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How Private Equity Firms Work and Why They’re Good
The recent spate of opinions expressed by many journalists, bloggers, social media users and all Mitt Romney detractors have, to a very large extent, been based on a lack of understanding about how private equity firms like Bain Capital work and why. Not that lack of knowledge has ever prevented the media or political zealots from expressing an opinion, but it’s necessary that any opinion be based on fact to have real value. That said, let’s look at the how and why of a typical private equity firm.
Private equity (PE) firms primarily consist of two components, management and investors. Under the broad heading of management there are executives, fund managers, business analysts and various support personnel. Investors are people, outside the firm’s employ, that put their money into various funds, or pools of money, offered by the PE firm.
This is an important concept to recognize as too many people seem to think that a PE firm only has to answer to their own management. Nothing could be further from the truth as the investors are the first people to whom management must answer, and provide an adequate return on investment to those investors. Failure to do this would quickly result in a PE firm’s inability to attract more money to invest.
Private equity firms are by their very nature risk-takers that invest in companies that have no other place to turn to for capital. There are many reasons why a company cannot obtain capital from other sources, but generally speaking they are not profitable or are trending rapidly downward. When a PE firm puts money in such a business they do so with full knowledge they could lose every dollar invested and therefore dramatically reduce the rate of return to their investors.
Since nobody invests money to lose it, a PE firm spreads its investments over many different companies to avoid the “all their eggs in one basket” syndrome that could be devastating if that one company failed. PE firms accept they will lose money on a percentage of their investments (possibly the entire amount), breakeven or realize a small loss or profit on a larger percentage, and see substantial profits from the smallest portion of their overall investments.
The bottom line is the winners have to return such profitability that they offset the certain losses in the much larger percentage of companies plus the overhead required to operate the PE firm on a daily basis.
Many of the attacks on Bain Capital and the practices of private equity firms have included statements that are factually inaccurate. Accusations of dividends and management fees that were improperly collected are just one such example. Consider the following laws and rules that PE firms and the companies they invest in must operate under and you can quickly see the fallaciousness of these accusations:
- As equity investors PE firms are last in line, so to speak, and they only make money if the company performs profitably or at a higher level of profit than the company was previously.
- PE firms, as well as all equity investors, come behind employees and all other creditors and are prohibited from receiving funds until all others are provided for appropriately.
- It is illegal for a company’s board of directors to issue dividends of any kind if the company is insolvent or if the payment of such dividends would render the company insolvent.
- The members of the board of directors can be held personally liable for any violation of proper dividend practices so they are extremely careful about the payment of such.
Another fallacy that has been opined about are the payment of exorbitant management fees to PE firms by the company’s in which they invest. Many times the first thing a PE firm will do in trying to turn a failing company around is to fire the executive management. That’s right, the CEO, CFO and other upper management personnel not the rank-and-file employees. Management fees are appropriate in these cases where the PE firm has to bring in new executives to run the company, many of whom are highly sought after elsewhere in the business world and can command commensurate compensation packages.
Any business, regardless of size, is only as effective and profitable as the sum of the value of both management and the employees working together to produce goods or services that can be sold into the marketplace for more money than the costs to produce them. The best employee workforce would be at certain risk of loss of their jobs if upper management is ineffective, so it is a team oriented proposition.
Does it always work? Of course not and when it doesn’t companies are forced to close down, employees lose jobs, investors lose money and the media opines on whose fault it was with a general attitude that it is always executive management. Here again nothing could be further from the truth. No PE firm would risk their investors’ money by foolishly causing a company to self-implode – yet this is a common theory offered by uninformed legions with apparently little desire to learn any more.
Capitalism is the essence of survival of the fittest, it always has been, and it should forever remain so. That’s the only way consumers benefit in the form of lower prices on goods and services they need. The more competitive the marketplace the greater the onus on a company to produce their products at lower retail prices while still maintaining profitability. However survival of the fittest means there will be carnage from time to time, as less capable companies fail and close their doors.
To believe there is a utopian climate in which no job would ever be lost is simply ludicrous. Every action taken by the government and the markets has negative impact on somebody, somewhere. The key is to ensure those affected have the chance to move on to another, frequently better, opportunity.
