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
- By JONATHAN MACEY
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).
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 Forbes.com 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.”
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.