveout has bipartisan support in Congress, and yet there are no known benefits to the public of this carveout – at least none known to me, and again, I’m ignorant.
Beyond the tax carveout, how many business owners think it makes sense to borrow money so they have a paycheck? If an agency owner can't afford to pay themself, they obviously lack cash flow. If an agency owner lacks the necessary cash flow, odds are they're running their agency incompetently. This isn't a start-up situation where no revenue is generated, and only expenses are incurred. These are established businesses with significant revenue streams.
Dividends are supposed to be an indication of financial health, proof a company is well-run and investors can count on stable returns. Historically, borrowing money to afford dividends is a sign of weakness. If you examine publicly traded companies that pay good dividends, you're unlikely to learn they’re borrowing money to pay them.
If operational cash flow cannot support dividends, and private equity dividends tend to be large, and borrowing is required, then the balance sheet tends to become lopsided toward liabilities, especially compared with real assets. By this I mean assets that are not self-appraised.
A number of quality studies (at least to me, these are quality studies, but I’m ignorant) show that self-appraised assets are materially overvalued. Denial is plausible if, per accounting rules, the PE firm commits to holding those assets long enough because OTTI (Other than Temporary Impairment) accounting rules do not seem to apply. One really has to appreciate the tax loopholes and accounting rules. In my ignorance, I wonder what would happen if regular tax rules and accounting rules applied?
This brings me to another question: if this model of borrowing money to pay dividends is so great, or even if the operating cash flow is sufficient to afford high multiples, why won’t private equity provide buyers of their equity with audited financial statements?
I may be ignorant, but I won’t give someone hundreds of thousands or millions of dollars if I am not allowed to review their audited financial statements. This is the PE model, and buyers of agencies usually require the agency seller to take material portions of the price in the buyer’s stock. But they refuse to provide audited financial statements. Instead, they show a piece of paper “proving” the value of such stock has increased 100%+. They do not disclose that this is a self-appraisal, possibly based on the last round of capital raise.
The parties that are giving them more capital get audited financial statements. The seller is giving them capital by taking a portion in stock rather than demanding cash, so why not treat both parties giving them capital the same?
I know no one ever loses money except for fraud and for this one other reason and maybe for these one or two other reasons, so no one needs to ask these needling questions. That is why I know I’m ignorant, because that is what I’ve been told by entities that refuse to share financials and must borrow to pay dividends and so on and so forth.
The Securities and Exchange Commission (SEC) has a sophisticated investor rule which is supposed to limit investments by unsophisticated investors. To me, an unsophisticated investor is someone who buys stock without any review of financial statements, or at least without a third party offering an opinion. I believe Madoff sold investors on the same promises without disclosing financials.
If a company is legitimate, it should easily offer financial data. In effect, when selling an agency to private equity, the buyer completes thorough due diligence of the agency’s financials. And then an exchange happens. Some portion is in cash and promises. Another portion is literally an exchange of stock, but only one party knows the true value through financial due diligence of the other party’s value, while the seller is totally blind. Which entity is more sophisticated, and who is unsophisticated and blind?
Again, I totally understand that only an ignorant person like me would ask these questions because if I were knowledgeable, I would not question any aspect of these transactions. I know almost everyone makes a lot of money in these deals, so questions are pointless and, worse, a waste of time and energy. This is why being ignorant with nothing better to do gives me the opportunity to address these obvious points.
Since I am ignorant, I asked Google’s AI for its opinion on buying stock blind. The response was succinct: “No, it is a very bad idea to buy stock if the seller refuses to provide financial data.” I refined the question to specify buying a private company’s stock, and the answer was just as succinct: “Buying stock from a private seller who refuses to share financial data is a very high-risk gamble and generally a bad idea.”
There you have it from a source that is not ignorant like me.
NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.
None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.