How to Become an Oligarch

Lady Gaga had it right when she sang 'Born this Way.' She wasn't referring to choosing one's parents on the basis of wealth, but the point pertains.

For the 99.9 percent of the rest of the world, however, that is not going to be an effective strategy.

And we couldn't all come of age in Russia as the Soviet Union was collapsing or in China as developing real estate became a profitable career rather than a capital crime.

So what to do? Well, the answer, as IMF chief economist Simon Johnson explains below, is OPM, other people's money. Committing as little of yours and as much of theirs as possible. While retaining control, of course. All from the comfort of your own desk top. JL

Simon Johnson comments in Project Syndicate

The business of investing in established companies through debt-financed purchases of controlling stakes.

Let’s say that you would like to become one of the richest people on the planet, someone with enormous wealth and access to the top rung of political power. This is not an unreasonable aspiration for any fresh college graduate in today’s winner-take-all economies. But how realistic is it?

You could have a good idea for a new technology with potentially widespread demand. With the right credentials and some luck, you could attract investment from a venture-capital fund. Many such ventures do not pan out; but – particularly in the United States – such equity-financed rapid-growth companies are strongly encouraged.

Or you could issue a lot of debt. This might seem like a strange idea in the immediate aftermath of a major debt-fueled financial crisis, and with many homeowners still underwater on their mortgages (they owe more than the house is worth, even if they can still afford the monthly payments). In any case, to the extent that any recent American graduate thinks about debt, it is in the context of paying student loans.

But a new book, Private Equity at Work, by Eileen Appelbaum and Rosemary Batt, explains exactly how a few people have become immensely rich through the shrewd strategic use of debt.

The authors present a broad, detailed, and fair assessment of private equity – the business of investing in established companies through debt-financed purchases of controlling stakes. (By contrast, venture capitalists support start-ups almost entirely through equity.) And Appelbaum and Batt are careful to point out that many private-equity firms bring better management or other efficiency improvements to their portfolio companies.

But some of the largest funds – in fact, most of the brand names in the industry – use the clever trick of securing the debt they issue with collateral owned by the company they buy. This is a little bit like buying a house. A bank or mortgage originator lends you a large amount of money, which is secured by the house as collateral. In other words, if you fail to make your payments on time, the lender can foreclose on the loan and take possession of the property – as millions of homeowners have experienced in the last decade.

And yet there is a major difference between how private equity operates and how a family buys a home. Only a small part of the equity ownership acquired by any private equity fund comes from money provided by the partners who found and operate the fund. Most of it is raised from outside investors. (This would be like a family financing its down payment not from its own savings but from distant relatives about whom the family cares little.)

The fee structure in this overall arrangement is such that the people running the private-equity fund want to have as much debt as possible; this will increase the way upside returns are calculated, which in turn is the main driver of the compensation that the controlling “general” partners can receive. More debt, of course, also means more risk; but this is not a sector focused primarily on risk-adjusted returns.

If the company cannot make its interest payments, its assets will need to be sold or its activities otherwise scaled back. But, in contrast to the case of the struggling homeowner, not much of those downside costs typically fall on the general partner.

In addition, there are various other fees – charged to portfolio companies and to investors – that further encourage high levels of debt. The US tax code allows interest payments to be deducted as a business expense; there is no equivalent allowance for payments to equity investors.

Appelbaum and Batt document in impressive detail the way in which top-tier private-equity funds have been able to earn high returns and ultimately enormous wealth for their founders, while not necessarily helping the companies in which they invest. Interestingly, when returns are measured properly, the outside “limited” partners in private equity – including pension funds, insurance companies, and university endowments – also do not necessarily do so well.

However, before graduates flock to private equity, they should know that only the very big funds can use debt to skew returns for insiders in this way, primarily because only they can raise the capital needed to buy well-established companies that are rich in fixed assets, and thus in potential collateral. Smaller private-equity funds typically buy into younger, smaller companies without such fixed assets, and the leverage in those deals is commensurately less.

Regulators have recently woken up to the incentives for excessive leverage in this sector – and to the risks that such leverage poses to lenders and the broader economy. Not surprisingly, big private-equity firms seem determined to ignore or otherwise circumvent new restrictions. As the policy debate on this issue heats up, one hopes that all participants will become better informed by reading Private Equity At Work.

If the new graduate in your life has the connections to join a very large brand-name private-equity fund, the path to immense wealth, political influence, or even power becomes much clearer. Without such initial connections, however, it is very unlikely that he or she will become an oligarch. But you knew that already.