The following originally appeared on Humanevents.com on August 22, 2012
With the economy continuing to struggle under his watch, President Obama and his campaign have launched attacks on Mitt Romney’s career at the private equity firm, Bain Capital. Given how successful Governor Romney was as both a businessman and a job creator, that’s a hard case to sell. Thus, the Obama campaign has broadened its attack, excoriating private equity as a whole.
These attacks on private equity are important more for what they reveal about the attackers than for what they reveal about private equity. The backlash to this strategy was immediate and came from all sides of the political spectrum, with even high ranking Democrats denouncing the President’s tactics as “nauseating.” When politicians attempt to demean private equity firms for campaign purposes, their attacks – though smacking of desperation — are at least understandable. But to the extent the attackers actually believe what they are saying, it calls into question whether they have even a basic understanding of how private equity works, let alone how our economy actually creates jobs, wealth and prosperity.
President Obama is trying to set private equity up as a bogeyman people should fear. Nothing could be further from the truth. Private equity is an overwhelmingly positive component of our free enterprise system. It generates value for its investors while creating jobs and wealth for a broad spectrum of individuals and entities. Both results are good for the country as a whole; it is good when investors are successful, and good when successful investments create jobs and wealth for other people.
What private equity firms do
In essence, private equity firms create funds and invest them in underperforming companies, with a view towards reforming the companies’ operations so as to increase their value. The primary objective is to create a return for their investors so as to encourage them to invest more with the private equity firm. When that happens, the investors are better off and the private equity firm increases its profits, with resulting benefits for the owners and employees of the firm and the companies in which they invest.
In essence, private equity firms raise money and invest in underperforming companies that are failing. Whereas banks tend to want to invest in “sure things”, private equity firms are willing to take risks, and sometimes big risks, on businesses that they believe have greater potential than their current performance would suggest. These are generally long-term investments because it takes time to create value in an underperforming business. Private equity investors demand high returns to compensate for the fact that they must tie up their funds for long periods without the liquidity of an investment in stocks or bonds. Private equity investors are generally pension funds, university endowments, sovereign wealth funds and the principals of the private equity firm. Every teacher, firefighter or police officer in this country who is either retired or contemplating retirement is dependent on private equity to assure that there are sufficient assets available to pay their retirement benefits. In fact, it is not too much to say that the largest retirement systems in the United States depend on private equity to maintain the soundness of their funds.
Creating a stronger company
Private equity firms generally acquire companies where they believe they can add value. This could be by improving a product, promoting a product more effectively, reducing the costs to manufacture a product, or lowering administrative costs. It could be by decreasing the number of employees if the business is overstaffed or adding employees if it is understaffed. In the end, the objective is to create a company that is stronger, more profitable and more efficient than the company was prior to purchase.
Let’s say a private equity firm finds a company that it would like to purchase. The company could be available for any of a number of reasons. For example, the founder may have retired leaving no one to run the business, the company may be operating at a loss with no viable plan to return it to profitability, or the private equity firm may believe the market has undervalued the company and is willing to pay more than the stock’s trading price. The private equity firm must first offer the company’s owners a sum sufficient to motivate them to sell. With both publicly traded and privately held companies, this involves getting shareholder approval for the sale. The bottom line is that the private equity firm ends up paying an amount the current owners of the business believe is sufficient to justify selling their company.
Let’s say Company A has cash flow of $1 million per year. The owners are willing to sell and the private equity firm is willing to buy Company A for 6 times that amount, or $6 million. Once it purchases Company A, the private equity firm’s objective would be to increase its value so it can resell Company A with higher cash flow and at a higher multiple of that cash flow. The best way to create value is to grow the business while controlling costs. Assuming the private equity firm can increase the company’s cash flow over the next 3 to 7 years from $1 million to $1.25 million, it will have increased the company’s value. If that happens, the private equity firm may get a higher multiple of those earnings in a sale.
Let’s say the market is now willing to pay 8 times cash flow for this improved business. The private equity firm will then sell Company A for 8 times $1.25 million or $10 million. The private equity firm will, in all likelihood, have limited its risk by borrowing a portion of the purchase price, assuming it could find willing lenders. Assuming that Company A generated sufficient cash to stay current on its interest expense, if the private equity firm invested $1 million from its fund and borrowed $5 million, it would repay the $5 million upon the sale of Company A, leaving $5 million or a return of $3 million on a $2 million investment.
By growing Company A and controlling costs, the private equity firm earned a significant return for its investors and produced a stronger company. If Company A increased its cash flow through growth, it more than likely added employees. Although the private equity firm’s intent was to create value, by growing Company A and increasing its value, the private equity firm may also have saved existing jobs and created additional jobs both in the company and among the suppliers and servicers of the company.
Some investments do fail
Clearly, this does not happen every time a private equity firm makes an investment. Unfortunately, there are investments that fail. There is no guarantee that the private equity firm will actually be able to increase a company’s value or save it from bankruptcy. The problems that caused the prior owners to sell may be unsolvable. In such cases, the private equity firm is left with a failed business and may have to either take it into bankruptcy or sell off the assets to recover what it can for its investors. Failure is never the goal but always a risk.
Ignoring the fact that private equity’s goal is always value creation, the critics of private equity use examples of such failed investments to demonstrate that private equity is bad for the economy. However, the private equity firm’s objective was growth and value creation, not bankruptcy. If the firm is left with bankruptcy or an asset sale as its only alternatives, it means the investment failed. No one makes an investment with the objective of failing. In fact, if a private equity firm has too many failures, no one will invest with it and certainly no one will lend it money to help finance future investments. Then the private equity firm goes out of business, and the principals who invested their money in the firm lose their jobs and their money.
Of course, that never happens with government. The Department of Energy has failed to create the “green economy” that President Obama has promised. But we still have the Department, and in fact its budget will probably go up. Those of us in private business do not have, nor should we have, the option of subsidizing failure by borrowing on the credit of the American people.
Attacking private equity may be a good campaign tactic in a political environment where anything goes. But the fact that President Obama is employing this tactic helps explain why our economy is staggering. You cannot create jobs by attacking job creators. Still, it is encouraging that so many Democratic leaders had the courage to denounce the attacks. It is a promising sign that a bipartisan consensus on behalf of economic growth is possible, if we elect a President who actually understands how the economy works and is committed to growth rather than ideology. That is our only hope for getting out of the mess we are in and the true choice in this election.