As Mitt Romney stumbles his way through the Republican primaries, his candidacy has brought renewed scrutiny of the oft-demonized world of private equity.
Before venturing into politics, Romney was one of the founders of Bain Capital, one of the largest private equity firms. Big buyout private equity firms such as Bain have been cast as among capitalism’s worst villains. For a time, some of them fit the bill. But private equity is actually structured to be capitalism at its reasoned best.
Many of the established private equity firms got caught up in the easy money that reached its fevered peak in 2006 and 2007. Debt financing was easy to get, so buyout firms often bought companies while saddling them with debt. Then they would take out another big group of loans or bonds and use the money to pay a dividend to themselves before they had the time to do anything for the company worth paying themselves dividends. Some even were able to sell these companies, often to other private equity firms, who in turn added more debt to its capital structure to make the buy. This cycle continued for several years and left broken companies in its wake. Private equity’s name was sullied.
But when the big private equity firms did this, they were operating against the standard model of private equity firms that had been established for decades. And while what they did was sleazy, it was 100% legal, and they got away with it because they were able to convince myopic shareholders to sell to them. So painting the private equity industry as a ruthless villain trying to toss grandmothers out of their homes won’t work. Private equity firms weren’t involved very much in the mortgage debacle.
And neither should it trip up Mitt Romney. Bain was not among the industry’s worst offenders and by the time the private equity industry became blinded by euphoria, Romney was long gone.
What people fail to realize about private equity is that it allows investors to avoid the often shortsighted, stock-market-driven view of businesses. Publicly traded companies have to disclose their returns every quarter. A bad quarter or even the expectation of a bad quarter can send their stock price down. And because anyone with enough money can buy stock, public companies have a shareholder constituency that can be a royal pain in the ass.
The way private equity is traditionally done, a firm can take time to make long-term investments in companies. In theory a private equity firm doesn’t have stockholders breathing down their neck every three months demanding positive returns. They can hold onto a company for the long haul and have a down quarter or two if it means they’re investing in a stronger future. A typical private equity firm has an investment period of 10 years and its investors are typically large pension funds, insurance companies, and a few wealthy individuals who want to keep money safe for long periods of time and walk away with a nice return. They know a new or struggling company may take some losses and that being off the public market can give it time to recover and grow.
And because companies that are owned by private equity firms don’t have the same disclosure requirements, they have an advantage. They don’t have to tell the public how much they are worth, how much they invested in new technology, or how many employees they have. This can give businesses a competitive edge in the business world and allow them to develop things under the radar.
This privacy is also what helps set buyout firms as great go-to villains. A cadre of wealthy investors that keeps things confidential is a boon to conspiracy theorists. With its many political connections and ties to the defense industry, the Carlyle Group was accused of everything short of kidnapping the Lindbergh baby, and in the last decade it has mostly divested itself from its defense holdings.
About 10 years ago, several private equity and venture capital firms had to disclose more information than they wanted to because their investors included state pension funds. State disclosure laws were brought to bear, and private equity firms had to disclose private company information that even many pro-disclosure law advocates agreed should remain private. The losers in the end were the state pension funds and other public entities, which were later shut out of some of the more lucrative funds.
Private equity can be a place of respite from the public market’s demands. However, many of the large private equity firms today have either gone public themselves or have some kind of publicly traded entity attached to them. They have investors, public and private, demanding they put money to work, and if they can avoid the temptation of easy money on the debt markets, they will be better for it in the future.
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