Private Equity and PRby Jeremy on 23/05/2012
Much has been already said and written about Newark, NJ mayor Cory Booker’s comments on Meet the Press this past weekend, and I don’t think there’s more that I can add. In the meantime, Andrew Sullivan posted a few reader comments on Monday in response to Bookergate, and one comment in particular presented an excellent summary of private equity and noted the difficulty Democrats have explaining what the complex investment strategy entails and why it matters. Excuse the huge block quote, but it’s definitely worth a read:
I have to take exception with your reader who argued that neither side gets the private equity story right. In reality, the left’s story is generally correct, though incomplete, while the right gets the story wrong because, well, it has to. In addition, a completely accurate telling of the story would include the terms “financial engineering” and “dividend recapitalization.”
Financial engineering is the alchemy that drives the entire private equity industry – by rejiggering a company’s capital structure, a private equity firm purports to “create value” that previously didn’t exist. Like all other forms of alchemy, if it actually happened that simply, it might not be a bad thing. Unfortunately, the processes that create that value for the private equity firm – levering the company’s balance sheet with borrowed money, reducing headcount, cutting costs and, yes, tax arbitrage – tend to whipsaw a company by depriving it of any margin of error (because it has to spend its cash flow on interest payments) while also diverting resources away from future profit-maximizing initiatives (because all of its cash is being spent on interest payments).
This is the legendary “discipline” that private equity apologists cite in these conversations, but there is very little focus on making the business, as the business, run better. Instead, the focus is on freeing up enough cash to service the debt and return cash to the new owners. The end result tends to be a less ambitious company with a far smaller footprint (employees, plants, etc.) and a reorientation away from investment in the future growth of the business and toward like as a “cash cow.” This is the case even when private equity “works.”
Dividend recapitalization is the most insidious subset of financial engineering – the owners take out a loan backed by the assets of the company and use the proceeds from the loan to write themselves a dividend check of roughly the same amount. The company is again forced to focus all of its attention on servicing this new debt, frequently groaning under the pressure. When it fails in that mission and tumbles into bankruptcy, the private equity backers toss the keys to the creditors and walk away, having already recouped most, if not all (or, in some cases, many multiples of all) of their investment. Loans are, fundamentally, supposed to be used to boost investment in productive enterprises, but in this case, the financial/private equity industry has bastardized that premise to funnel money away from productive uses and straight into their coffers.
I have worked around the private equity industry for nearly a decade, and I have never met anyone in it who can tell me with a straight face what productive ends the dividend recap serves (like your other reader, I do not consider tax arbitrage “productive”).
All of this (including the cash cow and tax arbitrage concepts) is complicated stuff that requires a familiarity with finance that not many voters possess, which is why the left has such a hard time explaining what is really going on and instead leaves itself open to charges of demagoguery by focusing on the human cost of Bain’s investments and follow-on decisions. That’s unfortunate, but it does not render false the left’s substantive critiques on the topic, regardless of what Cory Booker and Harold Ford say.
The right, on the other hand, can’t possibly reckon honestly with the pros and cons of private equity, because to do so would be an admission that it consists mainly of financial parlor tricks that benefit a small group of wealthy individuals at the expense of virtually everyone else. They know how that would play with the voters, and so they obfuscate at best, lie at worst and proclaim “class warfare” at every turn.
The Romney campaign hasn’t been urgent in defining private equity and Romney’s tenure at Bain for the public (besides saying he created x amount of jobs), because they really don’t have to be.