SOME STRAIGHT, IF NOT NECESSARILY PLAIN, TALK ON PRIVATE EQUITY

1/17/12

Anyone sentient has noticed the brouhaha being raised of late about presumptive GOP presidential nominee Mitt Romney’s career with Bain and Company in the adventurous and stimulating world of private equity.

I don’t pretend to be an expert on private equity, but, many years ago, I was at least anicillarily involved, as what best could be described as a very close spectator, in what we now call the private equity world. This was in a perhaps more honest age, back when “private equity deals” were called “leveraged buyouts,” or simply “LBOs” and “private equity firms” were called “LBO firms.” Yes, I realize that the change in terminology may have roots that transcend semantics. Some private equity deals, and more now than back when I was looking at the debt in these deals, are done with more equity than debt, but one has to emphasize the adjective “some.” Equity only, or even equity rich, private equity deals are rare, at least when measured in relative dollar terms, both because the size of such deals is limited by the availability of capital and because it is difficult to make such deals work for reasons outlined in the next paragraph. Further, having at least some experience with what is now called private equity, my level of interest and ability to comment intelligently on l’affaire Bain, or at least on what private equity activity does and does not do, exceeds that of the typical observer…and most of the candidates and their henchmen who are throwing Bain bombs Mitt Romney’s way. So a few thoughts from somebody who, unlike most of the commentators on this subject, knows something about private equity:

Listening to Mr. Romney and his acolytes crow about how “they turned companies around” or “saved failing companies” when the former governor was doing private equity deals sounds at least disingenuous to those of us who know something about how these deals work. Private equity deals do not work, contrary to the arguments on both sides of the issue, because expert management is brought in (Generally, the old management is retained and brought in as partners in many, if not most, LBOs, er, sorry, private equity deals.), enlightened Harvard MBAs deign to share their vast knowledge with the benighted who have actually worked in the industry at hand for, in many cases, longer than those wunderkinds have been alive, or even because costs, and, of course, payrolls are chopped with a degree of ruthlessness that would make Ming the Merciless envious. No, the typical private equity deals don’t turn companies around or spawn new companies (The latter is the work of venture capital companies, and, in its defense, Bain did do some venture capital work). A typical private equity deal works thusly: A company, usually a modestly successful concern with a presumably underpriced stock rather than a failing company, is purchased with very little equity and, to use a technical term, a ton of debt. The management, as mentioned before, is given, or buys, a large equity stake and is left in charge of the company. The company continues on its modest growth path. Due to the brobdingnagian amount of debt used to purchase the company, and the magnifying effect debt has on bottom line earnings growth, the benefits of that modest growth accrue to the equity holders in proportions that couldn’t be imagined under a more conventional capital structure. Without launching into a finance lecture, more debt results in higher fixed costs, in this case, higher fixed financing costs. Once that “nut” is covered, any additional earnings and/or cash generated from operations flows to the equity holders, of whom there are fewer with less money on the table; i.e., financial leverage (debt) magnifies earnings and cash flow increases for the benefit of the new owners, i.e., private equity firm, its investors, and its management partners. After a few years of increasing bottom line earnings and/or cash flow, the company is sold, either to a strategic buyer or another financial buyer, and the private equity investors cash out, hopefully at a substantial profit, and move on to the next deal.

Note that, for these deals to “work,” operating performance does not necessarily have to be improved; it merely has to be sustained. Financial leverage takes over from there. Often, earnings are enhanced by cutting costs (i.e., laying off workers), selling assets, or both. But such cost cutting at the operational level is not necessary for these deals to work. What private equity investors bring to the table is neither the operational brilliance its fans would have you believe nor an especially virulent strain of the kind of misanthropic blood lust that private equity’s more ardent opponents believe runs in the veins of all capitalists, but, rather, a degree of facility with financial engineering. In other words, private equity investors typically do not have much impact on operational performance; they do have an enormous impact on a company’s financial structure. In still other words, private equity investors do most of their work on the right hand side of the balance sheet rather than on the left hand side. This financial machination is where the fortunes are made, and not just for the private equity investors, but also for the shareholders of the acquired firm, the Wall Street firms who facilitate the levering of these deals and do the M&A work, pension funds and other investors who take part in the deals, the managers who go from being high income individuals to enormously wealthy individuals, and hosts of others. The losers, of course, are the workers who lose their jobs if the private equity owners choose to attempt to enhance their earnings by cutting costs, as is being trumpeted by those who are attempting to make private equity a campaign issue but, again, such cost cutting is not necessary to make these deals work; what is important in a private equity deal is the financial, not the actual, engineering.

