So Newt Gingrich’s allies have funded a movie attacking Mitt Romney’s record at Bain Capital, called “When Mitt Romney Came To Town.” You can watch it here. It scratches the surface and shows a lot about the toll that Bain Capital took on the people who worked for the companies that Bain would purchase. It’s worth viewing.

But I wanted to delve into a bit more detail about what private equity is, how it works, and why it bears so little resemblance to what people think of as building a business. Private equity, fueled by massive debt, is much more akin to strip mining than to growing a business. And it is fueled by the easy money available from the Federal Reserve. So I think it’s worth taking a moment to understand it, and how it applies to Mitt Romney’s record as a businessman, a record that is mixed at best.

Private equity generally buys companies by way of a mechanism called an LBO, which stands for “Leveraged Buy Out”. This is not significantly different from how a person might by a small business normally. As the buyer, you would make your down payment, and use a bank to borrow money using all the hard assets of the business as collatoral. Finally, you would obtain a note from the seller for the remainder of the business. Obtaining a note from the seller is necessary because few parties if anybody will loan money against the future cash flows of a business. And the buyer needs some assurances that the business is functioning as presented by the seller. Therefore, making the seller take a note puts him in a positon where he loses if he’s lying about the cash flows of the business, and he has every interest to make sure the business is running profitably after he’s gone. Finally, oftentimes a bonus will be paid to the seller if certain financial milestones are met after the transactions take place. That bonus is called an “earnout”.

When a private equity firm buys a company, they will utilize all of these methods as well, but they have access to much deeper reservoirs of cash, which affords them the opportunity to outbid other potential buyers. Buyers tend to come in two varities, financial and strategic. A financial buyer is someone like a private equity firm. Their interest is in the cash flows of the enterprise. A strategic buyer, on the other hand, typically is already in the same business or an adjacent business as the company that is for sale. Under normal circumstances, a strategic buyer should be able to offer the highest price for a company, because they will integrate the new company’s product lines into their own, and cut out nearly all the management and overhead. Moreover, they strategic buyer will often need to make the purchase in order to be competitive in their industry, which can incent them to bid even higher for the company being sold.

So why does a financial buyer such a private equity firm even have a chance? The answer, I’m afraid, stems from loose money flowing from the Federal Reserve spigot. Here’s how it works: The private equity firm issues bonds to conduct the buyout. These bonds are underwritten by the major banks, the ones with the free access to the Fed spigot. These banks have asset to loan ratios that they need to maintain, and they also are “too big to fail”. The loan ratio limits how many loans they can make, which incents them to make the highest yield loans they can possibly find (and ironically, eschew loans that are more conventional, safer bets).  And because they are too big to fail, they worry little about the consequences in loading up on these risky loans.  Not that they want to fail, but having that backstop makes them feel like they can take risks that they would not otherwise take.

So the banks find buyers for the bonds, and buy the remainding bonds themselves. Because these bonds are incredibly risky (because the financial buyer is likely overpaying for the comapany) they pay astronomical interest rates. In polite parlance, these bonds are termed “high yield”. In common parlance, they are called “junk”.

So using these bonds, the private equity firm acquires the company. But they still have money stuck in the company. So they do something that would never be possible for a small business to do: they take on more debt in order to pay themselves a dividend. In technical parlance this is called a “dividend recap”. In common parlance, it’s called “completely insane.”

Can you imagine being a small business owner, say with a small chain of restaurants, or a couple of gas stations, what have you, and asking the bank to loan your business money so that you can take your own equity out? Every small business owner knows full well what kind of reaction they would get from the bank. That’s because the small business owner is dealing with a bank that is not “too big to fail”. And if they are dealing with a bank that large, they still won’t take on that kind fo risk for a penny ante player.

So how does the private equity firm do it? Well, part of how they do it is by cutting fat They call in the consulting firms of the world, names such as Bain, Boston Consulting Group, and McKinsey, to come in and find fat to cut. Since no business in the world operates at 100% efficiency, they invariably find some, which generates more cash flows to borrow against. But that’s not the whole story. Invariably, they mess with the company’s product pipeline.

In a normal company, products have a certain life cycle.  It goes something like this:  in conception the company spends money on research and development, while earning no money from the product, only earning money from older products.  They launch the new product, which is priced high to recoupe development costs.  Over time, the price drops as the cost of producing the product drops, and the volume of sales increases.  Profits increase as well, as the product goes mainstream.  But then, the product becomes commonplace, copy cats are out in the market, and with increased competition sales drop, as do prices.  Eventually, the product dies.  If you’ve managed your product pipeline correctly, you will have a new product coming out before your existing product begins dieing its natural death, and you will have steady increasing profits over time.  Companies like Apple and Gillette are masters at this sort of thing.  If you fail, then your company may die, and a rival company will take your place.  This process, of replacing old products with new products, was described by Josef Schumpeter as “creative destruction”.

