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Private equity: Job killer or creator?
Presidential hopeful Mitt Romney has released his tax returns.
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Kai Ryssdal: Remember how we told you yesterday super PACs are changing the dynamics of presidential campaigns? That they can spend almost as much as they want -- on almost whatever they want -- to further the candidate of their choice?
The super PAC in the news today is called Winning Our Future. It supports -- to the tune of millions of dollars -- would-be Republican nominee Newt Gingrich. And it's doing so most prominently with a 28-minute video it released today criticizing, sharply, Mitt Romney and the private equity firm he founded, Bain Capital.
Those two words -- private equity -- are defining at least this leg of the Republican primaries. But what private equity is and what it does isn't alway that clear. So we've called Josh Rauh to explain. He teaches finance at the Kellogg School of Management at Northwestern University. Good to have you with us.
Josh Rauh: Thanks good to be here, Kai.
Ryssdal: In the simplest possible terms, what is private equity?
Rauh: Private equity is when a group a partners or people with some money buy companies with the idea of selling those companies back to other people in the future for a profit. Simple as that.
Ryssdal: Well, maybe that was a little too short. Is there an analogy that's going to help me understand this?
Rauh: Sure, well I guess it would be kind of like buying a used car, fixing up the car, selling it back to somebody else in the future, but there are some key differences with that. First of all, the people who buy companies and private equity funds, they are raising money from outside investors to do this.
Ryssdal: Right.
Rauh: So instead of buying the car with my own pocket money, I would be out to wealthy investors. In the case of private equity, these are pension funds and endowments -- like the California Public Employee Retirement systems, which invests money on behalf of public sector employees. Other investors include, sovereign wealth funds and university endowments. And raising money from them, buying companies with that money, selling those companies back later -- hopefully for a profit, splitting the proceeds with the investors who gave me the money in the first place.
Ryssdal: All right, but the thing about private equity, though, is that they don't always fix things up. I mean, the big knock -- that surely you've been reading in the papers -- is that private equity goes in and they strip out costs, they get their profit out and then they spin it around and go back to the market.
Rauh: Well, the discussions that are going on around private equity today are happening in a very politicized environment. On one hand you have supporters of Mitt Romney who are painting private equity as being this glorious thing where companies are bought and thousands of new jobs are being created. On the other hand you have opponents who want to paint private equity in a very negative light and argue that thousands of jobs are being destroyed. Now what that really masks is the fact that there is a huge range of activity that goes on in private equity. And academic studies have shown that -- on average -- the employment effects of private equity are really very small. So, on average there's really not much evidence that private equity either creates a lot of jobs or destroys a lot of jobs.
Ryssdal: Well, when private equity sends out a prospectus -- or whatever they send out -- do they list in there somewhere "We're going to create jobs," or prospectus do they say "We're going to maximize return for our investors?"
Rauh: The stated goal of private equity is always the maximization of return for investors. There is no stated objective of private equity to create jobs. And you can imagine profitable investments that involve job creation and ones that don't involve job creation. And the reality is that there is a vast range of types of private equity and different strategies of trying to buy companies and make money from those purchases and sales. The fact that it's called "private equity" reflects the fact that the information of about these transactions is largely private. The only really good source of all of the transactions is going to be the investors themselves.
Ryssdal: The firms themselves, though, they do all right. They get -- what? -- 2 percent of all investments and 20 percent of profits is the standard rule.
Rauh: That's the standard rule.
Ryssdal: Which when your talking big investments is a lot of money.
Rauh: Certainly, but private equity investors also have skills. Anybody who tries to get into the business realizes that it's actually quite difficult to make money in private equity.
Ryssdal: Joshua Rauh teaches finance at the Kellogg School at Northwestern University. Josh thanks a lot.
Rauh: Thanks very much Kai.
Kai, this report demands some real follow-up. The patty-cake you played with a softball academic who teaches the basis for these kinds business deals is hardly meaningful journalism. The 800 lb. gorilla in the room is the large number of these enterprises that involve heavy leverage heaped on the acquired company. The skills the good professor speaks of mostly come down to convicing some banking buddy, who probably attended the same school as you, to loan you most of the money to buy a company. At which point the company starts paying all the interest on the PE "investors" loan. The company I work for is currently under PE ownership. They are heavily leveraged and totally unprepared for any eventuality that doesn't involve a quick "flip" and some easy money. They brought in a COO from an industry that has no relationship and little pertinent experience.We're a luxury electronics company, they brought in a manager from business commodities industry. Money for innovation and research is now being spent on management fees and interest. The simple fact is this many of these deals are nothing more than gambling with borrowed money. They don't build anything or add value that lasts, merely attempt to pump up the apparent value to pass on the debt burden to the next unprepared owner. No wonder the american economy is such a mess. Talentless charlatans are trained by people like your guest that "hard work" involves pushing money around to extract the maximum return. Try building a company that makes quality products the owners, management and employees can take pride in... that's hard work. Work that makes a great country and economy. The PE model is nothing more than a shell game where everyone comes up empty except the deceivers who palm the ball and smile at you while they lie to your face.