Many government studies and case reviews from the likes of the Government Accountability Office (GAO) and the Securities Exchange Commission (SEC) have openly demonstrated and documented the success of private equity firms and their practices. Quoting from an excellent article in the Wall Street Journal by Jonathan Macey, a professor of corporate law, corporate finance and securities law at Yale Law School, How Private Equity Works:
“At the height of the financial crisis in 2008, the GAO’s private-equity report observed that academic research “generally suggests that recent private equity LBOs [leveraged buyouts] have had a positive impact on the financial performance of the acquired companies.” The same GAO report noted that in the 2004-2008 period it studied, none of the 500 complaints received by the Securities and Exchange Commission’s Division of Investment Management involved private-equity fund investors. The GAO also noted that institutional investor associations and bar associations reported that “fraud has not been a significant issue with private equity firms.”
Additional government reports paint a remarkably similar picture of the private equity industry all the way back to the 1970’s and 1980’s (the decade in which I was an investment banker) and through today.
Is the private equity world or capitalism with its free-market practices a panacea? Clearly it is not nor could it ever be expected to be such. Are jobs lost from time to time? Absolutely, but capitalism has a unique way of addressing those job losses. From another exceptional article in the Wall Street Journal by Holman W. Jenkins, Jr., The Truth About Bain and Jobs:
“But the best antidote to foolish thinking about job creation is the work of economists Steven J. Davis and John Haltiwanger. Their painstaking research has revealed a side of America’s dynamism that isn’t always pretty. Between 1977 and 2005, years roughly overlapping Mr. Romney’s business career, some 15% of all jobs were destroyed every year, even as total jobs grew by an average of 2% a year. Job creation and destruction are both relentless, the authors showed in paper after paper. The small difference between the two is what we call prosperity.”
Capitalism and a free-market economy is the irrefutable method for the US economy to be based upon. It is how we ensure every citizen who embraces personal accountability and responsibility has the greatest opportunity for advancement with the highest possible wage-paying job. It’s also how consumers are guaranteed the chance to purchase products and services at the most competitive prices.
What capitalism doesn’t do is to unnecessarily provide for the apathetic, ignorant, lazy and slothful with handouts. But it does provide for an economic climate where the truly helpless can be helped. In my opinion that is exactly how it should work and it’s time that private equity firms including Bain Capital are given credit for their contribution to this process, and not assailed by inaccurate exhortations.
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15 Comments
[...] is pretty convenient news following the post Tom just published here on TRS about why private equity firms like Bain are good: turns out, some of the workers in the “King of Bain” short film attacking Romney for [...]
Really very impressive piece. Hope people will read it and actually “get it”
This line is 100% correct “In my opinion that is exactly how it should work and it’s time that private equity firms including Bain Capital are given credit for their contribution to this process, and not assailed by inaccurate exhortations.” Its really not helpful when people who say they support free markets then condemn the very people who are making those markets work.
Be sure to read Brandon’s article for a political perspective of the egregiousness of unfounded and inaccurate accusations.
Thank you for the kind words, Marc. I too hope more people will read this article, or anything factually based that allows them to become educated about what PE firms really do, what Bain Capital did and put an immediate halt to the malicious and inaccurate attacks on Bain and Mitt Romney.
So, if what you are saying is true, how did Bain take an $8M investment in a company and turn around immediately to sell almost $100m in bonds if Bain was a last resort lender? This shows to me that the original owner was just too moral to put his company so deeply into debt it would have no chance of long term survival. Bain had no such moral qualms and hocked those companies as deeply as they could and had no qualms about selling those bonds to people who had no idea how screwed Bain was planning on leaving the company when it finally bailed out on the whole endeavor. Bain had no long term goals, Bain built nothing, Bain just simply bought companies to use them for leverage to boost their money. They made some changes to the structure of the company, usually laying off people or cutting quality of product or outsourcing some production to china to increase temporary profits so they could get those bond buyers, but over all, it was not with the intention of having a well functioning long term company left behind. r
First you list no specific company so I can’t comment. Second nobody outside of the private transactions knows what any of the real specifics are and last, no investment company as unethical and ill-managed as you paint Bain to be would have thrived, not just survived, as long as they have.
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Given that Bain’s attempts to save failing companies don’t always succeed, couldn’t Newt do an equally honest documentary about Ron Paul’s career as a doctor?
After all, Ron Paul was paid whether or not the children he delivered survived childbirth. Ron Paul was collecting his disgusting profits while devastated families buried their loved ones! Fortunately for Paul, people understand medicine in a way they often don’t when it comes to free enterprise.
