Barack Obama, private equity king
The Washington Post, May 23, 2012
If we're going to fight all year about the Larger Significance of private equity, it would be nice if we could move beyond dueling cartoons. The clash between "Bain personifies capitalism's heartless evil run amok" and "Bain exemplifies the 'creative destruction' that is capitalism's genius" offers little insight for those not already addled by ideology. Since a subtler assessment of private equity's pros and cons stands no chance of finding expression on the campaign trail, let me offer an idiosyncratic guide to the terrain as the Bain wars heat up.
The first thing to appreciate is that Barack Obama is the real private equity king in this race, not Mitt Romney. Obama's restructuring of the auto industry displayed, on a much grander scale, precisely the kind of tough-minded business calls Romney says are private equity's specialty. With help from ex-private-equity maven Steven Rattner (and a staff filled with other private equity refugees), Obama fired management, shed workers, slashed costs, revamped operations, restructured the balance sheet and fashioned new strategies. When the dust cleared, Obama had positioned General Motors and Chrysler to move forward as viable firms.
So Obama doesn't need any lectures in creative destruction from the GOP. He creatively destroyed more in a few months than Romney did over his entire career as an investor. But he did so with public goals in mind. That meant having Uncle Sam provide the bridge loans the market wouldn't offer in the scary climate after the financial crisis (a step Romney wrongly opposed, and now pretends didn't matter). As a result, Obama's de facto private equity chops saved the industry.
Truth is, the unsentimental restructuring that Obama brought to Detroit was an example, writ large, of the contribution private equity made in its early days. Back in the 1980s, the landscape was littered with bloated corporate conglomerates run more for their managers' benefit than for shareholders'. Pioneering private equity buyouts helped rationalize many of those firms in ways that helped revitalize the U.S. economy.
But the enormous personal wealth those early transactions generated also led countless copycats to chase their pot of gold. As the field became flooded with Henry Kravis wanna-bes, the world of private equity changed.
For one thing, intense competition for deals bid prices way up. If that early generation of dealmakers identified undervalued firms and improved them, the 1990s and 2000s were characterized more by auction sales—a process that's great for the firm being sold, but which often led PE firms to overpay in order to put their burgeoning resources to work.
Why did PE firms have so much cash to put to work? A flat stock market and an era of endlessly low interest rates made pensions funds, university and foundation endowments, and other institutional investors desperate for higher returns. When David Swensen, the influential chief of Yale's endowment, blessed the idea of diversifying into new asset classes like private equity, the floodgates opened and PE funding soared.
Somewhere along the way, the balance shifted from PE's original focus on making money by fixing underperforming businesses to a greater (and less socially valuable) emphasis on profit via financial engineering. Enormous levels of debt were the key. Mitt Romney is a wealthy man because of the outsized returns made possible by shrewd debt-funded bets. And while it's true that the need to cover debt payments can focus management's mind, it's also true that tilting an enterprise's full attention to servicing large debts can shortchange investments in things like research and development, and other building blocks of competitiveness.
Over time, PE has evolved to the point where extraordinary debt levels, as well as indefensible fees imposed by PE firms on the companies they acquire, explain an outsized portion of private equity's success (as opposed to real improvements in the businesses they own). Obviously I'm painting with a broad brush here—there are still laudable deals that improve underperforming businesses. Still, the money manager and author Michael Lewitt says that, adjusted for levels of debt and risk, top private equity firms are no more profitable than you or I would be if we bought a broad index of stocks with, say, 20 borrowed dollars for every 1 dollar we invested of our own money.
Meanwhile, the fees PE firms routinely charge the companies they own would be laughable if they weren't so obscene. Follow the bouncing ball: PE firms often have a business they acquire borrow fresh cash for the sole purpose of paying the PE firm an immediate dividend—a payout that effectively returns much or all of the cash the PE firm actually invested in the deal. (Business Week estimated in 2005 that in the prior two years banks lent companies $71 billion to pay such dividends to PE firms). The acquired firm may also pay the PE firm (for example) a $100 million annual "monitoring" fee, $75 million in "advisory" fees and a $50 million "transaction" fee as a reward for doing the deal in the first place. In one case, a PE firm got a $27 million fee for ending an advisory relationship.
As they say, nice work if you can get it.
It's hard not to view all these fees as gluttony by owners with the power to pile on debt and strip a firm's cash in order to take much of the risk out of the original investment. As veteran financier Felix Rohaytn once put it, "For the management of the company, [a buyout is] usually a windfall. For the private equity firms with cheap money and a very well structured fee schedule, it's a wonderful business. The risk is ultimately in the margins they leave themselves to deal with bad times [in the business itself]." The ones felled by that risk end up as fodder for Obama campaign ads.
Remember that old line from the National Rifle Association: Guns don't kill people, people kill people? Well, private equity isn't good or bad in itself. Leveraged buyouts have been used to good effect, and to bad. Like anything, they're subject to abuse. They've given rise to unsavory industry voices who defend tax breaks that leave PE kings paying lower rates than waitresses or nurses. Yet private equity has also helped spawn huge philanthropies.
In the end, the biggest downside of the private equity era may be the diversion of so much of the nation's top young talent to financial engineering, when America needs real engineers. Private equity wealth has also helped narrow the boundaries of political debate because both parties depend on its lucre to bankroll campaigns.
It would be nice if the president would point this out. But I'm not sure he—or any practical politician today—can afford to.