What Is Private Equity All About, Anyway?

by John Hinderaker in 2012 election, Economy

Most people are hampered in trying to evaluate the smears that have been directed at Mitt Romney and Bain Capital by leftists, abetted by Newt Gingrich and Rick Perry, because they lack any clear idea of what Bain and other private equity firms do. So I asked a friend who is an extremely sophisticated participant in the world of finance to explain private equity to our readers. He articulates succinctly why the charges being leveled against Bain and Romney are bogus:

I have been a banker and investor in private equity for two decades. Bain has been one of my many clients, and I’ve also worked with companies that sit on the other side of the table from Bain and other private equity funds. Attempts to characterize Mitt Romney and/or Bain Capital as “corporate raiders” or “vultures” will ultimately fail the test of facts, analysis, and fairness.

Private equity firms differ in a few respects from their public-investing brethren like Fidelity, T. Rowe Price, etc., but they are ultimately the same animals: they are looking to deploy equity capital for a return commensurate with the risk they are taking on. They invest on behalf of individuals, pension funds, insurance companies, and charitable foundations, like universities and hospitals, who trust them to manage their money for a decent return. Like any investor, Bain makes good bets and they make bad bets.

The key difference is that private equity funds tend to invest in shares that are not listed on stock exchanges and they often invest a large single amount so as to control the companies they invest with — although there are many exceptions to those rules. Bain, in particular, does a significant amount of non-control investments in companies (such as LinkedIn). In any event, they are singularly focused on getting their investment dollars into good companies, not bad ones, and backing exceptional management teams that are focused on running healthy, profitable companies. To paraphrase Samuel Gompers (the founder of the American labor movement): the biggest enemy of the working man is an unprofitable, poorly-managed company. He would applaud Bain.

What Bain Capital is NOT is a highly regulated entity, like a bank and brokerage, that also has access to the Fed borrowing window. Bain does not speculate, hedge, create new financial instruments, etc.. So while I might quibble with Romney saying he was not on “Wall Street,” the reality is Bain is NOT directly part of the thin-air, money-creation industry that everyone from Ron Paul to MoveOn.org has justifiable concerns with. Of course the biggest recent funny money operators have been Obama with his 100B per month deficits and Helicopter Ben who buys the debt via the fed printing press to keep interest rates low — but that is a topic for another day.

Critics might argue that by controlling their investments, private equity funds have an incentive to saddle their companies with debt and/or management fees and “loot” their companies. The main problem with this theory is: where is the advantage in stealing from yourself? Cash out equals a one-to-one reduction in the equity value of your holdings.

Moreover, private equity is an extremely competitive business and good managers are a highly sought-after commodity. The best industry managers (and those that follow these leaders) have ZERO incentive to go work for a company and shareholders in the business of cutting off their noses to spite their faces.

There may well be companies with assets and organizations that are simply unrecoverable, but that is more a function of uncompetitive costs, technology disruption, changes in consumer preference etc. These are the LAST companies that Bain and its brethren will look to put their money in, with the rare exception when they believe they can extend an “end of life” business and save related jobs.

Moreover, private equity has been a critical check on the 1970s-style under-performing, over-paid, entrenched public company management. All the teeth-gnashing about incompetent CEOs getting paid enormous sums by rubber-stamp boards goes away in the private equity environment.

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