As Mitt Romney cruises to his inevitable coronation as the Republican presidential candidate, increasing amounts of attention are being focused on his history at Bain Capital, where he made his fortune. Did he create 100,000 jobs, as he claims? Or is he a vulture and asset stripper?
Glenn Kessler has the definitive take on the job-creation claim, which he says is “untenable”; as he says, Romney’s method of counting jobs created when he wasn’t at Bain or when Bain wasn’t managing the companies in question doesn’t even pass the laugh test. Meanwhile, as Mark Maremont documents, Bain-run companies — even the successful ones — have an alarming tendency to end up in bankruptcy. And I think it’s fair to say that bankruptcy never creates jobs, except perhaps among bankruptcy lawyers.
The reality is that Romney would have been in violation of his fiduciary duty to his investors had he concentrated on creating jobs, rather than extracting as much money as he possibly could from the companies he bought. For instance, Worldwide Grinding Systems was a win for Bain, where it made $12 million on its initial $8 million investment, plus another $4.5 million in consulting fees. But the firm ended up in bankruptcy, 750 people lost their jobs, and the US government had to bail out the company’s pension plan to the tune of $44 million. There’s no sense in which that is just.
Romney’s company, Bain Capital, was a “private equity” firm — the friendly, focus-grouped phrase which replaced “leveraged buy-outs” after Mike Milken blew up. But at heart it’s the same thing: you buy companies with an enormous amount of borrowed money, and then dividend as much money out of them as you can. If they still manage to grow, you can make a fortune; if they don’t grow, they’ll likely fail, but even then you might well have made a profit anyway.
Private equity companies need growth, because they’re built on the idea of buying, restructuring, and then selling. They’re never in any business for the long haul: instead, they want to make as much money as they can as quickly as possible, sell out, and keep all the profits for themselves and their investors. When you sell, you want to maximize the price you can ask — and the way to do that is to show healthy growth. No one will pay top dollar for a company which isn’t growing.
Private equity is by no means unique in this respect: it happens at pretty much every public company, too. John Gapper, today, has a column about the way it destroys values at struggling technology companies:
Most public companies are run by people who hate folding 'em, and instead keep returning to the shareholders and bondholders for more chips…
Few senior executives, when debating options for a technology company in decline, admit defeat and run it modestly. Instead, they cast around for businesses to buy, or try to hurdle the chasm with what they have got. Sometimes they succeed but often they don't, wasting a lot of money along the way.
It goes against their instincts to concede that the odds are so stacked against them that it is not worth the gamble. Mr Perez would have faced a hostile audience if he'd admitted it to the citizens of Rochester, Kodak's company town in New York, but its investors would have benefited.
At many companies, then, both public and private, the optimal course of action is a modest one — run the business so that it makes a reasonable profit, and can continue to operate indefinitely. If you chase after growth, you often end up in bankruptcy: that’s one reason why the oldest companies in the world are all family-run. Families, unlike public companies or private-equity shops, don’t need growth: they’re more interested in looking after their business over the very, very long run.
There’s no limit at all to the amount of growth that the public companies will demand: in 2007, for instance, after a year when Citigroup made an astonishing $21.5 billion in net income, Fortune was complaining about its “less-than-stellar earnings”, and saying — quite accurately — that if they didn’t improve, the CEO would soon be out of a job. We now know, of course, that most if not all of those earnings were illusory, a product of the housing bubble which was shortly to burst and bring the bank to the brink of insolvency. But even bubblicious illusory earnings aren’t good enough for the stock market.
If you want to be fair to Mitt Romney, you could make the point that many of the companies he bought were highly risky, and would probably have gone bust anyway; in that sense he can’t be blamed if they eventually did just that. If a company is going to fail, you might as well squeeze the maximum amount of money out of it before it does. But doing that, at the margin, means more job losses, quicker job losses, and — as we saw at that steel company — a willingness to underfund staff pension plans and stiff the government with the bill. Mitt Romney turns out to have a personality which is highly suited to that kind of ruthlessly callous behavior; that’s how he became so incredibly wealthy. It’s an ugly part of capitalism; it might even be a necessary part of capitalism. But the one thing you can’t do is spin it as a great way of creating jobs.
In high school, you may have run across a “real life application” problem in which you calculate the result of compounding double-digit growth over 40 years?
