Good Leverage, Bad Leverage and Bain
Anthony Gardner’s critique of Bain Capital’s investment strategy, which Bloomberg View published on July 15, raises some valid concerns about the way private equity firms like Bain make money. Yet it conflates some effects of Bain’s investments that were problematic with others that were not.
Gardner notes that Bain under Romney made profits:
... in large part, through heavy use of tax-deductible debt, usually to finance outsized dividends for the firm’s partners and investors. When some of the investments went bad, workers and creditors felt most of the pain. Romney privatized the gains and socialized the losses.
Some of Gardner’s op-ed focuses on the losses experienced by bondholders when Bain leveraged up firms that then went bankrupt. But it takes two to tango: Nobody made anybody buy bonds in a firm going through a leveraged buyout. Increases in leverage are supposed to lead to a higher risk of bankruptcy, which is why "junk" bonds have their name and bear such high interest rates. Losses borne by bondholders are not socialized -- they are borne by bondholders, who agreed to take on risk when they bought the bonds.
The tougher issue is financial losses borne by workers, pensioners and the government. Bankruptcy makes it possible to impose concessions on employees that they would not otherwise face. Union contracts can be modified in bankruptcy. Even where there are no contracts, financial distress provides an argument for wage cuts that otherwise might be impractical for reasons of employee morale. Bankruptcy also makes it possible to renege on promised pension benefits, some of which are then paid for by taxpayers.
While bondholders respond to an increased risk environment by demanding a higher interest rate, workers and retirees generally are not in a position to do the equivalent. Added risk of bankruptcy accrues to workers, but the offsetting benefit goes to the firm's shareholders (or its customers). This is a problem, but it’s not entirely clear what should be done about it. Are firms morally obligated to have whatever amount of leverage best serves the interests of these other “stakeholders” -- which, in the case of pensioners, would likely be zero? How much risk of bankruptcy can a firm’s equity owners ethically impose?
Then there is the issue of the Pension Benefit Guaranty Corporation -- when a firm goes bankrupt with an unfunded pension liability, this government entity takes on much of the responsibility for paying pension benefits. The more likely a firm is to go bankrupt, the more valuable that insurance is. The correct way to deal with this is tighter pension regulation, forcing firms to properly fund their pensions so that unfunded liabilities left for the PBGC are small. Unfortunately, Congress has recently moved in the opposite direction.
Finally, Gardner raises the specter of plant closures and other job losses brought on by bankruptcies. But in general, bankruptcies induced solely by increased leverage should not lead to the closure of financially viable enterprises.
There are two types of corporate bankruptcy in the United States: Chapter 11, which is for reorganizing viable enterprises that cannot meet their debt and other obligations, and Chapter 7, which is for liquidating firms that are worth less than the sum of their parts. If the only thing wrong with an enterprise is that it carried too much debt, bankruptcy should mean reorganization, not liquidation.
Now, it is likely that Bain’s leverage, on some occasions, exposed the fact that certain enterprises ought to be liquidated. A firm and its owners might, for reasons of inertia or mismanagement, continue to operate a business that could be more profitably shuttered and liquidated. Bankruptcy would likely force their hands.
The closure and liquidation of such operations isn’t a bug of private equity -- it’s a feature. As the econoblogger Noah Smith points out, the alternative to a business culture where people stop doing things that don’t make enough money is one where they keep doing things that don’t make enough money. That’s worse, notwithstanding the local costs of plant closings.
Gardner is right that the Bain model of private equity involves a lot of risk shifting among the various parties that are involved in a corporation. But there’s nothing wrong with shifting risk between stockholders and lenders who willingly enter leveraging transactions. The questions of risk shifted to employees and retirees are real, but narrower, and it’s not obvious what they tell us about how much leverage is too much.
(Josh Barro is lead writer for the Ticker. Follow him on Twitter.)
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