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Losing the messaging fight on private equity

by Eric Ferguson on May 30, 2012 · 1 comment

We’re losing the messaging fight to the Republicans over the term “private equity”. It’s partly the same mistake Democrats, at least national elected officials and pundits, make over and over: using jargon as if anyone has a clue what they mean, and letting Republicans twist the meaning or even lie about the meaning. Partly, there has been sloppiness in using terms correctly, which has likewise let Republicans set up “private equity” as another word for “free enterprise”. They’ve taken a phrase with positive associations and equated it with an unknown phrase, leaving Democrats on the defensive about how they’re not attacking free enterprise by attacking private equity.

This is a follow up to a post from last February, which I’m reposting below, though here’s the original if you care to see it. My point in this post is we need to use the terms correctly if we’re to go after Romney’s weakness: the way he made money in a destructive way. That means going after not “private equity”, but “leveraged buyouts”. That’s not just picking the best words to convey an idea — that’s using the correct words to convey an idea, but if we don’t use them correctly yourselves, we’ll just stay on the defensive. When you’re spending your effort in trying to argue out of the other side’s frame, you’ve half-lost already.

Besides, I still think that Romney aside, exposing leveraged buyouts might help to get rid of this parasitic practice.

The gist is this: “private equity” is just an ownership arrangement. It’s neither good nor bad. It engages in different sorts of investments, and it’s sometimes useful, like venture capital, and sometimes destructive, like leveraged buyouts. If you’re not really sure what those terms mean, please familiarize yourself (just keep reading).

It’s much like being careful to avoid using “voter fraud” and “election fraud” interchangeably, as most of us have learned, and it’s really no more complex than that (though many of us still use “voter ID” and “photo ID” interchangeably — argh).

OK, here’s the reposting:

There might be one positive to Mitt Romney’s candidacy, besides Obama getting to run against the best choice of opponent when income inequality and unfair tax burdens are big issues. Finally an abused financial practice, the leveraged buyout, is being shown up for what it often is: a source of legalized fraud. Obviously I’ll be editorializing against it, but first, I hear commentary using several terms interchangeably and potentially confusing the issue. There are terms that are different but sort of the same, or overlapping, or subsets, or some combination, and if you’re getting confused, that’s pretty much the point. Allow me to unwind the confusion and define some terms so at a minimum, we can all sound like we know what we’re talking about when we get after Romney for enriching himself with scams like Georgetown Steel. There isn’t an obvious order for defining these terms, so I’ll just do my best to make them clear.

Private equity: A private equity fund is basically a company that isn’t publicly traded, which means you can’t buy shares on the stock market. The investors have to somehow be invited or find out, and they probably need to have affirmative answers to questions like, “can you put in several million?” So usually these are investors who are pretty rich to begin with, as Romney already was when he ran Bain Capital. However, investors can be funds with a large amount of money to invest, including the pension funds of people who actually work for a living.

There is nothing inherently nefarious in collecting a bunch of money and looking for businesses to invest in. If a private equity fund can buy a struggling business and turn it around, that’s a good thing. So Bain Capital did nothing wrong just by starting up and looking for places to invest. Where there are potential problems is the short-term strategy of private equity. The idea is to turn the business around and sell it within a few years. It’s tempting to buy a healthy but underpriced business, and sell off parts, or strip it of equity.

Bain Capital: Just to make sure there’s no confusion, Bain Capital is a specific company, which happens to be the one Romney ran, whereas private equity and venture capital are types of companies. Perhaps I should then define “venture capital” next.
Venture capital: Venture capital invests in start-ups. They get an ownership stake in exchange for capitalizing the business, and often offer connections or even mentoring to founders who may know how to make their new product, but not how to hire staff, handle accounting, market their product and so on. Like private equity, venture capital has a short term plan, hoping to take the company public or sell it to a bigger company in a few years. Now to add confusion, venture capital is a type of private equity, and private equity companies might engage in venture capital — so they’re not different companies exactly so much as different emphases. Venture capitalists have presumably told potential investors that they intend to fund start-ups, not engage in leveraged buyouts.

“Venture capital” has been used interchangeably with “vulture capital”, at least I think that’s what Rick Perry was doing when he attacked Romney with the term “vulture capital”. However, it doesn’t have to be the same. Funding start-ups is a very good thing. Mentoring people who can make something but lack capital or business skills is a good thing, not that all venture capitalists are good at it or running one business is like running another. Back in the tech boom, I worked for an internet company run by the venture capitalists who bought it with the intention of building the customer base quickly and going public. They didn’t actually understand the internet, as became apparent when one executive who had been with the company at least a year asked another how to access the company’s web site in a browser … we built web sites. I don’t think they got their money back on that one. Actually, they make their money on a few successes that pay off big and make up for losses, while they usually lose money as most start-ups fail despite financial backing (funny how Republicans pretend they don’t know this when they try to make a scandal out of each failed alternative energy company).