That is the Wall Street lie. It sounds great on paper, but real-life growth curves don’t look like this: http://www.ecofuture.org/pop/images/expp op_graph3.gif
They instead tend to look like this: http://www.benespen.com/storage/cycles/l ogistic.png
If a company acknowledges the slowing growth, it can reach a healthy and profitable steady state. If it doesn’t, it ends up following the blue curve on this graph: http://successfulsoftware.files.wordpres s.com/2007/04/boom_and_bust21.gif
(Guess where the bankruptcy comes in?)
I don’t follow your argument. You say that Romney and his partners at Bain Capital invested in risky, failing businesses, and then you criticize him for firing employees of those businesses…which you indicate were failing in any event. If a business is failing of course its employees are going to lose their jobs.
Fans of private equity would argue that the firms are actually run better because they have so much debt, and that net-net all this extra efficiency makes up for the losses from the firms that end up in bankruptcy.
“There's no limit at all to the amount of growth that the public companies will demand:”
This depends on P/E. If a stock has a 10 P/E, the market is typically content with flat earnings. If it has a 20 P/E, you need to show 15% YOY earnings growth each quarter.
When a stock has a 50+ P/E, it is doomed.
In my mind, chasing growth and failing is also known as creative destruction, without with the economy as a whole can’t grow, oddly enough. Growth occurs when companies fall to new and more vibrant companies with better ideas.
I can’t disagree with much of what you said; Romney is no doubt using the jobs card because it’s even more laughable for a career politician to do so.
“Romney would have been in violation of his fiduciary duty to his investors had he concentrated on creating jobs, rather than extracting as much money as he possibly could from the companies he bought.”
This is an absolute myth, that executives have a fiduciary duty to maximize the profit of the company. There’s no law that says that, it’s an excuse for executives to maximize their short term compensation. they have a fiduciary duty to do what’s best for the company, and making as much money as possible in the short term is not always what is best for the company.
If this were the case, then Wal-Mart wouldn’t have gave away truckloads of water to Katrina victims, because it lowered profits for that quarter. Intel wouldn’t have spent money on developing and promoting the USB interface, because they made no direct profit, and it cost them tens of millions of dollars, if not more. Google wouldn’t have offered Android for free. And countless businesses wouldn’t have made charitable donations to all kinds of non-profit organizations, because they don’t maximize profit. Yet all of these expenditures were made with the long term health of the company in mind.
Executives don’t have to justify every decision with proof that it will create profits, they just have to be able to say those decisions will be best for the company in the long term. Romney would not have violated any fiduciary duty by making decisions to create jobs, for usually it’s difficult to grow companies and increase value without hiring people.
While companies may fire CEO if they don’t meet their profit goals, that has nothing to do with fiduciary duty, just incredible shortsightedness of the board (of which there seems to be an endless supply).
And it’s not capitalism that kills companies, just bad execution or misinterpretation of a company’s value.
Not sure where to start, as there’s a whole lot of half-truth’s in here about fundamental matters including the nature of bankruptcy, why firms grow, and how private equity operates. To take one – you write about bankruptcy as if it equals liquidation of a firm, which is obviously not the case. In theory, Chapter 11 filings for firms that Bain Capital previously levered up to pay itself dividend recaps are just transfers of money from the debt holders who funded those recaps to Bain and the other equityholders. In practice, I’ll concede that the situation isn’t the clean, as a bad balance sheet usually has some negative impact on a company’s operations, but I stand by my point that a company isn’t liquidated because of a bad balance sheet, it reorganizes in bankruptcy.
Regarding your points on growth, you underestimate the risks of the alternative. Yes, companies do sometimes create risks by trying to grow to fast. In many industries, a small family-owned firm trying to “run the business so that it makes a reasonable profit, and can continue to operate indefinitely” eventually doesn’t operate indefinitely because some other small family-owned firm does grow and eventually puts it out of business. Look at retailing, where Wal-Mart’s impact on other retailers is one obvious example, but the trend is the same across most categories of retailers (pharmacies, department stores, grocery stores, etc.). In theory this process should happen in any industry that is subject to economies of scale.
