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Home Publications Blogs Beat the Press David Brooks Gets Private Equity Wrong for the Team

David Brooks Gets Private Equity Wrong for the Team

Tuesday, 22 May 2012 03:24

It's clear that the impact of private equity on the economy is going to be one of the central issues in the presidential race given Mitt Romney's boasts about his performance as one of the partners in Bain Capital. President Obama and others have pointed out that private equity firms often leave large numbers of laid-off workers and bankrupt companies in their wake.

To counter this image, David Brooks picked up the cause. He used his column to tell readers that private equity firms turned around the economy, getting inefficient firms up to speed and raising overall growth.

At the most basic level, the facts don't fit Brooks' story. If he wants to credit private equity with turning around the economy then we should have seen the turnaround in productivity growth in the 80s (or at least the beginning) when leveraged buyouts first became a major feature of the U.S. economy. Instead, we had to wait until the mid-90s, long after private equity was well established.

As a practical matter, turning around failing firms is only one way in which private equity companies make money. The most common way they make money is by gaming the tax system. This is done first and foremost by loading companies up with debt. Interest payments on debt, unlike interest payments to shareholders, are tax deductible. By reducing target companies' tax liabilities, private equity firms can make large profits even if they don't do anything to turn around the company.

Private equity companies can also benefit from other forms of financial engineering. They may also be effective at the Facebook trick, over-hyping companies when they issue IPOs, selling them off to suckered investors at an above-market price. While there are undoubtedly cases where private equity actually does turn around failing companies, this seems to be the exception as my colleague Eileen Appelbaum is discovering.

If Governor Romney's record at Bain in turning around companies is better than the record for the industry as a whole then presumably he could release a full list of the companies taken over under his watch and indicate what happened to them subsequent to their takeover. If he opts not to make this information public, then it is likely that the record is not a good one.

Comments (11)Add Comment
written by kharris, May 22, 2012 7:26
Matthew 7:20.
The three faces of David.
written by diesel, May 22, 2012 8:36
"May I speak to David White?"

Usually, David "White" speaks as a (what he calls) traditional conservative. A traditional conservative walks hesitantly. Human nature is flawed. A crack runs to its very core, rendering it unfit to carry water. Aware that everything we undertake is doomed to inadequacy and suffering from the sin of partiality, the conservative is justifiably skeptical of attempts to reform, remold and recast existent social structures. Circumspection describes his tentative steps forward as he is ever vigilant to the virtually inevitable prospect that the best laid plans not only go awry, but contain within them the seeds of their own dissolution as they inevitably bear the selfish stamp of their author, who cannot help but taint the outcome with his/her selfish or self-centered perspective. This is David "White", the Saint, Rabbi or holy man--whatever.

But let David discuss the virtues of the Hammer-wielding, free-swinging creative destruction of the Mighty Venture Capitalists and a decidedly different David appears--David "Black". This David rejoices in the fall of citadels, cheers to the resounding blows of the "Barbarians at the Gates" as they smash and plunder the hapless citizens who have bartered their freedoms for snug security and thereby forfeited their right to walk the Earth as Men. These Mighty can do no wrong--do in fact, God's Work. Cleansing and Purifying, exalting Valleys and laying low Mountains.

David "Black" is David "White's" evil twin. One is a manifestation of the other. They are opposite sides of the same coin. That coin bears the bust, in profile, of an Emperor. David's worldview is fundamentally religious and moral. But then, isn't everyone's?

In a word, no. For the Greeks, self knowledge meant that we accept that we don't know or aren't sure about who we really are. Life is a journey of self discovery. We accept the partiality of our knowledge about our nature and our place in Nature as a given and live with it. True, no existent circle is a Perfect Circle, yet this doesn't stop us from striving towards perfection or from drawing circles. We don't give up drawing circles just because we have discovered that our circles are somewhat out of round. In fact, we measure the discrepancy and try to improve and compensate. So we accept that we err first in this direction, then in that. We try to "keep it between the ditches". We don't give up in despair just because we recognize that everything we do or make is flawed. And standing in this awareness, we don't spawn an evil twin, the unknowable shadow of our purely "good" side.
the big lie
written by Peter K., May 22, 2012 9:32
Bobo's wider theme in the column is that government is inefficient whilst the private sector is lean and mean.

But what about JPMorgan losing that 3 billion dollar bet? And think back on the (global) housing bubble which was an epic private sector cluster#$%& enabled by the deregulatory mindset encouraged by the likes of Bobo.

As Baker points out a lot of government's inefficiency is crony capitalism or socialism for the rich (see the health care sector). It's inefficient economically but efficiently redistributes wealth upwards.