[...] It’s time we start singing this from the roof tops. When we distill down the differences between liberals and conservatives we are talking about socialism vs. capitalism. Read the whole article here. [...]
You say that the PE Firm is last in line for money — even in the event the company fails and has to liquidate assets? Doesn’t the PE Firm typically only contribute about 10% of the buy out cost, while using the assets of the company (to be bought out) as collateral to borrow the rest? Does that loan get paid off first? If so, that would be pretty close to putting almost nothing on the line, right? Is this understanding of LBOs incorrect?
Joe, there a lot of different ways a private equity form can invest in a company, and then even more ways to proceed after the initial investment. An LBO or leveraged buyout is only one of these many, and is unto itself a completely different methodology than a straight equity investment. The bottom line is equity owners are always last in line to get their money out of a company following employees, lenders such as banks and bond holders, and preferred stock holders.
In your particular LBO question, there is no “tried and true” formula for how much a PE firm may invest and how much leverage is available. It is also important to understand that LBO’s are not destructive by nature just one of many acceptable practices used by investment bankers, and any statement otherwise is not factual.
Thanks for the response. I understand that a company generally tries to make money by succeeding, not destroying, but I was hoping for a little more substance on LBOs. I don’t know the topic, so when I hear and read accounts stating how highly leveraged these buy outs can be, and reading your constrasting account that the PE firms get paid last, I need more information to reach a conclusion. It certainly sounds like the company is taking all the risk and the PE firm stands to reap benefits. The PE firm shares in the successes, while minimizing damage in failures. It sounds underhanded.
Maybe that’s the way it has to be with these companies, since this would be the last resort for raising capital and saving the business (and associated jobs), but the image doesn’t look good.
Joe, LBO’s are a highly specific practice used to actually take ownership of a company using, as the name implies, debt and equity where normally the debt is a greater amount than the equity, hence the name Leveraged Buyout. That said LBO’s should not be confused with an equity infusion by a PE firm into a company that needs to be turned around. The two, while possibly related, are not always used in the same company. One does not beget the other.
One other thought is the company is not taking the risk while the PE firm is insulated. They stand together in the risk and the reward.
“It is illegal for a company’s board of directors to issue dividends of any kind if the company is insolvent or if the payment of such dividends would render the company insolvent.”
The importance of this statement depends completely on how one defines “insolvent”. Bain added $420,000,000 to Ampad’s $20,000,000 debt after buying it for a mere $5,100,00 ; it then took back many times that 5.1 million in dividends and fees. That might not legally qualify as insolvency; the firm could still make or borrow enough money to continue operating and was eventually sold for “tens of millions” (I can’t imagine the sales job that took!). Does that mean that the fragile state in which Bain left Ampad was not obvious to anyone with a complete picture of its assets, liabilities and prospects? I doubt it. Under Romney, Bain must have left a large portion of its targets in fragile condition; 22% of them, including Ampad, went bankrupt within 8 years. It would be an insult to Romney for one to suggest that he would have been foolish enough to leverage these deals to the same extent had he personally been exposed to these debt loads. The main issue here is not Romney; he might even make a good president in spite of all this. It is the way that the limited liability corporation can be used by management and equity holders to gamble and loose other people’s money, help themselves to some of it, then sell it off and hide when the bills come due. I’m not arguing against private equity buyouts, the need to make painful job cuts at times, or even the existence of corporations with limited liability status, but I am arguing that the existence of corporations as they now exist is a privilege granted by the government, not a right. Such a privilege should come with stronger limits on the ability to run up debt (which inevitably subjects early and involuntary creditors to uncompensated risk) while helping themselves to dividends, fees, ever-increasing salaries and bonuses while the prospects for such creditors are getting grimmer. Defenders of modern capitalism love to talk about personal responsibility, but the corporation is often used to hide from just such responsibility. This is probably a necessary evil, but it does justify some restrictions on their beloved “personhood”. Absolute limits on debt/equity ratios and draconian disclosure requirements for political activity and excessive (in terms of the averages for all corporations) executive-pay/market-capitalization ratios would be a good place to start.
PS: I have to give Ron Scherer and Leigh Montgomery of the Cristian Science Monitor (via http://www.alaskadispatch.com/article/did-mitt-romney-really-create-jobs-bain-capital?page=0,0) credit (or blame) for the facts and figures I used here. Apparently, Romney’s people dispute the 22% figure, which originally came from the WSJ, but no alternate claim was mentioned.