Private Equity Explained

OK, this has been a really odd week in the Republican primary. I’ve always thought Newt Gingrich was a bit of a slimeball, but I’ve also had tremendous respect for his intellect and command of conservative, free market economic principals. I would argue that no single politician since Ronald Reagan roamed the halls of the White House has done as much for the U.S. economy as the Newtster did in the mid-90s with his Contract with America. He pulled us back from the brink the last time we had an 0ff-the-rails liberal president and, in fact, forced that president back onto a centrist course that served Mr. Lewinsky well and helped re-elect him. By they way, Newt is also a brilliant writer of historical fiction. His fictional historical account of Washington’s crossing the Delaware, To Try Men’s Souls, remains one of my favorite books of all time.

But, he has totally lost me with his moronic attacks on the private equity industry. In full disclosure, I work in the private equity industry so it would be a fair to say that I am biased and maybe just a little hurt. But, I’m also informed. Newt should just know better. The private equity industry has fulfilled a hugely important role in American capitalism. I expect the idiot currently occupying the White House to attack Mitt Romney’s profession in the general election, most likely because, unlike Obama, Mr. Romney has, uh, had a profession prior to running for office. It’s also because liberals in this country have launched a major attack on democracy and capitalism in an attempt to take us to a form of European Socialism (note the debt downgrades in Europe today). Some of us think that’s a bad idea. Newt says he does. So, very odd that he would attack one of the bastions of capitalism. Shame on you, Newt. Shame.

I hope the folks over at the WSJ don’t mind, but I am going to reprint a great piece that Jonathan Macey wrote explaining the important role private equity places in a capitalist system. If you aren’t familiar with it, you should read it. Note that Mr. Macey is a professor at a very liberal institution – Yale University.

How Private Equity Works


Mitt Romney’s candidacy is subjecting the entire private-equity industry—where Mr. Romney spent most of his business career—to vicious attacks by journalists and several of his rivals for the Republican presidential nomination.

Newt Gingrich’s political action committee is sponsoring a film called “When Mitt Romney Came to Town” that accuses Mr. Romney and his former company, Bain Capital, of taking over companies, looting them, and then tossing their workers out on the street. Jon Huntsman’s attacks on his rival include the description of private equity as a business that “breaks down businesses [and] destroys jobs, as opposed to creating jobs and opportunity, leveraging up, spinning off, [and] enriching shareholders.”

This is anticapitalist claptrap. Private-equity firms make significant investments in companies, mainly U.S. companies. Most of their investments are in companies that underperform industry peers. Frequently these firms are on the brink of failure.

Because private-equity firms are, by definition, equity investors, they make money only if they improve the performance of their companies. Private equity is last in line to be paid in case of insolvency. Private-equity firms don’t make a profit unless their companies can meet their obligations to workers and other creditors.

The companies in which private-equity investors are able to turn a profit generally grow, rather than shrink. This is because the preferred “exit strategy” by which private-equity firms profit is to take the private companies in which they invest and enable them to go public and sell shares that will help the company grow even stronger. As for turnaround success stories, Continental Airlines, Orbitz and Snapple have all benefitted at some time from private-equity investment.

Or take Hertz. Ford sold Hertz to private-equity investors in 2009 for $14 billion. These investors were able to take the company public less than a year later at an equity valuation of $17 billion. The Hertz success story is consistent with the empirical data that indicate companies owned by private-equity firms typically outperform similar companies that do not have a private-equity investor (as measured by profitability, innovation and the returns to investors in initial public offerings).

Private-equity firms not only help corporate performance, but in the long run they lead to more employment and higher wages as well. The alternative to the leaner, smaller firms created by private equity are bankrupt firms that do not employ anybody. And private-equity firms tend to use more incentive-based pay than other firms. A 2008 Government Accountability Office (GAO) report shows that the companies in which private-equity firms invested had low employment growth relative to their peers, and their employment growth rose after they were acquired by a private-equity firm.

These sorts of facts are an inconvenience for some. One U.S. business publication recently announced that “The U.S. Cannot Have a Private Equity President.” The article by writer Robert Lenzner goes on to say that there was only one transaction in which Bain paid a significant dividend, so Mr. Lenzner could make the case that the private-equity industry is one of “company stripping, the ruthless way for a raider to exploit a weakened prey for its own profit,” and he could add that “slightly more than a handful” of the deals that Romney did “went bankrupt.”

By law, a company cannot pay a dividend unless it is solvent. It also is illegal for a director to authorize a dividend that would render a company insolvent. Corporate boards as a matter of standard practice are extremely careful about paying dividends. This is especially true for companies with board members who are sophisticated and wealthy private-equity investors, because they face personal liability for authorizing the payment of dividends by an insolvent company.