It is really a disservice to listeners to allow Mr. Rauh to compare private equity to simply fixing up a used car and reselling it. A more correct used car analogy for private equity would be like finding a nice used car, that maybe has a scratch on the door. After raising money from private sources, you buy the car and take out a loan from yourself using the car as collateral, re-register the car in Singapore to avoid state DMV fees, sell the engine and tires to pay off the loan to yourself and investors plus interest, paint that scratch on the door but charge the car a large management fee, and try to sell the car for more than you originally paid to an employee retirement fund before they know it has been gutted and count your profits as low taxed capital gains. If you can't resell the car, then you scrap the car and collect a government subsidy to remove polluting cars, write it off as tax loss for your car owning corporate self while retaining the large profits in other corporate selfs that were collected in managing the car and financing it. The point is that the entire purpose of the activity was to extract a profit, and it may or may not leave a usuable car in the end. . . .
This used car analogy is still inadequate because it doesn't include the impact of the employees and communities associated with the takeover of businesses. It is all about getting money out a business any way that they can, which can include raiding pension funds and extorting tax breaks from governments. Mr. Rauh says that private equity has skills, which justifies their profits, but a pickpocket thief also has skills. The difference is that the pickpocket doesn't have lobbyists to make their activity legal and low taxed. The financial engineering of private equity has absolutely nothing to do with growing companies or employment. . . .
I was employed in a large division of a company that was sold to private equity. The division was profitable and had no debt, and it was sold at low price relative to revenue. It then became a stand alone company with $2B debt. It should be no surprise that the division head, that surely must have lobbied for the sale, end up as the interim President of the new company and sat on the board of directors. Immediately, sections of the company were resold which recouped nearly half of the original sales price. Layoffs began 6 months later, cutting the research and development and outsourcing many other functions, as the private equity managers used the company to pay off the remaining investment plus private equity profit. It managed an IPO only a few years later valued highly by wall street, with many fewer employees and reduced investment in new products. Does that deserve a capital gains tax break?
I was disappointed that the piece did not address what people find disturbing about private equity firms, namely ( http://www.cepr.net/index.php/blogs/beat-the-press/are-private-equity-fi...):
"The question is whether the high profits earned by the partners are primarily due to increasing economic efficiency or to rents earned by dumping costs on others.
As noted here, it is standard practice for private equity to load firms with debt. This means that taxable profits are turned into tax-deductible interest payments. The difference can be a gain to Bain and other private equity firms, but it is coming at the expense of taxpayers.
In the same vein, private equity companies often in engage in complex asset shifting. This can leave a heavily indebted firm with few valuable assets. If it eventually goes bankrupt, the creditors collect little money because the private equity company has transferred the assets with value into an independent company. This can also mean big profits for Bain and other private equity companies, but this is not a gain to the economy.
Another frequent game of private equity companies is to dump pension obligations on the Pension Benefit Guarantee Corporation. The reduction in liabilities can mean big profits for Bain and other private equity companies, but does not provide any benefit to the economy.
These are the sorts of issues that appear in serious discussions of the benefits of private equity."
Mr.Ryssdal, I am a big fan of your program and admire your reporting and commentary on the state of the economy. But this piece on private equity was a fluff job. Better to not have a story than deliver one like this. Your listeners deserve better and you do a disservice to your reputation as an interviewer. The "2 percent of all investments" is based on the idea of leveraged buyouts. You and I know that countless companies have struggled and failed because of the debt burden placed on them by leveraged buyouts.
Have academic studies really shown that private equity has had very little effect on the job market? Really? Studies by whom? The Hoover Institution?
Another reason for a follow-up: some, Paul Krugman in particular, say that it's not just the number of jobs (Mr Rauh says creation ~ destruction), but the quality of jobs. That is, the new jobs created tend to be for lower wages and lesser benefits. Are there reliable statistics for this?