I’m really confused by your concern that “struggling” companies attempt to turn things around. If they are in decline, isn’t that the alternative to laying off workers, milking the business for cash, and eventually liquidating? And, if it’s OK in that case for shareholders to take cash flow out of the business as it slowly declines, why is it wrong for them to lever up a business to pay shareholders a dividend when times are good? Mr. Gapper’s arguments are interesting, but there are some real problems in trying to run a shrinking business. One key one is employee morale and retention – who wants to work at (or run) a business where the explicit plan is to shrink gradually?
So, yes, businesses do sometimes run into problems by trying to change (I’ll use a broader term to encompass both revenue growth and efficiency gains). In a world that’s dynamic, however, you’re greatly overestimating the wisdom and applicability of “let’s keep doing things the same as last year” as a strategy.
“.. you buy companies with an enormous amount of borrowed money, and then dividend as much money out of them as you can.” In any other context that behavior would be called “Rape & Pillage”. That is what is in this context too. It doesn’t matter how you try to gloss it over.
Nor is any of this any qualification to be President of the US. What a President does and what a private equity person does are in no way similar.
Wait, on the one hand, private equity levers up and dividends out as much as possible, and growth is just gravy but not necessary. On the other hand, private equity companies need growth? Which is it? Need growth, or don’t care about growth?
Also, wouldn’t it start to get somewhat more difficult to find buyers of bonds in companies you take over if you stiff the bond-holders every time? Seems like there might be an incentive structure there, and it might lead to trying to generate growth.
Wait, you say Romney’s a Republican? In that case, I think you’re being too kind. It’s obvious that his motivation wasn’t even to make money by leaching out dividends. He just likes firing people.
The dirty little truth that Wall Street wants to keep ordinary people from figuring out, is that MOST of what takes place on Wall Street is of little benefit to society at large. While asset managament, M&A, venture capital, retail banking, and market making all arguably provide benefits to the public-at-large, but proprietary trading, which over time has become a larger and larger percentage of Wall Street activity, certainly does not.
From every angle I’ve looked at PE, I keep coming back to the tax treatment of dividends vs. interest as the core issue. CFO’s of public companies face a lot of issues in levering companies up to their maximum extent. At a certain level of leverage, longtime shareholders would rather have a lower chance of bankruptcy than the increased cash flows from tax deductions.
Meanwhile, private owners can lever up the company as much as the market will bear. The levering increases the Beta for the equity dramatically, but also increases alpha.
There is also the general issue of the banks who put up the secured portion of an LBO and the institutions (pension funds, insurance companies, etc.) who buy the unsecured junk bonds to fill out the transactions. The high interest on these junior debts enables managers who are looking to the next bonus instead of long-term capital growth. Since the leveraged company will almost certainly pay the high interest until the principal is due in five years or so, these managers enjoy high paper gains.
From this angle, I have a very hard time seeing how PE adds any social value. The Financial Engineering side of it certainly does not add any social value. The private management might add value, but there’s no requirement to use junk bonds to take a company private.
Great post, Felix. Those companies may or may not have survived without Bain Capital. But they sure were a lot more vulnerable when Bain loaded them up with debt, extracted cash for itself, and then loaded the company up with Bain consultants at $40,000/month per person. Biologically, this is parasitical behavior, and of course, when a host has lost a lot of blood to the parasite, it is much more vulnerable to infection, interruption in food supply, etc.
“Skimmers.” I really want to revive the term. It certainly applies to LBOs.
Felix, “US government had to bail out the company's pension plan to the tune of $44 million.” By the goverment I’m assuming you mean the PBGC, a goverment agency funded entirely by insurance premiums paid by private companies.
http://www.pbgc.gov/about/how-pbgc-opera tes.html
While I share you disdain for any private equity deal that leaves the company in chapter 11 and the PE firm with profits… it is unfair to say that the goverment bailed out the pension plan.
Berkshire Hathaway is basically a big insurance company that invests nearly all of its assets in private equity. The only difference between Berkshire and Bain is Berkshire never sells. You want to whine about the 15% capital gains rate for private equity…. Berkshire’s gains rate is ZERO because 99.9% of all the capital gains they have ever had are still sitting on their balance sheet unrealized.
Economics has many parallels with Ecology, particularly so in the areas of Ecosystems = A country’s Economy and individual companies equating to different species competing with each other for the resources of the ecosystem. Nature has a way of maximising the returns of any ecosystem that economies have not yet figured out.
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