Almost as an aside, financial leverage has the same magnifying effect on decreases in operating earnings that it has on increases in operating earnings. Debt, needless to say, adds risk as well as opportunity. This is why so many private equity deals fail, in some cases while the private equity firm still owns the company, in others after that firm has sold the usually debt ridden company to a buyer who suddenly discovers that the debt taken on to enable the original private equity transaction was unsustainable. This is why when one hears from Mitt Romney’s defenders, even those who should, and probably do, know better that failure is just part of the free market, one suspects that those making such an argument are ignorant, uninformed, or being disingenuous. Failure is an inevitable part of the free market system; indeed, capitalism without failure is akin to Christianity without hell. But private equity deals that saddle target firms with inordinate amounts of debt expedite such failure or, in some cases, cause the failure of firms that could have survived, indeed, were thriving, under more conventional capital structures.

One also tires of hearing defenders of Mitt Romney, Bain Capital, and the private equity world castigate attacks on private equity as socialistic assaults on “the free market.” Private equity is indeed part of the free market and a necessary one at that. (See the next paragraph.) But it is not “the free market,” only a component of the free market. One can be leery of the salubriousness of private equity activity without being a card carrying Communist.

Having written all of the above, I, like most clear thinking observers, am not opposed to private equity deals, private equity firms, or the private equity world. Private equity activity is indeed a necessary tool in the ongoing effort to keep managements, primarily of publicly traded firms, focused on their primary, most would say only, mission; i.e., enhancing shareholder value. Many managements forget that they are not, except in a limited sense, the owners of the companies they manage; they work for the owners, i.e., the shareholders, of the companies they manage. When managements neglect the interest of their shareholders, the companies they manage can quickly come to the attention of private equity types who will do what is necessary to make sure the value, or at least more of the value, of the firm finds its way to the shareholders. That having been said, however, this argument quickly falls apart when one considers that a great many (but not all) private equity deals, as noted above, involve leaving the former management in place. But at least theoretically, a market in which private equity firms are free to pursue their own interests, and, as a consequence, the interests of the shareholders of the companies they seek to buy, is a healthier market than one in which private equity activity is discouraged, or worse.

So private equity activity is not a savior of endangered companies, a spawner of new companies, or a creator of legions of jobs, as its proponents, and Mitt Romney’s supporters, would have us believe. Nor is the very embodiment of the free market system. But neither is private equity some sort of plague infecting our economy, the very personification of a Snidely Whiplashesque approach to the free market in which bulbously proportioned capitalists feast on the carcasses of the working class, as its opponents, and presumed nominee Romney’s challengers, would have us believe. Private equity is far more complicated than that, but it is primarily the application of financial engineering to modestly successful concerns in an attempt to make money for the financial engineers, sometimes, but not always, at the expense of workers and communities. Private equity also serves, at least theoretically, a vital check function on the machinations of managements, helping to keep managers focused on the interests of their employers; i.e., the shareholders of the firms they run. Bear in mind, when considering this last point, that we can’t rely on pure motives to bring about good outcomes; Francis of Assisi has long ago gone home, and there haven’t been many more like him since he abandoned this mortal coil. One of the many beauties of the free market is that it enables people to help others by pursuing their own interests, i.e., to do well by doing good. We would do well to avoid unnecessary, if well meaning, constraints on the mechanisms that facilitate this function.