The Forbes article also goes on to assert, in the same vein as many other attackers, that “the nature of private equity is to be ruthless and only care about using as much borrowed money as possible in order to gin up the potential return on equity.”

Such an accusation fundamentally mischaracterizes the relationship between debt and equity. Equity investors do not get paid until the creditors do. Moreover, unless those lending money to the portfolio companies of private-equity firms are abjectly incompetent, they will not lend to companies that are not highly likely, if not virtually certain, to be able to repay it. In fact, the leverage ratios—meaning the amount of debt that a company has in proportion to its equity—of private-equity firms declined dramatically during the financial crisis, and they are only now rebounding.


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.”

Unlike some other investors who trade in debt and derivatives, private-equity firms make money by investing in businesses that make things and provide services. This industry should be applauded, not attacked.

Assaults on the private-equity industry really are attacks on economic freedom, because the private-equity process is nothing more and nothing less than free-market capitalism at work. Shame on all the people, particularly those who claim to be friendly to capitalism, who attack Mitt Romney because of his association with the U.S. private-equity industry.

Mr. Macey is a professor of corporate law, corporate finance and securities law at Yale Law School.

About Bruce Robertson

Bruce Robertson is an amateur writer and professional provocateur
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10 Responses to Private Equity Explained

  1. Dan Grabois says:

    Well, I will not claim to know the first thing about any of this, since I don’t. What I do know is that I’m a little annoyed (I direct this at Mr. Macey) at being told I hate America (and when someone calls you “anti-capitalist” or “anti-free-market” that is the implication) every time I am unhappy with the way things work around here. You, Bruce, have admitted that we need a government agency making sure our drugs are safe. Do you hate the free market? You have also admitted that the government has a role to play in safe aviation. Are you anti-American? Of course not.

    Some people imagine a world in which money is not constantly being concentrated into the hands of the very wealthiest people. Some people imagine a world in which their middle aged friends can afford health insurance. Some people imagine a world in which their friends can find a job. Just because these people disagree on some points of how our system runs doesn’t mean that they wish Stalin were in charge over here, nor does it mean that they are ill-informed morons who don’t have a brain in their head (though that may describe me).

    I leave to those who know more about economics to argue the finer points of Mr. Romney’s heroism or nefariosity (I know that isn’t a word). I guess I am willing to say that George Bush was not intent on destroying the country by plunging into a crazy, expensive, and probably futile war (I will admit that he thought he was doing something right, good, and moral, even though I might disagree), but I think you should admit (though I’m guessing you won’t) that Barack Obama is not attempting to turn us into a 1950s Soviet bloc country. You and I can agree that Obama hasn’t done a great job, but we’ll have very different reasons. People can legitimately have differing views (even though mine are actually right) without there constantly being a charge of “you hate America.” Don’t you think?

    I’ll just add one thing that I find scary. If in fact one role of VCs is to tighten up the functioning of companies so that they are more productive with fewer people, then eventually we’re going to have an even bigger unemployment problem than we have now. If the world gets so efficient that 5 people can produce everything we need, then I don’t know what we’ll do with the other 5,999,999,995 of us. I’d love to hear your views on this. And I won’t call you a moron or anti-American, even if I end up disagreeing with you.

    • Dan, deep breath time. I re-read my post and the original Macey article and I don’t see where either one of us accused liberals of hating America. In fact, I don’t think Obama’s economic policy demonstrates any such thing. I think his foreign policy (and that of many others on the radical left) does show some self-hatred (bowing to Arab leaders, reaching out a friendly hand to Iran – how did that work out – and so on), but I didn’t write about foreign policy. I wrote about economic policy.

      Also, I never made any suggestion (as you did) that Obama’s vision was to take us to Soviet style communism. I don’t believe he is. I said he, and many on the left, have a vision to take us to European style socialism. There’s a big difference between the two and by trying to reword my post from one to the other, you have changed the subject of the discussion. So, what do I mean by “European style socialism?” Think about Greece, Italy, Portugual, California, New Jersey, New York. OK, the last three are not European countries, but they’ve run their state economies into a huge ditch by emulating those countries. Hard not to believe that Spain, France, and others are on the same path, maybe just a bit earlier in the process.

