Why Private Equity Still Makes Us a Little Queasy

Whatever its other educational benefits, the race for the Republican presidential nomination has served to introduce legions of hitherto oblivious Americans to the joys and sorrows of private equity. Informed would-be voters now have a basic grasp of how the process works. A firm — let’s call it Bain Capital — raises a large amount of money from institutional and individual investors. Perhaps the endowment fund of your kid’s college, or your uncle’s public-employee retirement fund, or the wealthier partners of Bain & Co., the management consultancy. The PE firm then goes looking for a business it judges underperforming. If the auguries of “strategic due diligence” suggest a favorable outcome and bankers are willing to lend lots to help finance the deal, the PE masters of the universe acquire the property and put in place a “performance improvement plan” to make their new asset more profitable. Such plans frequently include giving managers financial incentives to do what they should have done before — concentrating on the most promising lines, selling off dud businesses, and “leaning down” operations, often including headcount. If all goes as planned, within five to seven years — the typical lifespan of each fund raised — the acquired business, now much improved, is taken public or sold, this for gobs more than was originally paid for it. The PE firm itself, already cushioned by an annual fee of 2% of funds under management, rakes in 20% of all profits on the deal above a nominal return rate for the limited partners. “Vulture capitalism,” as Governor Perry has suggested? Or merely good old Schumpeterian creative destruction at work, as, for instance, columnists in the Wall Street Journal would have you believe? Various academic studies are being cited on the net effect of PE on jobs, but it’s unlikely these will tip public opinion one way or another on the subject. In the meantime, Mitt Romney’s Republican opponents seem to be backpedaling on their criticism of his Bain Capital career, in service to the principle that free-market capitalism trumps any petty intramural disputes. You don’t have to be down on capitalism, or one of those loose-living European socialist types, to be given pause by certain aspects of private equity. I suspect that as the presidential campaign rolls on, at least if Romney is the nominee, more questions will be raised among the electorate, some along the following lines: Sure, PE fixes up ailing businesses, but does it really create anything new? We’re not talking about the next Apple or Google here. And no, Mitt’s example of Staples doesn’t really count; that more properly fits under the heading of venture capital, which is not what most PE firms engage in. These PE folks seem to increase the value of some businesses they acquire so much and so fast. Is something fishy going on? The WSJ cites one such example: Wesley Jessen Vision-Care Inc., where Bain Capital invested $6.4 million and realized a gain of $300 million (“Romney at Bain: Big Gains, Some Busts,” WSJ, Jan. 9, 2012) in about four years, which must have entailed one helluva profit-improvement plan. Or, a cynic might ask, did the PE smarties put one over on the people who sold them the business, and then again on the people who eventually bought it? They also really pile on the debt. “Private equity” is, after all, just the modern name for what used to be called the “leveraged buyout” business. The argument is that having lots of debt to pay off serves as an incentive for management to make the business more profitable, faster. But haven’t we learned in the global financial crisis that too much debt can sink a business, as it has in fact done in the case of some of the businesses that Bain Capital took through the PE process? PE people certainly pay themselves well. It’s the “2 and 20” compensation scheme, plus its favorable tax treatment, that lifts private equity out of the realm of Main Street capitalism, whatever that is, and into the realm of Wall Street or financial capitalism. This is a neighborhood shared with hedge-fund managers and investment bankers, not the types most of us think of as “running a business,” Romney’s self-described leading credential for higher office. They don’t appear to be in it for the long haul. While companies are born and die all the time, we share a sneaky, sentimental fondness for those that endure, and for the men and women who help them to do that. It’s no accident that Built to Last by Jim Collins and Jerry Porras is a perennial favorite among business readers. PE, in contrast, by virtue of the necessity to get out within the 5- to 7-year lifetime of the fund, is more like Keats’ Joy — its hand ever at its lips, bidding adieu. There but for the grace of God goes my not-always-completely-lean-and-mean employer. As we think about private equity I wonder how many of us feel slight pangs of guilt and anxiety wondering about how the enterprises we work for would fare if put through the PE drill. Would we wish that very clear-eyed, very hard-nosed brand of capitalism on ourselves?

Why Private Equity Still Makes Us a Little Queasy

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