Romney Honed the Right Skills in Private Equity: Steven Kaplan
Mitt Romney’s career as the co- founder of the successful private-equity firm Bain Capital LLC is coming under intense scrutiny and is portrayed in some quarters as a liability, or at best irrelevant to the presidency.
The opposite is true: The skills he acquired in that industry would be both relevant and valuable in the White House.
The scrutiny tends to focus on two related issues. The first concerns the results that private-equity firms deliver. These firms invest in portfolio companies with a combination of equity and debt. The debt comes from banks. The equity comes from the firms themselves, which in turn receive their funding from limited partners that include institutional investors such as pension funds, endowments and sovereign-wealth funds. These are the firms’ customers.
In a recent paper I co-wrote with Robert S. Harris, of the Darden Graduate School of Business Administration at the University of Virginia, and Tim Jenkinson, of the University of Oxford’s Said Business School, we look at returns to PE funds net of fees.
We compare those returns with those an investor would have earned in the stock market. We find that the average PE fund has beaten the markets by a substantial margin over the past 25 years. On average, $1 invested in a PE fund delivered 20 percent more than a $1 invested in the Standard & Poor’s 500 Index. (SPX) This benefited the pension funds, endowments and other limited partners that invested over this period.
Some critics assert that PE funds do so well simply because they use a lot of leverage. At least in an up market, a leveraged investment will outperform an unleveraged one because the leverage magnifies the positive return. This, however, doesn’t explain our finding of outperformance of public equities not only in up markets, but also in down markets.
Even in an industry with such strong performance, Bain Capital stood out. During Romney’s tenure, the firm raised five funds that all outperformed the typical PE fund. Four of the five were well into the top quartile of performance.
In other words, Bain Capital and Romney delivered spectacularly well for their customers, better than other PE firms that on average outperformed the public markets. Today, those customers include the California State Teachers’ Retirement System and the Teacher Retirement System of Texas.
Where does this outperformance come from? After a private- equity firm buys a company, it typically applies three types of engineering: financial, governance and operational.
Financial engineering involves providing very high-powered incentives to the chief executive officer and top executives. This usually means high equity upside if the investment is profitable, but real downside for the executives if the investment doesn’t pan out. The upside and downside tend to be greater than for executives at comparable public companies. Financial engineering also usually includes greater debt and greater tax deductions (from interest payments).
Governance engineering involves playing a strong role in corporate governance. Private-equity investors control the boards of their portfolio companies. They closely monitor and regularly advise the company and its executives.
In the last 10 years, most top private-equity firms have added operational engineering capabilities. That means bringing consulting and executive resources to help portfolio companies become more efficient. This includes advice on and help with pricing, sales management, manufacturing, information technology, benefits and procurement.
Bain Capital pioneered the use of consulting in private- equity investments by using its sister company Bain & Co. More than 20 years later, almost every top PE firm has copied this practice. In that sense, Romney was an important innovator who had a large impact.
The second issue that is now facing scrutiny is the way financial, governance and operational engineering affects portfolio companies. Large sample studies in the U.S., U.K. and even France, consistently show that these companies become more productive on average: i.e., operating margins and cash flows improve relative to other companies in the same industry.
What about employment? Some, including the economist and New York Times columnist Paul Krugman, have criticized private- equity firms for gutting companies and destroying jobs. The industry, however, argues the opposite, that they create employment.
In a recent paper, my Booth School colleague Steven J. Davis, Josh Lerner of Harvard University and their co-authors find some truth to both claims. Employment declines at existing locations (relative to other companies in the industry) but increases in the new locations where PE firms’ portfolio companies expand their operations. The net effect is to leave employment somewhere between constant and down 1 percent. The authors conclude that “the overall impact of private equity transactions on firm-level employment growth is quite modest.”
The evidence overall, then, is favorable. On average, private-equity firms make companies more productive and, in so doing, have delivered strong returns to their customers. At the same time, PE firms don’t have much of an effect on net employment one way or the other.
This suggests that Romney should argue his PE experience is very relevant to his quest for the presidency. As president, he would need to cut costs, particularly entitlements. When appropriate, PE firms cut costs. He would also need to promote policies that encourage job creation and growth. When appropriate, PE firms invest in and expand their businesses and employment.
And the firms make these cuts and investments not for their own sake, but to deliver results for their customers. Similarly, the president’s job isn’t to cut or expand programs for their own sake, but to deliver results to the end customers -- the voters.
PE firms in general, and Bain Capital run by Romney in particular, have delivered strong results for their customers. He should argue that the experience, focus and skills that made him successful in private equity are exactly what are needed to help the U.S. economy become more productive and grow.
(Steven N. Kaplan, a professor of entrepreneurship and finance at the University of Chicago Booth School of Business, is a contributor to Business Class. The opinions expressed are his own.)
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