      What these countries (and US states) have in common is a complete reliance on government to run the economy, at the expense of the private sector. Lavish government mandated benefits, pensions, etc. have begun to crowd out the private economy. They have created cost burdens on the government that can no longer be met at current tax rates. So taxes get raised, but that further crushes the private sector. In the case of CA, NY, and NJ the private sector just flees for higher ground. Rick Perry is a total idiot, but his state’s favorable environment for business has created a virtuous cycle of employment growth in the private sector.

      I absolutely believe that the data supports the assertion that Obama’s vision is a complete reliance on the government at the expense of the private sector, which he clearly views as evil. This vision, from a man who never worked a day in his life in a job that relied on the function of private markets, is troubling because the Euro experiences (and that of CA, NY, and NJ) show that it simply doesn’t work. There’s no free lunch and never will be.

      You say your vision is a country where middle aged people can find jobs and be able to afford healthcare (which presumably they’ll be able to do if they have a job). Hey, we agree! Where exactly do you anticipate that they will find those jobs? Should we just grow government by 25% (again) and have them all pushing paper around the Dept. of Commerce? Sorry, see Socialism, European for how that plays out. It doesn’t work. No free lunch in this paragraph either. Your friends will find jobs when the economy grows and that will happen (as it has througout history) when government gets the hell out of the way.

      As to your last paragraph about VC inveting creating so much efficiency that nobody needs to work any more….c’mon, Dan! First, neither Macey nor I said anything like that. In fact, the Macey article makes the point more than once that private equity (more on the difference b/w PE and VC in a moment) tends to create, not destroy, jobs. But, it does so by growing the size of the pie vs. trying to take a bigger slice of a shrinking pie (as hiring by government does). Furthermore, throughout history, Schumpterian creative destruction has characterized the most successful economies. By your logic, we should all be using manual typewriters. Sure, we’d be less efficient than we are with our iPhone, iPads, iToilets, etc., but at least we wouldn’t have had to fire those poor folks over at the Royal Typewriter Company.

      As always, thanks for the thought-provoking comments and dialogue.

      Note on the difference between PE and VC. PE is typically a leveraged (i.e., equity + debt) investment into an operating company, often without a ton of innovation or technology (though sometimes there are both). PE deals tend to be larger deals in larger companies. VC is high-risk equity (generally no or little debt) into small, young, innovative companies. Nearly all VC money goes to IT, healthcare, and energy these days. I am a VC guy, not a PE guy, but my firm does both.

      • Dan Grabois says:

        I was referring to this sentence from Mr. Macey:
        “This is anticapitalist claptrap.”

        My point was that, by labeling something “anticapitalist,” you are opening a large ad hominem can of worms. Anyone who is anticapitalist is either wrong or evil. I have no problem, incidentally, with his use of “claptrap.” If he believes the argument is fatuous, poorly thought out, ignorant, or whatever, fine. But when one suggests that anyone who thinks that Mr. Romney has been more of a job destroyer than a job creator ONLY thinks that due to being “anticapitalist,” one has claimed a monopoly on virtue to which one is not entitled. I am very sensitive to language, and I hear this kind of language attaching itself to political discourse all the time. I am really sick of it. And if I may respectfully disagree with you (and again, I am taking issue with Mr. Macey’s language, not your own), when you label something “anticapitalist claptrap.” you really ARE saying “you don’t like the way America works” (= “you hate America”).

        I am interested in your argument that by my logic, we should all be using manual typewriters, slide rules, and so on. Ever since I was a kid (you were one at the same time!), I have been hearing about time saving efficiencies, greater productivity, growth, etc. Please note that I am not arguing that these things are necessarily bad, nor am I suggesting that I would like to go down to the river and beat my clothes on the rocks to get them clean. I am wondering, in my anticapitalistic claptrapic way, if all the progress we are striving for is getting us a truly better life – better not as measured in dollars but in some more deep (if such a thing is conceivable) way. On the one hand, we have plumbing, showers, cars, planes, trains (oops, that was anticapitalistic), and hair gel. On the other, we have horrible pollution, desperate inner cities, a calcifying socioeconomic structure, etc. I look at life in socialistic Europe, and I see people who live a life that makes them VERY happy. I go to festivals frequently and perform with Europeans, and we frequently talk politics. I will admit that I am having these conversations with musicians, which means they are basically lefties (there’s that claptrap again), but all the Europeans and Canadians with whom I have discussed health care, and it’s a fairly large number, are thrilled with their systems and think we are morons in the States.

        Now, you may bring up Greece and Spain all you want. What has happened to these countries is quite complicated, as you well know. Going on the Euro was probably moronic for most of the poorer European countries, but don’t go looking for my monograph on the topic in Foreign Affairs magazine. I’m just saying that it’s more complicated than that they have high tax rates and now their economies suck.

