It appears that former Bain Capital CEO and outspoken fan of firing unsatisfactory service providers, one Willard Mitt Romney, is poised to lock up the Republican nomination.

Some of Mitt’s competitors, most notably Newt Gingrich and Rick Perry, have started to criticize him for engaging in “predatory corporate mugging” and “vulture capitalism.” This line of attack will only continue into the general election campaign, which makes now as good a time as any to answer some questions about what exactly private equity firms such as Bain Capital actually do, and whether the accusations leveled against them hold any water. As someone with a little professional experience in the industry, I can help.

What is private equity?
Private equity (PE) is equity (stock) in a business that is not traded on public markets.

Many companies choose to list their shares on major stock markets because it allows them to raise large amounts of capital (money) by offering a limited form of ownership (stock) in the business to a wide and diverse range of investors (you, me, mutual funds, 401(k)s,
Abu Dhabi, etc.). Investors buy stock when they believe a company will grow in prestige and/or profit, thus increasing the demand for its stock by other investors and, consequently, its share price. Because of the established, high-volume markets in which these stocks are traded, they are extremely liquid, meaning they are easily convertible to cash.

Public companies are required by the Securities and Exchange Commission to release quarterly financial information and a comprehensive annual report, the Form 10-K. Private companies have no such obligation. Therefore, they can take more aggressive and sometimes unconventional positions regarding borrowing, investor distributions and executive compensation without having to worry about prying eyes.

How would someone invest in private equity?
Public equities are traded at the appropriately-named stock exchanges, where millions of buyers and sellers come together at one venue and, yes, exchange stocks at whatever the determined price at the time happens to be.

Private companies may have a handful or even one sole owner, or seller in this case. The pool of buyers is much more limited as well; not only are the shares not listed, but no private company wants a bunch of small shareholders. Would you rather have a $100 bill or 10,000 pennies if you were trying to be discreet and efficient with your accounting and financial reporting? Needless to say, the Benjamin Franklin investors are a much smaller group than the Abraham Lincoln investors.

An enterprising investment group or single investor might approach owners a private company that had no intention of selling all or part of the business, and try to persuade them to consider an equity investment. The reverse happens as well, with motivated sellers seeking out qualified investors.

Arranging these negotiations can be a tricky thing, as senior management of private companies often do not want employees being aware early on of any possible changes in ownership for fear they might bail en masse and seek jobs with a company without that kind of uncertainty. I would. To manage this, these companies usually hire some kind of investment bank, business broker, lawyer or other intermediary to connect the owners to potential buyers and, for lack of a better term, “stage” things. Who are these $100 buyers?  Some are very rich individual investors or “family offices,” but many are professional private equity firms.

What is a private equity firm?
Private equity investments are generally organized by firms in the form of individual funds with their own guidelines, fees and profit splits. A sample fund of $200 million might have a 2 percent management fee paid to the PE firm, plus the firm would be entitled to 30 percent of profits made from any fund investment. PE firms aren’t restricted to one fund at a time either, and many like to take on as much as its staff can humanly handle, and then some.

As the management team of a PE firm tends to be pretty small relative to revenue, compensation can be quite robust. Long and unorthodox hours and plenty of disposable income can be a dangerous combination for some of the younger guns in the industry. There’s a reason exotic dancers and cocaine dealers have not occupied Wall Street.

Most PE firms have a handful of senior people who handle negotiations, work investor and financier relationships, and sit on the boards and manage the executives of the businesses the firm is invested in. The more junior people, analysts like yours truly, get to spend late nights gazing longingly at Microsoft Excel.

There is no stock exchange that gives us the daily market price for one share of a private company. Analysts have to dig into the numbers and build financial models that project out the future performance of the company. They are constantly testing and tweaking projections and models; incorporating new data and updating old, to basically answer the following three questions: What should we pay? How much of the business should we receive for this? Once we’re in, what’s the best way to use our money and access to debt to maximize profit?

There are a few flavors of private equity investment, but the most common and (in)famous form, and the one Mitt is most closely associated with is called the leveraged buyout.

What is a leveraged buyout?
In the simplest possible terms, a leveraged buyout (LBO) is a transaction in which a buyer uses a combination of its own cash and borrowed money, largely the latter (leverage), to purchase enough equity in a company to give said buyer a controlling interest in the business (buyout). Leverage allows for a large investment without committing a ton of cash up front, i.e., purchasing a home by taking out a mortgage loan. The buyer can then come in and make all sorts of changes it feels will increase the value of its investment (shareholder value).

The best and most obvious way to go about doing this is to increase the profitability, or net income, of the company. Raising revenues is (almost) always a goal, but cutting costs also boosts net income. What’s the easiest way to do this? Close facilities and fire people.

Walk me through a sample private equity investment.
Let’s say that I am the managing principal of a private equity firm, Illuminati Capital Partners. ICP buys a controlling interest in Tinfoil LLC for $8 million: $2 million in cash and a $6 million bank loan that charges 7 percent. Of course Tinfoil is the borrower on the loan, and I am not going to be signing any kind of personal guarantees, so if Tinfoil defaults, my riches are safe. Tinfoil is profitable enough where I, having been elected chairman of Tinfoil’s board by ICP, am comfortable paying the interest on the initial loan.

