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Creative Destruction
Private equity is a rapacious destroyer of the middle class. No, it renews American industry by infusing old companies with capital and ideas.
Well, which is it? You won’t get the answer from the campaign trail, where Mitt Romney is getting kicked around for his private equity credentials even by fellow Republicans. (Rick Perry called Romney’s old firm, Bain Capital, “vultures that are sitting out there on the tree limb waiting for the company to get sick.”) Romney’s argument against Barack Obama hinges on the former Massachusetts governor’s record in the private sector, which is why he insists that he helped create 100,000 jobs at Bain. The rhetorical fog machine is at full throttle, and nothing resembling a straightforward answer is likely to emerge from any candidate’s mouth between now and Election Day.
It might be good, then, to lower the volume on your television and consider the evidence. For the most part, private equity firms such as Bain are neither job-creating machines nor bloodsucking villains. They’re agents of what the Austrian economist Joseph Schumpeter called “creative destruction.” That’s the economic theory that says destruction is the yin to creation’s yang; you can’t make an omelette without breaking a few eggs. (If he were alive, Schumpeter would love Romney.) The real issue is less about the details of Bain’s record, which varies from deal to deal, than whether a skilled practitioner of creative destruction is the right person to sit in the Oval Office in January 2013.
Private equity is the new name for what used to be called leveraged buyout firms. There are many investment plays, but the most common strategy is simple: buy an undervalued company, usually with borrowed money to juice returns. Whip it into shape. And after five years or so, sell it back to the public, paying off the debt and keeping the profits. Big private equity firms such as Bain Capital, Blackstone Group, Carlyle Group, and Kohlberg Kravis Roberts are partnerships that raise funds from outside investors, known as limited partners. The outside investors typically pay management fees equal to 2 percent of the size of the fund per year, plus 20 percent of the profits above a hurdle of an 8 percent annual return to the limited partners.
Done right, private equity rains down cash. Carlyle Group announced on Jan. 10 that its three founders made $413 million last year. If the One Percent Club had its own One Percent Club, people like Romney, KKR’s Henry R. Kravis, and Blackstone’s Peter G. Peterson would be members in good standing.
Studies show that private equity firms are excellent at generating returns for their investors, which include college endowment funds and teachers’ pension funds that represent ordinary people. That’s a good thing. The firms appear to shrink employment slightly, which is bad. On the liability side of the ledger, they benefit from special tax breaks, including the “carried interest” rule that allows them to treat their profits as lightly taxed capital gains. On the asset side, they force bad managers and deadwood employees to look elsewhere for work.
Investigative reporters and rival campaigns have been climbing all over Bain, trying to assess its record while Romney ran it from its founding in 1984 until he left in 1999 to save the Salt Lake City Winter Olympics from a corruption scandal. The Wall Street Journal reported on Jan. 10 that 17 of 77 firms that Bain bought either filed for bankruptcy reorganization or shut down in the eight years after Bain invested. On the other hand, there were also huge successes such as startups Sports Authority and Staples. Of the targets that failed, Bain says that some went under after it no longer controlled them.
©2011 Bloomberg L.P. All Rights Reserved.
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