By: Sam Kinsman
Mitt Romney has been the steady presidential candidate during the GOP primary season, leaving his opponents seeking sources of criticism for the Massachusetts governor. In the absence of more major points of attack (such as past DUIs, secret second families, or notorious divorces and marriages), Romney remains a relatively squeaky-clean candidate for the Republican nomination. As his opponents vie for the top spot, however, they have focused in on what many have determined to be negative attributes of Romney's past: his role as the head of the private equity firm Bain capital and his enormous wealth (estimated at several hundred million dollars) that largely resulted from this post.
The issues of whether a president should be wealthy and whether Romney has too much money are individual choices that need to be made by voters. A candidate's professional experience, however, is very important if we are to understand what kind of transferable skills and experience he or she will bring to the table as a presidential candidate. To understand Romney's skills and the attacks on his experience, it is essential to ask the questions: what is private equity, and why is it important in the 2012 presidential race?
Private equity in its modern form (also called the leveraged buyout industry) came to the spotlight during the famous boom days of Wall Street in the 1980s. The idea was simple: 1. Buy poorly run, struggling companies; 2. Make them better (finance people love the term “creating value”); and 3. Sell them later at a higher price (because they are worth more) to make money for investors. Though the industry has developed with new technology and private equity is now thought to include other types of investments (venture capital, mezzanine capital, growth capital, etc.), this original model of the industry remains essentially unchanged. The criticism of Mitt Romney's role in the private equity industry comes from each of these three steps.
Step 1: Buy struggling, undervalued companies. Finding poorly run companies is not a very difficult task. With today's technology, anyone can see which public companies are losing money by reading their quarterly and annual financial reports online or by picking up a nearby copy of the Wall Street Journal or New York Times. After the private equity company selects the company it wants to buy, it has the challenge of finding the money to make the purchase. This is where debt comes in. Private equity firms use both funds they have raised from investors and debt (called leverage) to make the purchase. To the consumer working to pay off their mortgage, car loan, credit card, or student loan, this can seem counterintuitive. Why would any company want to voluntarily take on debt to make the investment? The simple answer is that using debt allows the private equity company to make more money for its investors by increasing their return on equity. To see why this is a good thing, keep reading.
Step 2: Make the company better. In much the same way as a person who buys a broken car to fix up and then sell, this step involves the private equity firm using its expertise to imp
rove the company it now owns. This simple idea, however, becomes much more complicated when put into practice. Many people ask how a group on the outside (the private equity firm) can know how to run a company better than people who have worked there for their entire careers. This is where the skill and experience of the private equity firm come in. Successful firm leaders like Mitt Romney spend their careers developing skills and strategies to turn around failing companies. The accumulation of their experience and outside view bring fresh perspectives.
Step 3: Sell the company at a higher price. After a lengthy period (usually 5-7 years), the private equity firm has improved the company they purchased and are ready to sell. This improvement is not self proclaimed, but rather proven by the increased price the market is willing to pay when the company returns to the public in an initial public offering (IPO).
If this is the essence of a private equity transaction, what then is the problem with private equity? What are the sources of criticism that have led to Romney's opponents calling him a “job killer” and claiming he plundered companies for years to become rich? The answers rely on misrepresentation of the details. For example, step 2 involves the private equity firm improving the poorly run company. In many situations, this step involves cutting excess costs and these costs can include the wages of excess workers. While the job loss for the few workers who are let go is a very real consequence, the jobs of a vast majority of workers are often saved in the long run by turning around a failing company that may have gone out of business.
What about the exploitation of companies to make the private equity firms and their owners rich? It is true that when firms successfully complete steps one through three, they will be compensated for making successful investments and retuning profits to their investors. For the largest firms (including Bain Capital), this compensation can be hundreds of millions of dollars. Stating it in these terms fails to portray why this is a good thing for society. The largest investors in private equity firms are often pension funds (such as the California State Teachers Retirement System) and university endowments (such as Harvard's endowment fund). These institutional investors need successful investments to continue to support programs of public employees' retirement and the expansion of university education. Furthermore, private equity firms are usually paid on a system called 2 + 20 with an 8% hurdle rate. This means that private equity firms take a small management fee (2%) for their work (steps 1-3) and only take part in the profits if they are successful in making money for the investors (20% of returns over 8%). This means they do not get paid if they do not perform.
What does this indicate about Gov. Romney's experience to be an effective president of the United States? This answer to this question remains the responsibility of the voters to decide. It is undeniable, however, that success in the competitive private equity industry is earned by brilliant, skilled firms who have the expertise and the boldness to take risks in order to create value. By many measures, the United States is struggling to tackle its problems of unemployment, public debt, and economic growth. A successful leader in the complex private equity industry like Mitt Romney might have the skill, leadership, and boldness to turn the country around to a brighter future.