Targeting Private Equity is Bad Politics

“In short, private equity buyouts catalyze the creative destruction process in the labor market, with only a modest net impact on employment.”

US Census Bureau for Academic Studies, October 2011

For a publicity shy industry, private equity has been attracting an enormous amount of attention lately. Given Governor Mitt Romney’s background as the founder of one of the industry’s leading players – this is hardly surprising. What I’m not sure anyone was expecting though was that the  Obama Administration, Democratic National Committee and liberal Super PACs would whip up an anti-private equity media firestorm. The end goal has been of course to question Governor Romney’s fitness to lead.

Following on from negative campaign attacks on Governor Romney’s private equity background by President Obama and Vice President Joe Biden, sanity was briefly injected by the left into the debate by Democratic Newark Mayor Cory Booker on Meet The Press – comments which he subsequently walked back – and finally and most authoritatively by President Bill Clinton on CNN. However, viewers would have turned off their tv sets and put down their newspapers this weekend none the wiser about the role of private equity or Bain Capital in the economy.

Leaving the politics to one side, there are three separate issues in play. Firstly whether or not private equity is a force for good or for evil. Secondly, whether private equity in general – and Bain Capital in particular – creates or destroys jobs. Thirdly, whether his track record at Bain qualifies Governor Romney to be President. I am hopeful that clarifying the facts will help us to move past these issues and focus on matters of substance.

First. Whether or not private equity is a force for good or for evil presupposes a clear understanding of what private equity is and what Bain Capital does. However, neither the Administration nor the Romney camp, let alone the media, appear interested in educating the public about private equity. No-one has talked about the need for failing companies to be turned around or shut down in order for sustainable businesses and jobs to be built; of the thousands of jobs created in the technology, life sciences and clean-tech sectors in companies funded by private equity; of the essential funding gap in the capital structures of SMid cap companies provided by mezzanine investors as traditional banks have pulled back from lending activities.

Private equity (PE) investors generally provide capital to private companies in exchange for equity or equity-linked-securities – in most cases the private companies are early stage with a limited track record or they are established but financially troubled companies. Private equity capital is used for working capital, to expand, recapitalize, or in some cases to cash out existing shareholders and take control. Private equity investors generally have a 5-10 year investment horizon then look to exit their positions via an IPO or trade sale etc. Unlike most public company investors, private equity investors will often take seats on the company’s board, help develop business plans, introduce new staff, advisers and so on. It is a painstaking, illiquid (hard to exit or sell) and very risky business – many firms fail, others succeed spectacularly.

As someone who has worked in the alternatives industry (private equity is considered by many to be an ‘alternative’ investment like hedge funds, real estate and more esoteric asset classes) for the past 15 years or so, I should declare my bias; I firmly believe that the private equity industry performs a valuable economic function within a democratic capitalist system. There is no doubt that some LBO deals have vastly over-leveraged target companies and that cash flows have been structured to advantage the financiers at the expense of other stakeholders – such as employees. Equally though, it is important to realize that private equity exists because new and emerging companies or financially troubled established companies lack access to ‘traditional’ capital and management expertise. This capital funds innovation and job creation in sustainable companies.

Private equity has represented an increasing proportion of institutional investors’ portfolios in recent years – to as much as 9% of total U.S. public pension fund assets according to Cliffwater (that’s about $300 billion). To institutional investors such as pension plans, foundations and endowments and family offices, private equity represents a valuable asset class. For example, the long term investment horizon (5-10 years) is suited to long duration plan liabilities, the close relationship with a select group of GPs makes due diligence relatively simple, and the strong absolute returns and lack of correlation to traditional investment exposures across the plan provides powerful diversification at a portfolio level.

So how does Bain Capital fit into the picture? Bain comprises 5 separate businesses, running about $65 billion with approx 800 employees and offices in 4 US locations, 3 in Europe, India and 3 in Asia. While Bain has participated in several large LBO club deals, its business model is diversified across the entire private equity spectrum as well as public equity investing and specialist credit.

Bain Capital Private Equity – has launched 10 funds and more than 250 investments including LBOs and and recapitalizations. Check out the list of portfolio companies on Bain’s website which includes Dunkin’ Brands, Burlington Coat Factory and Toys “R” Us to name just a few. Brookside Capital makes public equity investments (both long and short). Sankaty Advisors runs approximately $15.5 billion across credit, distressed, mezzanine and structured products. Bain Capital Ventures has provided over $2 billion in venture capital to more than 70 active portfolio companies. Absolute Return Capital – invests across fixed income, currencies, commodities and equities.

Second. Does private equity create or destroy jobs and what is Bain’s track record in this area?  While both sides of the political debate will continue to trumpet particular deals that have led to outside job growth on the one hand or plant closures and lay-offs on the other, the truth is that the wider question can not be rationally answered by reference to individual transactions.