Vulture capital: this isn’t a technical term, just a pejorative. Certainly applies to what Bain Capital was doing (I know I’m holding you in suspense, but I will explain it), basically making money by taking businesses apart instead of building them. You may have heard this term in regards to people who buy the debt of poor countries who can’t pay their debt, buying it from sellers happy to get back pennies on the dollar. Then they use western courts and the leverage of western financial institutions, and maybe good old-fashioned bribery, to force poor countries to forgo development or even food in order to pay the debt to the vulture capitalists. The term can be applied to other behaviors, like applying it to Bain for what it did to the aforementioned Georgetown Steel.

What did Bain do? At last, here’s where we get to defining a “leveraged buyout”.

Leveraged buyout: a leveraged buyout is the practice of buying a company on borrowed money with the purchased company serving as collateral. There’s nothing inherently wrong with using the purchased asset as collateral. That’s what we do with cars and mortgages. Where leveraged buyouts get dodgy is somehow, through some loophole in law, the buyer doesn’t carry the debt. The purchased company carries it. This means a company that was hanging on or even profitable suddenly has to service this debt, which they can’t always do, so they take short-term measures like selling pieces or laying off staff. If that isn’t enough, the purchased company goes bankrupt and leaves creditors hanging — which gets to why I call this “legalized fraud”.

When the purchased company goes bankrupt, the private equity firm isn’t on the hook for the debt. It would have kept the profits if there were any, but it doesn’t have the debt. The creditors are stuck with it — not that the private equity firm loses money. Here’s where a really neat trick is pulled, and how Romney earned the epithet “vulture capitalist”.

One reason the purchased company can’t service the debt is the private equity firm takes the money. Yes, I mean it that bluntly. Company cash isn’t used to build the business, but to pay the private equity partners “management fees” or “dividends”. In the case of Georgetown Steel, Romney’s Bain juiced the short term profits by doing things that harmed the company long term, and used those profits to get another loan, which was owed not by Bain but by Georgetown. Bain then paid itself the money while Georgetown declared bankruptcy and couldn’t pay back the loan, and presumably left other creditors in same condition like unpaid employees, unpaid vendors, and governments unable to collect taxes. Yes, it’s not just the foolish lender to the private equity company who gets stuck, but creditors who did not voluntarily take that risk.

Also keep in mind that private equity firms have a bunch of investments at any given time, so it’s not that they couldn’t have used their cash to buy a company outright. They just chose to borrow the money so the lender is at risk, not themselves, even when they’re planning to take the money rather than build the business.

Bain is merely the best known user of leveraged buyouts to commit fraud, but hardly the only one. A business columnist for the Minneapolis Star Tribune, Eric Weiffering, recently explained how Caxton-Iseman did it to Buffets Inc. Buffets runs Old Country Buffet restaurants, which, at least in Minnesota, have become much less common as the company fell into bankruptcy:

Buffets was growing and profitable in all but one of the five years before Caxton-Iseman bought it. In 1999, its last year as a publicly traded company, Buffets earned more than $42 million on sales of $937 million. Its long-term debt totaled a measly $42 million.

The Caxton-Iseman investment group chipped in $130 million toward the $643 million purchase price. The remaining proceeds came mostly from asset sales, such as the sale of Buffets headquarters building, and heavy borrowings that are typical of most private equity purchases.

So marked the beginning of Buffets’ slide. Its net income never again reached pre-buyout levels, thanks in no small part to the $22 million in investment banking fees and estimated $200 million in dividends Caxton-Iseman collected over the years. And even though Buffets had an executive team in place, Caxton-Iseman also negotiated an annual services fee that entitled it to 2 percent of Buffets’ earnings before taxes, depreciation, amortization or the mounting interest payments on its debt.

The linked newspaper, the Minneapolis Star Tribune, was itself a victim of a leveraged buyout, and failed to service a massive debt dumped on it as print media were starting a downturn. The same thing happened to the Chicago Tribune and Chrysler. Just in this post, that’s five different companies in four different industries.

And it’s legal.

It seems easy to fix (if you discount buckets of lobbyists whose job is keeping the law as it is): require leveraged buyers to take on the debt themselves. So if the purchased company can’t service the debt larded on to it, the private equity firm has to pay. That will stop this legalized fraud quickly.

To wrap up, I want to address a possible counter-argument, which could come up since I mentioned Chrysler. Doesn’t Chrysler’s success show that these buyouts and turnarounds work? No. The turnaround came when the private equity company was gone. The federal government bought Chrysler not to resell in a few years and strip it in the meantime, but to stop its collapse. It took on a risk, but not as a necessity of business, but because saving the auto industry served the national interest, and the government’s profit won’t be large or even guaranteed. It took actions meant to rebuild for the long term, not make a short-term profit to fool a lender or buyer. The new majority owner, Fiat, isn’t a private equity company technically because it’s publicly traded (in Italy, not in the US), but mostly because Fiat isn’t in the business of buying and selling other companies. Fiat builds cars. Their expertise isn’t business, it’s that business, and they appear to be in for the long term. Above all, if Chrysler can’t service its debt, Fiat is on the hook for it, at least proportionally to its ownership. Put very shortly, it couldn’t be a much different situation than what Bain and its cousins created at formerly healthy companies.

One interesting follow-up blog post by Wieffering took on a similarly dissimilar counter-argument using Apple. So I’m not creating a strawman. Conservatives are defending Romney using companies that weren’t bought by private equity or anyone else looking for a quick profit, and just aren’t comparable.

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