        Finally, you kind of lost me at the end of your reply (I’m on tour now, with limited brain power), but mega-kudos for “Schumpterian creative destruction.” No idea what the hell that is, but I am going to avoid it like the plague for the next three days as I record a CD that will sell 17 copies.

  2. David Mumford says:

    Bruce, this is your Tenants Harbor friend, David Mumford. You won’t be surprised to know I’m a card carrying liberal but I’m making an honest attempt to “get into your head”. You talk of “European-style socialism” with obvious scorn. (Let’s not get into the Euro crisis which seems a different issue caused by incomplete integration of economic/financial policies of the various countries.) What I’d like to ask is what you think of European-style medical care? Everything I’ve read suggests it is cheaper per head and gives universal coverage. Surely these are our goals too? Also, the Swiss have a version closer to ours but I read that they have very strong government regulation of the private medical insurers. It seems that the much maligned “Obamacare” was a serious compromise with the Republicans made by the “idiot” in the White House, an attempt to find the middle of the road. Nor have I figured out why Mitt’s MA plan doesn’t fit the country as a whole.

    Your neighbor and friend,


  3. David, thanks so much for reading my blog. I think I can now officially increase the number of readers from 2 to 3! Welcome aboard! Thanks also for commenting. I love good discourse.

    So, how do I feel about European healthcare. In a word (or words), I don’t like it. I trust your numbers (sort of) that it provides equivalent or better cost per patient and universal coverage. But, it provides substantially worse outcomes. You can find studies that will show that we all more or less die at the same rate and age, but there’s a lot of living between birth and death and a lot of factors that confound those data. For example, Americans are considerably more fat than the rest of the world (one of the few things I like about the Obamas is that Michelle took on childhood obesity as her issue). We have to figure out how to deal with that; it’s literally killing our nation. But, to compare overall longevity of a bunch of fatties like us with the much trimmer Brits is not a fair comparison. You’re a mathematician so you know that.

    When you dig deeper into the healthcare data, what you find is not pretty for the national health systems. Waits are long for “elective procedures,” which would include things like a spinal laminectomy for a patient who can’t take a step without shooting sciatic pain. More troubling are the survival rates for cancer patients. If you’re diagnosed with breast cancer in the United States, your odds of being around in 5 years is a lot better than if you’re in the UK or Canada. Likewise, the time from onset of Type I diabetes to first insulin treatment is much shorter in the US. Now, we have a lot more diabetics due to our obesity epidemic, but that doesn’t change the need for fast treatment to stave off the co-morbidities that accompany that disease.

    My big concern is that neither party is really talking about the problem that plagues our system, which is the near total disconnect between the consumers of healthcare and the payors. It’s hard to imagine a highly functioning market where buyers and payors are different. Think about how you spend money when you’re on expense account vs. when you’re paying the bill yourself and you got our healthcare system. Furthermore, we “insure” things that should never be insured. It would be like making a claim to your car insurance company for an oil change. That’s crazy, but it’s exactly how our healthcare market functions. Someday, I hope to have the energy to blog about that, but maybe not because I think my other 2 readers just like when I write the funny stuff!

    Thanks again for reading and commenting. I had a great dinner with your step-son-in-law in San Fran this week!

  4. Dan, I think I hear you now as saying you equate “anti-capitalist” with “anti-American.” I missed that the first time. But, as my PhD advisor once said to me, “when my head is nodding it means my ears are working. It does not mean I agree with you.” Frankly, I think this hits a bit of a nerve with liberals because it forces them to really think about their own failed ideology. Personally, I do NOT equate being anti-capitalist with hating America. I equate it with a lack of understanding as to how markets work and what’s driven our economy to success throughout most of our history. I think someone can love America and wish for a utopia that doesn’t exist where the government takes care of everyone and there’s plenty of money to pay for it and the economy grows and employs people. It’s a noble goal and one that many a political scientist has pursued. Sadly, it just hasn’t ever worked. Not in Europe. Not in California. Not in New York. Not in New Jersey.

    And, I also disagree with your assessment of the United States as a place where we have horrible pollution (just not true), calcifying socioeconomic structure, and decaying inner cities. I take your point on inner cities and that’s a real issue, which at least in part would be helped if the unions would get off the backs of the educational system so we could educate kids in the inner cities, but that’s a topic for another blog.

    As to whether technology has made our lives better, I have no idea. I like the fact that I can clear 5 emails at every stoplight so I don’t have to do it at home in the evening, but that begs the question of whether my life would be better if I had no e-mail and just went home and checked my mailbox to see if anyone had anything to say to me.

