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Home Publications Blogs Beat the Press David Brooks Thinks that Romney and Bain are About Efficiency

David Brooks Thinks that Romney and Bain are About Efficiency

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Tuesday, 17 July 2012 15:08

Yes, that is what Brooks told readers. His column today mourns the fact that Romney and Bain are being blasted for being capitalists. He then tells readers:

"Romney is going to have to define a vision of modern capitalism. .... Let’s face it, he’s not a heroic entrepreneur. He’s an efficiency expert."

Brooks is certainly right that Romney is not a heroic entrepreneur, but it doesn't follow that he is necessarily an efficiency expert either. The private equity folks like to tell stories of how they find poorly managed companies, clean them up, and then sell them for a big profit. 

Undoubtedly there are cases where this is true, but these are likely the minority of companies that are taken over by private equity (PE) firms. Finding companies that can be quickly turned around by better management is not easy. After all, if it were easy to find better management, someone would have done it already (economist humor).

What PE is very good at is taking advantage of tax dodges. It's likely that your stodgy family-run business has not kept up-to-date with the state of the art tax avoidance schemes. However PE companies do, and there can be big bucks in applying these modern tax avoidance schemes to old-fashioned businesses.

To see this, let's take a simple example. Suppose an old widget company was operating with a ratio of debt to book value of 20 percent. Let's assume that its book value is $1,000 million and its debt $200 million, leaving shareholders' equity of $800 million.

For simplicity, assume the combination of before tax profit and interest is 10 percent or $100 million. The company will  then pay 6 percent interest ($12 million) on its debt. This leaves before tax profit of $88 million. if it pays a 35 percent tax rate, then its after tax profit is $57.2 million, as shown below.

private-equity-fig-1-07-2012

 

Now suppose some clever PE types come in. One of the first things they will likely do is borrow a substantial amount, let's say $600 million. They will use this money to repay much of the $800 million purchase price of company. The interest burden on the higher $800 million in debt ($600 million in new debt plus the old $200 million) is $48 million, leaving $52 million in before tax profits. Assuming that the company still pays 35 percent of its profits in taxes, its after-tax profit as a PE-owned company is $33.8 million.

While this means that our PE folks are taking home less from the widget company than the old-fashioned family owners, it is important to remember that they have gotten most of their money out of the operation. They only have $200 million invested, as compared to the $800 million invested by the previous owner, as illustrated below.

private-equity-fig-2-07-2012

This means in principle that the Romney-Bain folks can find three other widget companies. If they do the same deal with each, they will manage to pocket over $135 million compared to the $57.2 million earned with the same amount of capital by the prior family owner.

Note that this increase in profitability assumes nothing about efficiency. In this story the Romney-Bain gang did nothing to improve the operation of the factory. They just found ways to reduce its tax liability.

This is clearly an overly-simplistic story, but it does illustrate how PE companies can make large profits without doing anything to increase efficiency. This is one of the ways in which PE companies make money. To get the full list, read the work of my colleague Eileen Appelbaum.

But the important point is that PE companies can make lots of money for themselves in ways that do not involve increasing efficiency. In other words, contrary to what Brooks told readers, there is no reason to assume that just because Romney got rich in PE that he is an efficiency expert.

Comments (11)Add Comment
...
written by Bloix, July 17, 2012 4:22
What I don't understand about this example, or the entire Bain operating strategy, is why a lender who lend at 6% to a company that has a debt-to-equity ratio of 1 to 4 will lend at the same 6% to the same company when its debt to equity ratio is 4 to 1. Doesn't the lender demand a risk premium? Can't it do the same calculation you just did, and conclude that the extra profit flowing to Bain should belong to the lender in exchange for taking on more risk?
...
written by Brett, July 17, 2012 4:33
Ah, good ol' Leveraged Buy-outs - the bane of the newspaper industry and MGM.
If it is so easy PE's should compete each other away...
written by pete, July 17, 2012 5:42
PE guys are not a friendly crowd. It is incredibly cutthroat. I suspect that as with hedge funds, the rate of return is not great for the investors, but more likely the managers, like Mitt. Once in a while they get lucky, but sometimes they blow it. Sure there may be tax advantages to debt, but there is a limit. What you are saying is that the company does not have an optimal capital structure. That can be fixed internally as well as through a buyout. In fact some internal managers do take over companies with levered buyouts.