But if you’re looking to do a dividend recap, then you need to find additional cash flows with which to pay the back the money you’re borrowing.  So if you’ve already cut out all your fat, you now need to start cutting muscle.  And there are two sources for this: you can degrade the quality of your current product lines by cutting corners, or you can cut R&D for future products, or both.  Either way, what you wind up doing is juicing the numbers today at the expense of future productivity.  Farmers might call this “eating one’s seed corn”.  

Now sometimes, shenanigans like this occur at the small business level as well.  A business owner looking to sell his business “juices” his numbers by cutting out repair and maintenance expenses, in the hopes he can sell his business for slightly more than it’s worth by faking a higher profit margin that he really has.  But to be sure, no small business owner cuts his own repairs and maintenance with the hopes of retaining ownership in his business.  It’s just not a long term strategy for success.

In the private equity world, some number of companies so abused by the methods described above do in fact survive.  Those companies reap enormous rewards for their private equity owners.  This is more common in good times than in bad, of course.  But nevertheless, it does happen.  But what concerns people is what happens when times aren’t so good, when the enormous risks taken do not in fact pay off.

Corporate bonds are typically issued for 5 years, after which time they must be paid back.  Now a company that is levered by 70-80% is not going to be able to pay back that much in 5 years.  So they are accepting a refinancing risk when they issue the bonds.  That is, they are risking that they can roll over their debt at the end of the five year period.  Their chances may be quite good if times are good in 5 years, or they could be poor.  But this is the risk that companies owned by private equity firms take.

As time progresses, the bank holding the company’s debt will make a judgment call as to whether or not it thinks the debt can be refinanced.  Based on this and its own portfolio management strategy, they may offload their bonds onto other parties.  In polite company these parties are typically called “foreigners” and “municipal pension funds”.  In common parlance, they are known as “suckers”.  But they may also be another kind of private equity firm, one that behaves as more of a vulture.

This second kind of private equity firm loves to buy up distressed debt.  They too are making a judgment call, as to whether or not the company is likely able to refinance its debt, and whether or not the private equity firm that owns it is likely to walk away from the company it owns and let it slide into bankruptcy.  They are also making a judgment that the assets of the company are worth more than the price of the debt on the open market.  If it is, then they buy in.

Let’s use some concrete numbers to illustrate.  Say a small manufacturing company is owned by a private equity firm.  They are purchased for $100 million.  They have assets in the form of their factory and inventory worth $25 million.  And they are levered by the private equity firm for $75 million.  While the bonds have a face value of $75 million, they are heavily discounted by the market, which believes are unlikely to be able to be refinanced or paid back.  So the second private equity firm buys on the open market for a steep 80% discount.  If you do the math, you will note that they paid $15 million for a debt worth $75 million, backed by a company with $25 million in hard assets.  If the company goes bankrupt, the new private equity firm will have earned at least a 60% profit on the deal, for essentially doing nothing, just for selling off the equipment.  Not that they will always opt for this route.  Sometimes they will in fact endeavor to turn the company around, and sell the company for the $100 million that it was worth at one time.  But that entails more risk, risk that the firm may just not want to take on.

As you can see, it is entirely inappropriate to describe the process outlined above as “creative destruction”.  In a scenario of creative destruction, there is some creation occurring that is causing the destruction: the iPhone kills the iPod, the Fusion kills the Mach III.  But here, there is no creation going on whatsoever.  Just reckless risk taking that didn’t pay off.  It is inconcievable that the economy as a whole is benefitted by overlevering profitable, working companies, and then selling the carcasses off to vultures for a profit.  It’s not creative destruction, but just plain destruction.  Or “destructive destruction” if you will.

To be sure, Mitt Romney’s record appears to be a mixed one.  He did some venture capitalism early in his career.  In particular his investment in Staples appears to be a true example of creative destruction, causing the demise of many smaller stationary stores.  And even in his private equity investing, he surely wasn’t the worst of the bunch.  From what I’ve read, he appeared to be the private equity guy with a conscience as opposed to the soulless villian.  Think Darth Vader instead of Voldemort.  Still, I have trouble wanting to vote for Darth Vader, no matter how effective he was a blowing up Alderan.

The point here though is much larger than any one candidate.  The point is that allowing for loose money from the Fed, coupled with a corporate income tax system that encourages firms to lever up, overlaid onto an economy that still has plenty of manufacturing assets to be sold off, run and operated by a banking class that seems incredibly dishonest is a recipe for looting every last bit of manufacturing out of the US economy.  And it is that that we should be concerned about if we are to survive and prosper into the future.

Tags: Fed, Federal Reserve, Mitt Romney, priv, Private Equity

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