Private equity has created many millions of jobs (over 8 million according to the Private Equity Growth Growth Council), while at the same time spurring corporate restructures, sales/ divestitures, and the occasional bankruptcy that have shed a large number of jobs. This is the whole point – private equity is a conduit of what Schumpeter called ‘Creative Destruction’, that process of industrial mutation ‘… that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one’. If you believe in capitalism and free enterprise then you must logically support the disruptive, innovative role of private equity.

For anyone wanting to research this topic further I can suggest:

• World Economic Forum Working Paper on Private Equity 2010; key findings include:  “Industries where private equity funds have been active in the past five years have grown more rapidly than other sectors, whether measured using total production, value added or employment…Activities in industries with private equity backing appears to be no more volatile in the face of industry cycles than in other industries, and sometimes less so. The reduced volatility is particularly apparent in employment.”
• Private Equity and Employment (Oct 2011) – US Census Bureau for Economic Studies Paper No. CES-WP-08-07R;  key findings include: “In short, private equity buyouts catalyze the creative destruction process in the labor market, with only a modest net impact on employment.”

While I have not done the analysis, my hypothesis is that if you look at the totality of the transactions Bain’s five businesses have been involved with since inception of the firm, you would find that many jobs have been created and many jobs have been lost or reallocated. I also strongly suspect that you would find Bain’s influence has resulted in stronger, more enduring enterprises on the whole. This point has been missing from the debate. Those who think that a firm can consistently rape, pillage and plunder companies and build a long term sustainable franchise are not living in the real world. PE is about putting long term capital at risk and building sustainable businesses in partnership with management and other stakeholders. The institutional investors backing Bain and other PE houses – particularly public pension plans – provide another check on GP behavior. A GP’s end goal of course is ultimately to exit a portfolio company having built a sustainable business, returned strong IRRs to investors and been paid handsomely for its good work. There is no doubt that Bain has done well on this score.

Third. Does Governor Romney’s tenure at Bain qualify him for the Presidency? So what actual objections have been raised? Both the President and Vice President have stated that running a business with the objective of maximizing profits is totally different to running a country for the benefit of those unable to or unwilling to look after themselves. The VP went as far as to say that Governor Romney’s private equity experience makes him no more qualified to lead than a plumber. Really?

There are two issues here. Whether private sector experience is relevant to running the country in general and whether private equity in particular deserves singling out. There is no doubt that running a country and running a corporation are different. However do the leaders of the free world seriously believe that ALL business leaders should be disqualified from the Presidency? From public office? Surely this is completely unjustifiable as the similarities between running a global business and a country are too great to ignore. Leadership, team-building/ human resource management, stakeholder collaboration, capital structure and balance sheet management, communications, production, distribution, foreign relationships etc. are all shared practices.  Secondly, singling out PE makes no sense as all companies exist to generate profits for their owners. At a time of economic malaise, the essential role of PE in funding innovation, turning around failing enterprises by streamlining, re-financing and operating the business more efficiently, and funding mid-caps unable to obtain traditional financing, makes a strong argument that PE experience would bring some essential corporate acumen to public policy.

Nonetheless this is clearly a wrong-headed issue for the media to be focusing on in isolation. It is the entirety of the Governor’s experience – from founding and managing Bain Capital, running the State of Massachusetts, to turning around the Salt Lake City Winter Olympics – that deserves voter scrutiny. As far as founding Bain goes, demonstrating the capability to build an enduring franchise of the highest quality and orchestrating numerous creative, and on balance successful private sector transactions, would surely give voters of all political stripes cause to at least think – wow, I may/ may not vote for him, but Governor Romney is a clever, successful guy with a lot of corporate experience.

So where is this debate heading? First. President Clinton’s strong defence of PE last week signalled that the Administration/ DNC cannot continue to campaign on an anti-private equity/ anti-free enterprise platform. Capitalism and ‘can do’ entrepreneurialism are woven into the American spirit. Private equity is a disruptive, innovative force for capitalism. It is neither ‘good’ nor ‘evil’. It has become an essential part of a democratic capitalist system. Failing to recognize this should give voters pause to question the Administration’s economic thinking and basic common sense.  Second the argument that PE in general and Bain in particular have destroyed jobs not created them, just is not backed up by the facts or academic support. This won’t stop both sides campaigning on the merits/ downside of specific transactions. The GOP will be quite happy with jobs and wider economic backdrop being the focus of the campaign. So in some respects they may try to keep the PE issue front and center for as long as possible. Lastly, it would be madness for the left to continue to question Governor Romney’s fitness to lead based on his private sector experience – a broad coalition of voters will see the value of having a senior business figure with broad public experience in the White House at a time like this. More to the point, the Governor has a much broader and more relevant background and skill-set than President Obama did when campaigning as a junior senator and local community organizer 4 years ago. It seems to me that the left is skating on thin ice.