I thought Brook's argument about global growth was interesting. Here the social efficiency comes into play. Suppose we assume the proper social welfare function is Rawlsian. Based on this do we stop at the border, i.e., only Rawlsian within our borders, which means to become mercantilist/nationalist..lower growth but more equality. Or do we care about folks outside the border, such as in Africa, India, etc? This a real critical consideration. Seems like with Europe and USA able to pay 10%-20% or more of their population massive global GNP/capita dollars to remain idle, while raising the incomes of the rest of the globe, ain't such a bad trade off.
romney is toast
written by mel in oregon, July 17, 2012 6:00
why? let me count the ways. 1. he probably lied to the SEC which may be construed as a felony if the SEC follows up on it. at any rate it is a sword of damocles hanging over romney's head from now on. 2. he cannot release his tax returns for the very probable reason that he hasn't paid taxes recently. 3. he supports the ryan tax plan which if looked at closely cuts medicare, medicaid, unemployment compensation, food stamps & social security. 4. he has tax sheltered his capital in bermuda, the caymans & switzerland to avoid the IRS. 5. why would he get 100k from bain capital up until 2002 as the CEO & main shareholder if he quit in 1999? 6. his age: he will be alm- ost 74 if he is elected & reelected, meaning according to life actuarial tables & the stress of holding the office, that there is more than a 25% chance he will die while in office. sheldon adelman then would be a perfect choice for vp. 7. he is losing quite remarkably in most of the swing states. nuff said...
so, to summarize
written by saurabh, July 17, 2012 6:24
They are basically cashing out the equity in the company and sucking on the profits until such time as they trade the thing in for scrap. You might remember a similar scam that the gangsters in "Goodfellas" pull, where they find a friendly sucker, get ahold of his credit and pull as much money as they can out until they've run his good name into the ground.
...
written by Last Mover, July 17, 2012 6:52
You're all wrong. Brooks was obviously referring to Romney's efficiency expertise in time and motion studies as an industrial engineer complete with clipboard and stopwatch designed to measure how high employees could jump when he walked into a room of employees of the acquired company.
Typos
written by NotAnEconomist, July 17, 2012 6:55
I think: "Assuming that the company still pays 65 percent of its profits in taxes" should read "Assuming that the company still pays 35 percent of its profits in taxes"

Also, I am not sure I understand the following: "This means in principle that the Romney-Bain folks can find three other widget companies. If they do the same deal with each, they will manage to pocket over $135 million compared to the $57.2 billion earned with the same amount of capital by the prior family owner."

Should that be $57.2 million instead of billion?
"What, me worry?" - Romney's attitude about the SEC
written by JDM, July 18, 2012 12:26
he probably lied to the SEC which may be construed as a felony if the SEC follows up on it. at any rate it is a sword of damocles hanging over romney's head from now on.

Given that we've seen over the past decade that the SEC is rather corrupt and very uninterested in going after rich people who do even worse stuff than Romney, I don't think he has the slightest worry from them. In a better world they'd already have had the coppers knocking on his door. It's going to take a lot to build that better world from where we're at now.
Bloix...
written by David, July 18, 2012 3:51
Read the Appelbaum & Batt paper that Dean provides a link to. It describes the business model. Basically, $600 million is secured by the $200 million, so the PE can buy the company, thus the bank has the same risk exposure ($200M), hence the 6% rate is unchanged. The PE firm then passes the assumed liability to their newly acquired company.
It's Also Called Equity Extraction or More Simply, Piracy
written by Stephen Kriz, July 18, 2012 2:31
Some liberal commentators have referred to Bain Capital's takeover practices as "equity extraction" and I think that is a pretty good description. It describes your diagram quite well, where debt is substituted for the underlying equity, which is then removed from the company in the form of dividends or "management fees". A slightly more colorful but still useful adjective might be "piracy", where the noble Bain Capital simply loots what someone else has created!
MBA 101
written by scott moore, July 23, 2012 12:39
Dean, right on the mark. This is MBA 101.

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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.

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