Siphoning Value through Captives: Private Equity and Securitization

Yves Smith has a fascinating post about how private equity firms (which, as she notes in the comments is largely a polite rebranding of "leveraged buyout firms") charge fees for services provided by captive affiliates to their portfolio companies.  On some level none of it is anything so new--part of the LBO game has always been to suck out fees and dividends from the target company, while gambling that the target would be able to service the debt incurred for its acquisition.  Even if the target goes bankrupt, the LBO sponsor may have still made money because of the fees and dividends. 

What I thought was really interesting here was to see the parallel with the private-label mortgage securitization market.  

In securitization, as with private equity, investors have very limited ability to see into the financial details of the operations.  It makes it very difficult for investors to know if their economic agents—the servicers or the private equity firms—are siphoning away value.  Thus, RMBS investors lose out when servicers use captive insurers for force-placed insurance and captive property management company to winterize or sell a property--all at much higher than arms-length prices.  Those are costs that the servicer recovers and which reduce the RMBS investors' recovery.  Same deal with private equity--the sponsor has a contractual 2 & 20, but to the extent that funds are siphoned out of the portfolio companies through captive fees, the portfolio companies will be less valuable. 

Missing in both situations is some sort of truly independent and motivated monitor.  For RMBS, this is the problem of the do-nothing trustee,.  Private equity doesn't have any such monitor.  The only discipline is, in theory, the market, as PE firms that siphon off too much value will have lower returns to investors.  But if all firms are engaged in this sort of behavior (and of course they would be because it offers immediate concrete benefits, rather than uncertain long-term benefits), then it's not clear how much good market discipline will do.  One would hope that if the returns get low enough that investors would bail from private equity, but who knows.