By James Kwak
Recently, a lot of the political debate has been about whether private equity—and by extension Mitt Romney—is good or bad. The argument on one side is that private equity firms are vultures who destroy firms to make money; on the other, that private equity is just capitalism at work, creates value, and creates jobs.
A private equity firm is an asset management company. It creates investment funds that raise most of their money from outside investors (pension funds, insurance companies, rich people, etc.), and then manages those funds. As opposed to a mutual fund, however, instead of buying individual stocks, these funds usually make large investments either in private companies or in public companies that they “take private” (more on that in a minute). While mutual funds and most hedge funds try to make money by guessing where securities prices will go in the future, private equity funds try to make money by taking control of companies and actively managing them. (There is a bit of a spectrum here, since mutual funds and hedge funds can exercise pressure on company management and private equity funds do take minority positions, but that’s the ideal-typical distinction.)
A private equity firm is just a rebranded version of what were called LBO (leveraged buyout shops) in the 1980s, before they got a bad name. The classic transaction is to take over a company by contributing a small amount of equity and borrowing a lot of money. So if a company has $100 in assets, $100 in equity, and no debt, a private equity fund might chip in $20 in equity and then borrow $80 in the credit markets. That $100 in cash goes to buy out all the current shareholders, so the private equity fund now has 100% ownership of a company that has $20 in equity and $80 in debt—and the debt is owed by the company, not the private equity fund. (The 100% ownership means the company’s stock no longer trades, hence the “going private.”) Because of that leverage, small increases in company value mean high returns for the private equity fund: if the company’s value goes up by $20, from $100 to $120, the value of the equity doubles, from $20 to $40, because the burden of debt remains fixed in nominal terms.
The argument for private equity is that it increases the value of companies. In practice, if a company’s market value is $100, the private equity fund will have to pay a premium to buy it—say, $120. Then, for the fund to make money, it has to increase the company’s value up above $120; otherwise, the fund will lose money on the deal. And in principle, if you can take some set of assets and make them worth more than they were worth before, that’s a good thing.
And in a frictionless world, this would be true. But that’s not the world we live in.
The discussion of the power of leverage above should have reminded you of something: the credit bubble and financial crisis. Leverage means higher expected returns, but it also means higher risk, transaction costs, and the potential for looting. So, for example, a private equity fund could use $20 to take 100% control of a company with $120 in assets (by making the company take on $100 in debt). Then it could use that control to liquidate assets and pay itself $30 in cash, giving it an instant 50% return; since there aren’t enough assets left to pay off the creditors, the company could then go bankrupt. Taking a company with ongoing operations and forcing it into bankruptcy generally destroys value, not only because of transaction costs but also because the whole point of a company is to have ongoing operations that are worth more than its assets.
And this happens, though not as nakedly as in the example above. In 2003, for example, THL bought Simmons (the mattress company) for $327 million in cash and $745 million in debt. In 2004, Simmons (now run by THL) issued more debt and paid a $137 million dividend to THL; in 2007, it issued yet more debt and paid a $238 million dividend to THL. Simmons filed for bankruptcy in 2009.
Now, if we had perfect capital markets, this couldn’t happen. Investors would not lend money to a company if they knew that both (a) the cash was going straight through to the private equity fund that owned it and (b) the company would be unable to service the new debt. But if we had perfect capital markets, the housing bubble couldn’t have happened, either. Instead, during the credit bubble, banks were falling over each other trying to lend money into private equity deals, whether as syndicated loans or as bond offerings. There was too much money going into private equity deals just like there was too much money going into mortgage-backed securities, and for the same reasons: bankers whose bonuses were based on up-front fees that were in turn based on deal size; credit rating agencies that were either too clueless or too corrupt to see what was going on; bank sales forces that pushed debt into investors hands; and investors who didn’t read their prospectuses, didn’t understand what they were doing, or had too much faith in Alan Greenspan.
With perfect capital markets and perfect monitoring, private equity firms probably would be a good thing—but so would credit default swaps and collateralized debt obligations. In the real world, it’s much less clear. When it’s easy to make money just by piling on debt and paying yourself hefty “dividends” and “fees,” why go to the bother of actually making a company better? In that case, it’s simply a case of shareholders (private equity funds) taking money from creditors, with employees left as collateral damage.
So what should we make of the private equity kings themselves, since this whole debate is really about Mitt Romney? The good ones are good at making money for their investors (the people who invest in their funds), which in practice means a combination of both improving undervalued companies and raiding them to transfer cash from the company treasury to their funds. In this respect, I’m not sure they’re that different from most of the class of people we call “bankers”: they do a job that is good for society in principle, but in practice is more ambiguous; some contribute more to society than they take out, some take out more than they contribute.
I have no idea which category Mitt Romney falls into. Personally, I’m less concerned about the fact that he was a Bain Capital executive than by (a) his positions on virtually every significant policy issue and (b) the fact that many of those positions have complete shifted since he was governor of Massachusetts.