Hope you have a relaxing vacation, you deserve it.
Public Sector Employment
written by Ron Alley, May 22, 2012 10:02
Brooks mentions the inefficiencies of the public sector but conveniently ignores the sharp decline in public sector employment, across the board at the federal, state and local government levels, and particularly in the "Red States".
written by skeptonomist, May 22, 2012 10:21
Again, productivity is not a good way to measure efficiency in the short term, or of a specific company or industry. Cutting work force will give productivity and profits a quick boost but may be harmful in the long run. If you wipe out a firm's research division it will cut labor costs and not immediately effect production, but with no new products there will eventually be a cost in sales.
Private Equity Firms
written by H-Bob, May 22, 2012 11:10
Private equity firms are analogous to leeches in medieval medicine -- they suck out the money from a business similar to leeches sucking out blood from a patient. Sometimes it hastens the patient's death, sometimes the patient survives anyways and on the rare occasion the patient actually improved. Nevertheless, the head leech is not a diagnostician and shouldn't be promoted to physician !
"Robert Reich Explains How Mitt Romney Got Obscenely Rich"
written by Gadfly, May 23, 2012 9:41
A related 3-minute video that's well worth watching: http://www.moveon.org/r?r=2755...YeiTHx&t=1 .
Irrelevance of Equity Finance to Funding US CAPEX
written by TVeblen, May 23, 2012 9:56
The FRB "Flow of Funds" data show that net new equity issuance has been mostly negative over the last couple of decades (i.e., stock buybacks exceed new issuance). Moreover, the ratio of net new equity issuance/capital expenditures never went above 10% for the last century. Thus, the stock market plays virtually no role in aggregate US capital formation (as opposed to the debt market which does). Now there are a snall cluster of high-tech sectors that do get a significant share of new capital from equity markets, but they're tiny generators of new employment ( mostly for biochemistry, math, comp sci. and other science MS/Phds). Bain, McKinsey, and the other corp. "rationalisers" are what both Smith and Marx would call "unproductive" labor.
written by Max.J, May 29, 2012 9:39
I understand your point here, however saying something like "If he opts not to make this information public, then it is likely that the record is not a good one" would require much more transparency from President Obama as well. Your article is good but since there is a lot of hypocrisy concerning the money that the President uses for his campaign from private equity, you may come up against some opposition here.

People think that they can require information to create a website from one candidate and not the other so that they can somehow make the other person look bad.

written by Angry Panda, May 29, 2012 7:49
The post betrays a...lack of familiarity with the world of Private Equity (PE).

The interest expense deduction doesn't even come close to the explanation, particularly since the world of PE cares not about Net Income or EPS, but about EBITDA - which is explicitly a pretax measure. [For evidence, crack open an offering memorandum - any offering memorandum.] To be sure, LBOs do usually result in no taxes - but that's because the transactions are structured to "generate a loss" by writing off the assets of the LBO target. [Essentially, the tax code allows the company to then apply this "paper loss" against its cash taxes for the next 20 years or until the "paper loss" runs out - effectively, "forever", from the PE buyer's standpoint.]

No, the way PE firms make money is twofold.

First - dividend recaps. After you buy a company, within a year (or two, or three), you replace whatever debt you'd put on the thing with an even bigger chunk of debt, paying the difference out to the PE fund as a dividend. Back at the market peak, you could literally pay yourself back your entire equity investment within a year - your actual ownership of the business was a "free option". [At various times, upwards of a quarter of all high yield debt financings was for dividend payments.]

Second - you flip the business. All you have to do is show EBITDA has grown by, say, 10% or 15% since you'd bought it - doesn't matter if you're using "future unrealized cost savings" as addbacks, doesn't matter if you've just laid off half the staff (because the savings hit in the short term, while the cost to the business takes time to become apparent). However you can, get EBITDA to grow. And pray that the market EBITDA multiple (i.e. market valuation for a specific kind of companies, one of which you are trying to flip) continues to rise. Then find a buyer and cash out - could be another PE shop (if they're greedy), or could be an IPO (i.e. the public - see Facebook as quasi-exhibit A, the insiders bought in at something like $20 and cashed out at as high as $42 while the "public" got stuck...).

Now, obviously both these strategies only work when markets are rising. Hence the PE booms coincide with the broader market booms, and hence PE funds started up in 2007 (at the very peak) are struggling to deliver the 20%-25% returns they've promised their investors - because markets are "sideways", IPOs sometimes don't happen, dividend recaps can't always be done, EBITDA sometimes shrinks rather than grows...and so forth. And make no mistake, each PE firm's offering docs explicitly promise something like "25% return on investment over a 5-year time horizon" (so you basically have to double your equity investment, one way or the other, over 3-5 years to make your number - and you can't "not-invest" either because after a certain period of time investors can pull their money...).

This was never about "jobs". This was never about "turning around" companies. This is about how much money a PE guy can extract, via dividends or a flip, over what period of time. Obviously if you buy an undervalued asset - a company that's in trouble because of incompetent management - and "realize" its true value, you've made a bundle right there (because all its metrics improve by a lot) - but that's more of an exception, and a lucky one, than the rule.

Oh, and in case anyone had any illusions - almost always, while the PE guys are busy figuring out how to flip, or finance a dividend, or whatever else - they also charge the company they bought with (mostly) other people's money management fees. Anywhere between $2 and $20 million a year. That's directly to the PE firm, i.e. not to the fund (because the PE guys only get a fraction of what goes into the fund - management fee plus a percentage of profits - but "management fees" from the LBO companies themselves go straight to the bottom line...).

Yeah. Fun world.

What does any - any - of this have to do with "interest deduction"? Is it really so hard to crack open a bloody book on how PE operates? It's not as if it's top secret information, you know...
interest deduction
written by Ben Leet, May 31, 2012 7:27
Illinois Congresswoman Schkowsky presented a budget in 2010 when she also dissented for the Simpson/Bowles committee on which she was sat. $70 billion a year was the projected revenue boost she figured by eliminating the interest deduction to financial corporations. I can't say that applies to PE, but I assume it does. Also William Lazonick has written that over 450 companies on the S&P 500 spent 40% of profits on buybacks and 54% on dividends. He asked, "How much was left for investment in the companies? Not much." from Lazonick's article "How Corporations Were Transformed from Producers Into Predators."

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.