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Sunday, January 15, 2012

UK: Bain Capital and Mitt Romney

The Economist

Mitt Romney's background
The meaning of Bain

Jan 13th 2012, 18:37 by M.S.


OVER at Forbes Online, Josh Barro writes about "The Discussion We Should Be Having About Bain". His take: Bain represents creative destruction; the debate should be whether government policy, while accepting that destruction is necessary for the economy to grow, should act to alleviate the suffering of affected workers, and prepare them to take advantage of changes.

"Private equity firms like Bain often seek to fix firms that have failed to adjust to economic change. This can mean downsizing, increased automation, offshoring, and the like. These changes make enterprises more efficient, and in some cases save firms that would otherwise have gone bankrupt... But it is also important to note that certain classes of workers have faced especially large negative effects from economic changes...

The question [Romney] should be asked, then, is what policy implications arise from the economic shifts of the last few decades, driven (in small part) by private equity. Does rising income inequality mean that fiscal policy should be more redistributive? Does a reduction in job security call for a stronger safety net? Do new workforce needs mean we need a shift in education and training policies?"


This is certainly one conversation we should be having about Bain. But there are other conversations we should also be having about Bain. And, in fact, we are. One of those conversations has to do with leveraged buyouts and dividend recaps. These are two mechanisms private-equity firms use to get companies to carry much heavier debt loads, which can then generate revenue streams for their owners. But the heavy debt load can make companies more vulnerable to bankruptcy. And the extra revenues generated rely heavily on the fact that while profits are taxed, interest payments on debt are not. Critics say that in effect, taxpayers are subsidising private equity's extraction of value from firms through tax arbitrage. Here's Mike Konczal interviewing Josh Kosman, author of "The Buyout of America: How Private Equity Is Destroying Jobs and Killing the American Economy".

JK: The original leveraged buyout firms saw that there were no laws against companies taking out loans to finance their own sales, like a mortgage. So when a private equity firms buys a company and puts 20 percent down, and the company puts down 80 percent, the company is responsible for repaying that. Now the tax angle is that the company can take the interest it pays on its loans off of taxes. That reduces the tax rate of companies after they are acquired in LBOs by about half... The company then could use those savings to pay off the increase in its debt loads. For every dollar that the company paid off in debt, your equity value rises by that same dollar, as long as the value of the company remains the same.

MK: So the business model is based on a capital structure and tax arbitrage?

JK: Yes. It’s a transfer of wealth as well. It’s taking the wealth of the company and transferring it to the private equity firm, as long as it can pay down its debt. It think it is real – the very early firms targeted industries in predictable industries with reliable cash flows in which they by and large could handle this debt. As more went into this industry, it became very hard to speak to the original model. Now firms are taken over in very volatile industries. And they are taking on debts where they have to pay 15 times their cash flow over seven years — they are way over-levered.

MK: The most common argument for why Bain Capital and other private equity firms benefit the economy is that they are pursuing profits. They aren’t in the business of directly “creating jobs” or “benefitting society,” but those effects occur indirectly through the firms making as much money as they can. But even here, “profits” — how they exist, where they come from, and how they are timed — have a crucial legal and regulatory function. A recent paper from the University of Chicago looking at private equity found that “a reasonable estimate of the value of lower taxes due to increased leverage for the 1980s might be 10 to 20 percent of firm value,” which is value that comes from taxpayers to private equity as a result of the tax code. Can you talk more about this?

JK: That sounds about right. If you took away this deduction, you’d still have takeovers, but you’d have a lot less leverage and the buyer would be forced to really improve the company in order to make profits.

Now, maybe Mr Kosman is wrong, and private equity really is overwhelmingly creating new efficiencies and generating value in the economy, rather than exploiting a tax feature that delivers money to owners while depriving the government of revenue and making otherwise healthy firms more vulnerable to bankruptcy. But this is certainly a debate we should be having. Because for many people, it's clear that "capitalism" as represented by post-1980s Wall Street is a different beast than capitalism as represented by 1950s Detroit. It may be a better beast. It may be a worse beast. It may just be a new beast we'll have to learn to live with. But Mitt Romney is a walking incarnation of this variety of capitalism, and he's forcing the topic into the public consciousness. As Michael Lind puts it, he confronts America with a choice between different visions of the economy:

The choice is between "stakeholder capitalism" and "shareholder capitalism." According to the theory of stakeholder capitalism, corporations are and should be quasi-public entities with responsibilities to the nation-state and to the communities in which they are embedded. The corporation should make a profit and provide a fair return to investors. At the same time, workers who contribute their labor to the company have a legitimate interest in it as well as investors who provide capital. Managers serve the company and the country, not merely the investors.

In the theory of "shareholder capitalism," the corporation exists solely for the purpose of the investors, whom the managers serve as agents. In shareholder capitalism, short-term profits are the only goal, and if that means laying off workers instead of retraining them or reassigning them, breaking up the company and selling the assets to enrich private equity partners and shareholders, so be it.

The stakeholder conception of the firm is still the norm in Europe and East Asia, as it was in mid-20th century America. But beginning in the 1970s, the shareholder conception of capitalism prevailed in the United States.


In at least this sense, Newt Gingrich's attacks on Mitt Romney are on the mark: he is not the same kind of capitalist as Steve Jobs. There are plenty of people who think Mr Romney's capitalism is just as valid as Mr Jobs's kind, liberals like Jonathan Chait among them. But when the GOP nominates a private-equity CEO for president, this is one of the discussions we're naturally going to have.

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