Private Equity: Hero or Villain?
Private equity is a rapacious destroyer of the middle class. No, it renews American industry by infusing old companies with capital and ideas.
Well, which is it? You won’t get the answer from the campaign trail, where Mitt Romney is getting kicked around for his private equity credentials even by fellow Republicans. (Rick Perry called Romney’s old firm, Bain Capital, “vultures that are sitting out there on the tree limb waiting for the company to get sick.”) Romney’s argument against Barack Obama hinges on the former Massachusetts governor’s record in the private sector, which is why he insists that he helped create 100,000 jobs at Bain. The rhetorical fog machine is at full throttle, and nothing resembling a straightforward answer is likely to emerge from any candidate’s mouth between now and Election Day.
It might be good, then, to lower the volume on your television and consider the evidence. For the most part, private equity firms such as Bain are neither job-creating machines nor bloodsucking villains. They’re agents of what the Austrian economist Joseph Schumpeter called “creative destruction.” That’s the economic theory that says destruction is the yin to creation’s yang; you can’t make an omelette without breaking a few eggs. (If he were alive, Schumpeter would love Romney.) The real issue is less about the details of Bain’s record, which varies from deal to deal, than whether a skilled practitioner of creative destruction is the right person to sit in the Oval Office in January 2013.
Private equity is the new name for what used to be called leveraged buyout firms. There are many investment plays, but the most common strategy is simple: buy an undervalued company, usually with borrowed money to juice returns. Whip it into shape. And after five years or so, sell it back to the public, paying off the debt and keeping the profits. Big private equity firms such as Bain Capital, Blackstone Group, Carlyle Group, and Kohlberg Kravis Roberts are partnerships that raise funds from outside investors, known as limited partners. The outside investors typically pay management fees equal to 2 percent of the size of the fund per year, plus 20 percent of the profits above a hurdle of an 8 percent annual return to the limited partners.
Done right, private equity rains down cash. Carlyle Group announced on Jan. 10 that its three founders made $413 million last year. If the One Percent Club had its own One Percent Club, people like Romney, KKR’s Henry R. Kravis, and Blackstone’s Peter G. Peterson would be members in good standing.
Studies show that private equity firms are excellent at generating returns for their investors, which include college endowment funds and teachers’ pension funds that represent ordinary people. That’s a good thing. The firms appear to shrink employment slightly, which is bad. On the liability side of the ledger, they benefit from special tax breaks, including the “carried interest” rule that allows them to treat their profits as lightly taxed capital gains. On the asset side, they force bad managers and deadwood employees to look elsewhere for work.
Investigative reporters and rival campaigns have been climbing all over Bain, trying to assess its record while Romney ran it from its founding in 1984 until he left in 1999 to save the Salt Lake City Winter Olympics from a corruption scandal. The Wall Street Journal reported on Jan. 10 that 17 of 77 firms that Bain bought either filed for bankruptcy reorganization or shut down in the eight years after Bain invested. On the other hand, there were also huge successes such as startups Sports Authority and Staples. Of the targets that failed, Bain says that some went under after it no longer controlled them.
Bain Capital is not necessarily representative of an entire industry. Two major academic studies published in 2011 allow us to examine the record of a broad swath of private equity firms on the two key questions: returns to investors and job creation. An analysis of 598 buyout funds that existed between 1984 and 2008 found that even after fees, their weighted-average returns to outside investors were 1.27 times the returns on the Standard & Poor’s 500-stock index over the same periods. That’s a huge margin. That performance wasn’t limited to just a few lucky years, either, according to the study by Steven N. Kaplan of the University of Chicago Booth School of Business, Robert S. Harris of the University of Virginia Darden School, and Tim Jenkinson of Oxford University’s Saïd Business School. The buyout firms underperformed the S&P 500 in only 5 of the 25 years. Kaplan says the funds’ outperformance is evidence that private equity firms genuinely unlock value through “strong incentives to management, strong oversight, and operational consulting.”
Why should ordinary Americans care about the financial success of private equity? They shouldn’t—unless they’re invested in it. According to Preqin, a London-based data provider, 25 percent of the dollars going to private equity funds from 2009 to 2011 came from public pension funds. That included teachers in Texas, California, and New Jersey.
Of course, most of the voting 99 Percent cares more about the hiring and firing that private equity-backed firms do than about their investment returns. In September, Josh Lerner of Harvard Business School and four other authors released a working paper looking at the employment patterns of 3,200 firms targeted by private equity from 1980 to 2005. In a big advance over previous studies, it compared them to a control group of firms that were similar in industry, size, age, and prior growth. The paper’s summary—which is the one most likely to be quoted in news stories and congressional testimony—concludes that in comparison to the control group, the PE firms’ employment shrank “less than 1 percent” in the two years after a deal.
That’s not the full story, though. The comforting statistic understates the job destruction attributable to PE because it gives buyout firms credit for jobs that were added via investment banking—i.e., jobs added through acquisitions, minus jobs lost through divestitures. Excluding such transactions, the authors report, the PE-backed firms lost 2.1 percent of their employment vs. the non-PE baseline in the two years after a deal. In other words, having your company acquired by a private equity firm is like living through a national recession.
The facts, then, both support and refute the populist rhetoric of Romney’s rivals. But the facts aren’t all that matter during silly season. The whistle-stop attacks are making trouble not only for Romney’s campaign but also for the entire private equity business. Romney hasn’t made matters better by refusing to release his tax return, a routine step for Presidential candidates in recent decades. The sector is at risk of being defined by the now-famous photo of Romney and his fellow partners with dollar bills stuffed in their hands, pockets,and even some mouths.
Private equity has a lot to lose from a populist backlash, including its carried-interest tax break. The Private Equity Growth Capital Council conducted a study claiming to show that eliminating the special tax treatment “could reduce private equity investment in the U.S. by $7 billion to $27 billion a year,” judging from responses to previous tax changes. The study says that by the methodology used by the Obama Administration to calculate the effect of stimulus spending, “employment could be 37,000 to 128,000 lower” as a result. If private equity loses the public-relations war, lawmakers may dismiss the study and give private equity a kick in the pants.
The chief problem for Romney and for private equity is that it’s 2012. The virtues of creative destruction are abstract, while the reality of 8.5 percent unemployment is vivid. Romney’s résumé might have gone over better in 2000, when the unemployment rate was 4 percent and workers were confident that if they lost one job, another would pop up soon. Today there’s no such assurance—which is why people are voluntarily quitting their jobs at a lower rate now than even during the 2001 recession.
Romney is trying to accentuate the “creative” and eliminate the “destruction” from his message. Still, the claim that he helped create 100,000 jobs is a stretch. It counts employment increases at firms long after Bain ceased to be involved—and appears to exclude layoffs at other firms. (In his 1994 Senate race, his campaign claimed “more than 10,000” jobs created.)
Private equity does not raise corn, build cars, or teach children. What it does, when it works, is make the economy more efficient—while enriching the likes of Mitt Romney. That’s what the facts show. Whether America’s next President should come from the privileged precinct of private equity is something only the voters can decide.