    As to happy Europeans, there are lots and lots of happy Americans too. I’m just wondering if the chronically unemployed in the sclerotic European countries who have perpetual unemployment in the teens are all that happy. Maybe they are for a while as the government pays them not to work, but now we are seeing how that story ends……and it ain’t pretty.

  5. Dan Grabois says:

    OK, per your instructions I have now taken a deep breath and seen you nodding, listening, and disagreeing. But I still have not been able to convey my thought to you – we’re not talking about the same thing at all. My inarticulateness knows no bounds, evidently. My initial point was not that I myself equate anti-capitalism with anti-Americanism. Instead, I am objecting to Macey’s use of language. I read him saying this, in essence:

    —> people who criticize Romney for the business he did with Bain are obviously anti-capitalist in addition to being foolish.

    OK, back to me. I don’t know if you even agree that that is an accurate digest of Macey’s opening salvo. I will assume, for the sake of this blogreply, that you do. So on to my objection. I will leave aside for now the question of whether Macey is right or wrong. My only point was that, in my opinion, Macey is resorting to name-calling. In this country, calling someone “anti-capitalistic” amounts to fighting words, and really does imply that the critic is not a true supporter of our American way.

    To be specific, Macey describes the attacks, and then writes, “This is anticapitalist claptrap.” I am objecting to this invective. If he had said, “Critics of private equity don’t understand the value of PE in boosting the economy,” I would have said to myself, “OK, let’s hear your explanation, I’m interested.” If he had written, “Critics of private equity are not only mistaken but are doing a disservice to capitalism,” I would have been interested. But when you label anyone who disagrees with you as an anti-capitalist, you are claiming that ALL critics are opposed to America’s economic system. And that is BS, and I resent Macey’s putting me in a box which he labels “anti-capitalistic,” claiming exclusive rights to morality for himself and his ilk.

    As to the rest of your reply, you are absolutely right: plenty of Americans are happy with the way things are, and plenty of Europeans are unemployed. We can agree that inner cities are in part bad because of our education system (our ideas for solutions probably differ, but that’s ok). You are right that the European governments have largely committed themselves to unsustainable levels of payments to citizens for unemployment, pensions, etc. And I am right that there are piles of unemployed Americans and piles of uninsured Americans. I am right that many Europeans are very pleased with their health insurance.

    What I especially liked, though, about your comments is that you didn’t tell me that my reply was anti-capitalist claptrap (you may have thought it, but that is no way to have a serious discussion, as you know). You didn’t try to tell me that my interest in helping the environment (and YES, things are much better now than they used to be) makes me a stupid commie. This is what Macey did in his article, and that was my objection.

    My favorite blogs of yours are the political ones where you argue a point cogently and with passion. I read them, nod my head, listening carefully, and disagree.

  6. Ah, I think I may finally be nodding my head and agreeing with (part of) what you’re saying. I completely agree that name calling is counter-productive to intelligent discourse. For example, calling the President of the United States and idiot would not be productive. Oh wait, never mind. Seriously, though, I didn’t actually read Macey as saying anyone who questioned Mitt Romney’s past as anti-capitalist. So, while I agree that name calling is best left for the playground (and references to the dope in the White House), I don’t really think Macey was engaging in it. I think he was referring to some of the rhetoric around PE killing jobs and crap like that. So, labeling the rhetoric, not the people spewing it. Maybe it’s shades or gray and we probably should convince each other (especially since neither of us really knows) whether or not Macey was engaging in name calling. We do agree with the principal that name calling is no good. So, I promise never to use name calling against the anti-capitalist, anti-American dopey left wing. I just refuse to do that.

  7. Rodney North says:

    As a company owner, and former board director, I definitely get the points about approving dividends, and being the last in line to to be paid in case of bankruptcy. So as one of your pinko-commie relatives this is a good lesson to learn. Certainly not the impression I was getting from my daily MSNBC habit. (Just kidding- we actually don’t watch any TV news.)

    But could you explain the recurring charge that Bain & the like collects hefty management “fees” from the aquired firms through-out the process? The implication, of course, is that this income might make the rest of the math moot. I don’t pretend to know what’s really going on.

    Lastly, this also reminds me alot of my own efforts to fend off attacks – all loosely based in economic theory – against my baby, Fair Trade. Time & again a critic is working with alot of ideological momentum and clearly no real understanding of the mechanics of Fair Trade. Hence they’re inclined to level some really strong criticisms, stated as if they were axiomatically true, when in fact they have no idea of how ignorant they are about that which they just dismissed.

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