Private Equity – Not a Vampire, but not a Saint either

We do not live in a black and white world although the political partisanship that goes on in this country tries to paint it that way. The latest issue under scrutiny is this concept of private equity. It was tagged with the term “vampire capital” by Rick Perry, Rick Santorum and Newt Gingrich during the GOP debates and campaign to discredit Mitt Romney. Messrs. Perry, Santorum and Gingrich called it that due to the job destruction that was generally left in the wake. The GOP leadership rightly cautioned against indicting private equity as the candidates were truly throwing the baby out with the bath water. The President’s campaign has picked up on this theme with respect to Bain Capital while trying not to denigrate private equity, in general. Even economist Paul Krugman has advocated in his column that private equity is not value additive on the whole.

In my experience with firms owned by private equity, I would not call private equity vampire capital. I would not call it a saint either. So, what is it? Private equity is typically deployed in start-ups or companies who are not clicking on all cylinders. In other words, companies who need help and are not big or sufficiently valuable enough to obtain equity on the open market are key targets. The private equity firms represent investors who are looking to buy a controlling share in these undervalued companies and turn them around for a profit. The private equity firms usually do not want to hold onto an asset like this for the long term, so the focus tends to be very short-term (3 – 7 years). While there are exceptions to this rule, the understanding of this short-term mindset is important.

The short-term focus allows the private equity firm to sell off under or non-performing assets fairly quickly. This might include a low margin line of business or product line. These lines would include the employees who would be sold with the company or be part of a downsizing. In essence, the private equity firm is looking to dress up the company for eventual sale to someone who will hold onto it for a longer time. This short-term mindset focuses the priorities away from long term profitability to profits that are additive or “accretive” to earnings in the short-term. This unfortunately includes employees, who tend to be viewed less as assets and more like to expenses. So, training and career development may be shortchanged as the expense savings would show up now, while the gains from career development may be later. Compensation and benefit costs would tend to be suppressed. I am not saying this happens in every circumstance. I am just illustrating that when the focus is more short-term, priorities for investment that are longer term in nature tend to get pushed down the list.

Many of these companies are successful long term and once the private equity firm sells its interests, they are owned and managed by people with a long term focus. Some are not successful and end up in bankruptcy due to their inherent problems or added debt burden when a private equity firms buys them. Some of these will emerge from bankruptcy while others will be shuttered. And, others may be sold to other private equity owners or companies who may be able to better leverage the investment as they own companies in a similar business.

So on the positive side, private equity plays a role in providing capital and leadership to companies who cannot easily get them elsewhere. At its best, private equity can help a troubled or start-up company survive. At its worst, it can strip a company of its profits and gut its staff before it goes under. The intent of the private equity firm is to make money for its shareholders over a shorter term horizon than would be true for the typically stock market investor. Again, there are exceptions to this rule, yet the short-term focus appears to be very normative.

I think this is where Mr. Krugman focuses his concerns. When companies focus on the short-term, they tend to make decisions that benefit the short-term which may be at the expense of longer term profits. And, as noted in my earlier post citing the lessons from “Built to Last” the companies that are most successful over the long term are the ones who look to build an organization for the long haul.

Does all this mean Mitt Romney was a job creator or job destroyer when he led Bain Capital? The real answer is we don’t know until we see data before, during and after the time of ownership of these companies. Can Bain take credit for jobs that grow after the sale to another investor? Is Bain responsible for cutting fat built up from days prior to their purchase? My main thrust is the focus of private equity is more short-term than it is for other investors. If private equity tended to gut companies to glean their profits, I would tend to be more critical of what they did.  If they were more altruistic and looked to build something that would last, I would be more complimentary. My guess is they have examples of both in their historical portfolios.

I do think the President has the right to suggest Romney’s Bain experience does not necessarily translate to running the country where a  longer term focus is needed. Yet, I also think it is unfair to paint Romney as a vampire capitalist. I would consider it a data point, just like his experience as Governor of Massachusetts and the Olympics are data points. My main concerns are Romney represents ideas of the GOP – cutting taxes which would be deficit increasing, the head in the sand stance on global warming, the discriminatory posturing of the evangelical right and lack of concern for the huge economic disparity in this country – these are what trouble me most should he win, not that he was part of a private equity firm.