Let’s now say that I have cut overhead at Tinfoil and pushed up prices to the point where profit has improved enough that I feel comfortable taking on (and more importantly, the bank feels comfortable lending) another $4 million at 7 percent. Not only can I use this to pay ICP its initial $2 million back, but I can pull out another $2 million to do whatever with. I might use it to hire salesmen to try to grow revenues, buy some new equipment, improve the facilities, or I might distribute some or all of it to the other shareholders. I can do this because I have a controlling interest and my financial statements only need to be known to Tinfoil, ICP and the IRS.

Now ICP has all its investor cash back (and more), and no borrowing risk for the loans that replaced it, while maintaining control of and stock in Tinfoil. As a private equity firm, the plan for ICP is to try to continue to grow profits and then sell its ownership for significantly more than the $8 million paid for it, but once the cash is out, even the business fails and Tinfoil defaults on its crushing load of debt, ICP is safe. If the business or general economy turns south before ICP is able to get its equity out, it is still only on the hook for the initial $2 million, not the full $8 million, and will likely live to fight another day.

So is private equity really “vulture capitalism” or is any criticism of it an attack on our free enterprise system?  Should I believe Mitt or his opponents?
Mitt Romney and his critics are both wrong. His career in private equity does not define him as a job creator or a job destroyer; rather, it makes him a jobs-neutral value creator.

Why Mitt is wrong:

Private equity firms are singularly focused on increasing shareholder value, which is perfectly appropriate given the nature of the business. Whatever the number of jobs gained or lost that correlates with the increase in profit is irrelevant to them. There’s a reason Mitt could not defend his job creation record with comprehensive data from his career at Bain Capital and had to rely on round number estimates. Neither Bain nor its investors were concerned with job numbers at its businesses; it’s not a statistic they would bother keeping.

Mitt cannot in good faith take full credit for a byproduct of his actions, when the byproduct was not his primary intent. The “look what I found” argument should insult our intelligence. He did not go into business to create jobs and hope to make money along the way, but even if he happened to lose money would still be happy as long as he created jobs. He is profit-driven and jobs-neutral rather than jobs-driven and profit-neutral. It’s not that he hates jobs, it’s that he just doesn’t care. If he cared, he would have kept records.

Why his critics are wrong:

Some companies are legitimately mismanaged and need a consultant (like Bain & Company), or an equity investor (like Bain Capital) to point this out, and in the latter case, actively fix it, before they go under and all, instead of some, of their employees lose their jobs. Often times, one division of a business is viable but is weighed down by other money-losing divisions, and it takes an outsider to see the forest through the trees. In other cases (like the movie “Tommy Boy“), a strong executive departs and a company really struggles with the leadership void. A PE firm might have been a better alternative to Zalinsky, had Tommy not been able to sell those brake pads.

The preceding could be a Romney campaign ad, but that doesn’t make it any less true. We have already established that private equity firms want to maximize shareholder value, but that does not necessarily correspond to a decrease in jobs or in the level of customer service. I worked on a transaction in which my firm joined another to purchase a service business in a mid-sized Western city. We then purchased another company in the same industry in that market and merged it with the company we had previously invested in. Naturally, while consolidating operations there was a reduction in force, as some positions became duplicated or otherwise unnecessary with the acquisition. However, because of the complementary strengths and weaknesses of these two companies, we were able to grow profits while improving service (based on qualitative feedback from actual customers) and even cutting prices in many cases.

I do not want to understate the importance of a single person losing their job, and I do believe that in many cases analysts are too far removed from the people behind the numbers on their financial models. That being said, in this case, a private equity investment seems to have not only improved service to the local customer base, but the post-merger company is thriving and poised to grow, which means new jobs. I’m not going to recite Willardesque hyperbole about how private equity firms really care about customer service, but aside from monopolies and the former Soviet Union, it’s more challenging to have a profitable business with deeply unsatisfied consumers.

It must also be said that the rewards are much greater in making a private equity investment in a business that takes off through explosive growth than they are in stripping a company down to its skeleton. You can only take something down as far as zero, but upside is theoretically limitless.

What’s the verdict?
There are many reasons I’m no longer in private equity. My last boss in that industry is a humane and caring person; many of his and my ex-colleagues are decidedly not. Maybe Mitt likes to fire people, but I never liked knowing that someone was going to be axed at the end of the quarter and calling her a few times to review financials, having to act like nothing was wrong. I’m a bad person if I don’t tell her, but if I do, she leaves, the company has to scramble to replace her, and that creates huge problems for them and most importantly, me. There are plenty of unsavory things about this business. I sleep much better now.

Having said that, it is very possible and quite common for the most heartless of impersonal bean counters to end up growing businesses and create jobs as a consequence. Nixon opened up relations with China.
Private equity is not necessarily a vehicle for job creation, though it can be—just as it’s not necessarily a vehicle for job destruction, though it also can be. It is value-focused and jobs-neutral, and not the other way around. Mitt Romney, and the private equity industry as a whole, is a proactive wealth creator and a circumstantial job creator (or reducer), and these two things should not be considered or weighted the same.

Mitt Romney may know how to create jobs, but he definitely knows how to create wealth. Does the long arc of prosperity eventually curve toward economic justice, or is all the growth funneled to people like him? That’s the question he’s going to have to answer.

http://www.neontommy.com/news/2012/01/inside-private-equity