A reader responded to my Hospitals & Financial Engineering post, where I made the case that hospitals should be protected from various financial engineering tactics that allow for short-term profits for investors that result in major challenges for the company in the long term. From my post:

”I'm a big fan of capitalism, and I generally support the work of private equity firms in delivering returns to their shareholders, many of which are large pension funds, endowments, and foundations. But Steward's collapse is an important signal that our most important and prized institutions shouldn’t be operated as attractive targets for short-term, financially engineered profits.

Hospitals are different. They're a special thing. And regulators should ensure they're treated that way.”

The reader asked: Shouldn't these regulations apply to every company? Why just hospitals? Should private equity investors be allowed to hurt any company in the interest of taking their own short-term profits?

It was with this question in mind that I came across this piece in the WSJ, titled Private-Equity Firms Desperate for Cash Turn to a Familiar Trick. The piece points out that private equity deal volume is way, way down since the increase in interest rates. There just aren't that many deals happening in this environment which is making the investors that invest in private equity firms rather anxious. They'd like to start to see some returns and get some liquidity. Because private equity is illiquid and doesn't trade in the public markets, these firms can't get their investors liquidity until they sell the companies they invested in. But this isn't a great time to sell; it's hard to do because of the low volume, and you might not get a great price.

So, to give their investors liquidity, private equity firms are doing what's called a dividend recapitalization. That is, some firms are having their companies take on a large amount of debt and then taking the cash and giving it to their investors in the form of a dividend. From the piece:

”Among the largest dividend recaps so far this year is a $2.7 billion recapitalization by auto-body repair center Caliber Collision, according to data from PitchBook LCD. The company is backed by investors including the private-equity firm Hellman & Friedman. A report from S&P Global Ratings said the money was used to pay existing debt and distribute a $1 billion dividend to its equity holders.

In March, rail and transportation services company Genesee & Wyoming completed a roughly $2.7 billion recapitalization. The company, backed by investors including Brookfield Infrastructure Partners, used the transaction to pay a $761 million dividend, according to S&P.”

So investors get some short term return and liquidity without the PE firm having to sell the company. This leaves the company with a new, potentially very large debt obligation without a corresponding asset to show for it. So you're potentially hurting the company in the long term in the interests of short-term profits for investors.

Similar to the point I raised in the hospitals post, are these transactions that benefit investors in the short term at the cost of the company's health in the long term ethical?

Rather than answering that question directly, I think it's worth first asking who a company is meant to serve. A company isn't a living thing, so it technically can't be hurt by or benefit from such decisions. What a company actually is is a set of stakeholders who have an interest in it: leadership, employees, investors, vendors, customers, and the community.

That's a lot of stakeholders with different incentives and different desires and timelines for the company. Who should the company serve first?

The technical, business school answer is that a company's purpose is to maximize returns for shareholders. Not employees. Not management. Not future investors. So if you believe that, and the company's board believes that taking some cash out of the business — by putting a lot of debt on the balance sheet that might harm employees in the long term and might result in less return for future investors — is good for current investors, then that's what they should do.

Again, without taking a side in these debates, the point I'm trying to get to is that as an investor or operator, it's important to zoom out and remember who the company is trying to serve. The answer can be different depending on a variety of factors such as its industry, stage, and the way it’s financed. And seeing these very public financial engineering tactics brings this issue front and center. Getting alignment and transparency around this point is crucial in aligning all stakeholders and managing difficult tradeoffs so management and boards can make good, consistent, clear-minded decisions in the short and long term.