I am not a PE expert but I will try to explain using the mortgage analogy. This is drastically simplified. The shoehorned part of the analogy is that a bank won't exactly lend as described below.
You take out a mortgage for a property you intend to cashflow by posting it on AirBnB. You open an LLC to do so. You put down a fraction of the price of the home, let's say 5-10% and then you do some upgrades, but you borrow against the price of the home for the upgrades, not against your own credit. Now, you start AirBnBing this very nice house out for absolute top dollar. It's nice and people love it, you have great reviews. Every time you get a payment from AirBnB, you take most of the money and move it to your personal bank account as a "management fee" or a "bonus" and you put the smallest amount possible into the mortgage and the second mortgage (the one you used to upgrade the house). Now, as the house gets more use, or you cut costs, say on having the pool cleaned, or on yard maintenance, the house goes down in quality pretty significantly, but your original AirBnB ratings are there and people are willing to pay significant sums so you continue to rake in cash, and you try to avoid maintenance as much as possible.
Eventually, the place is a run down heap, and people are leaving terrible reviews, so you stop having bookings/cashflow. Okay, now you just send the keys to the bank and say "it's your problem". They get a rundown house that has barely repaid its mortgage, and you get to keep the cash. The trick is to have moved a lot more cash into your account than you lose in the mortgage down payment.
Edit: I should add that PE firms aren't always trying to extract value at the cost of the business (sometimes they absolutely are). However, they are always incentivized to make cash flow and take maximum business risk for potentially even larger payout.
> Every time you get a payment from AirBnB, you take most of the money and move it to your personal bank account as a "management fee" or a "bonus" and you put the smallest amount possible into the mortgage and the second mortgage
Correction: you pay your debt first. Then you take the money and spend it on yourself versus investing in the business, upgrading the home.
It’s basically the acquisition (buying out) a company using debt-financing (leverage). The typical plan is usually to use business revenue to finance the interest payments, optimize the business via cost-cuts or roll-ups, and flip it for a profit in 5-7 years.
Like most things, PE can be helpful or destructive depending on the execution and the exact strategy for flipping.
At its best, it’s bringing in experienced operators and maturing a company into something that is stable, before selling it to an acquirer or IPO.
At its worst, it’s saddling a weak business with debt, hiring terrible execs, and making unsustainable cost cuts to stave off an implosion.
The strategy matters a lot. Some funds specialize in “distressed assets”, for example and are very good at carving up dying company and selling it for parts.
Thank you, this is a balanced and detailed response. I don’t personally “buy” the narrative that all LBOs are destructive. After all there are entire funds devoted to LBOs and how would these PE outfits carry on getting loans if their companies constantly defaulted?
lazerpants|2 years ago
You take out a mortgage for a property you intend to cashflow by posting it on AirBnB. You open an LLC to do so. You put down a fraction of the price of the home, let's say 5-10% and then you do some upgrades, but you borrow against the price of the home for the upgrades, not against your own credit. Now, you start AirBnBing this very nice house out for absolute top dollar. It's nice and people love it, you have great reviews. Every time you get a payment from AirBnB, you take most of the money and move it to your personal bank account as a "management fee" or a "bonus" and you put the smallest amount possible into the mortgage and the second mortgage (the one you used to upgrade the house). Now, as the house gets more use, or you cut costs, say on having the pool cleaned, or on yard maintenance, the house goes down in quality pretty significantly, but your original AirBnB ratings are there and people are willing to pay significant sums so you continue to rake in cash, and you try to avoid maintenance as much as possible.
Eventually, the place is a run down heap, and people are leaving terrible reviews, so you stop having bookings/cashflow. Okay, now you just send the keys to the bank and say "it's your problem". They get a rundown house that has barely repaid its mortgage, and you get to keep the cash. The trick is to have moved a lot more cash into your account than you lose in the mortgage down payment.
Edit: I should add that PE firms aren't always trying to extract value at the cost of the business (sometimes they absolutely are). However, they are always incentivized to make cash flow and take maximum business risk for potentially even larger payout.
JumpCrisscross|2 years ago
Correction: you pay your debt first. Then you take the money and spend it on yourself versus investing in the business, upgrading the home.
ahzhou|2 years ago
At its best, it’s bringing in experienced operators and maturing a company into something that is stable, before selling it to an acquirer or IPO.
At its worst, it’s saddling a weak business with debt, hiring terrible execs, and making unsustainable cost cuts to stave off an implosion.
The strategy matters a lot. Some funds specialize in “distressed assets”, for example and are very good at carving up dying company and selling it for parts.
coastermug|2 years ago