How To Succeed in Business Without Adding Value

Private equity funds first emerged in the late ​’70s and ​’80s as part of an ideological shift toward making the most for shareholders, giving momentum to an early wave of banking deregulation and to changes in the tax code that made financial engineering more profitable. Firms like Bain Capital, spun off in 1984 from the consulting firm Bain & Company, benefited both from the elimination of old controls and from the new rules encouraging globalization and financialization.

Here’s how it works: The managers of private equity firms create big investment funds in which they are ​“general partners.” They pool unregulated private money from a variety of ​“limited partners,” ranging from public pension funds to rich individuals (including, in the case of Bain, dubious Central American plutocrats operating out of tax havens such as Panama). The general partners then buy a business in what is called a ​“leveraged buyout,” using more limited-partner capital and a huge loan, but very little of their own money.

The high debt, or ​“leverage,” greatly multiplies the profit on successes, but also increases financial instability. The loans must be paid off even if business slows – a minor worry for the private equity fund, because it isn’t responsible for those payments. Instead, the purchased business owes the debt created to buy it. The interest on this debt is tax-deductible (meaning that these deals are taxpayer-subsidized), but paying down the principal still puts pressure on the acquired businesses. They in turn typically squeeze employees as the easiest, quickest way to meet interest payments and profit targets.

After Bain-style buyouts, employees often face wage and benefit cuts or mass layoffs. Businesses can also use takeovers to renege on implied contracts or to engineer bankruptcies, thus avoiding obligations to workers such as pension payments.

After a few years, maybe a decade, the fund’s partners typically try to sell the business at a profit. But the funds also have quicker ways to make money. They sometimes arrange for the businesses they buy to borrow money to pay extraordinary dividends in the first year, so that a firm such as Bain can quickly return to the general partners many times their original investment.

In a Vanity Fair article, reporter Nicholas Shaxson relates what happened after Bain took over and merged two medical firms in 1994. First, Bain cut Dade Behring’s research budget to half its competitors’ level and began closing branches, even where the two firms had recently received location-based tax incentives for job creation. It converted traditional pensions to inferior alternatives (saving up to $40 million) and nickeled-and-dimed employees on benefit payments. Then Bain had Dade Behring borrow $421 million to pay itself, Goldman Sachs and some top managers $365 million in dividends. These participants had only invested $85 million. Romney continued to profit from the deal until at least 2001, one year before Dade went bankrupt.

Such outsized profits, even from unsuccessful businesses, are still not enough for some private equity firms. They also charge fees to their own investors. In a forthcoming issue of Challenge: The Magazine of Economic Affairs, Eileen Appelbaum, a Center for Economic and Policy Research economist, and Rosemary Batt, a Cornell professor, explain that private equity funds typically charge limited partners – such as pension funds or insurance companies – 2 percent of their investment each year as a ​“management fee” to participate, plus 20 percent of any profit (though Bain charges a heftier 30 percent). After taking fees and other factors into account (such as having an investment tied up for years), Appelbaum and Batt calculate that most limited partners would actually profit more from buying a broad stock index fund. But a minority of private equity funds sometimes provide spectacular returns, enticing players to return to this casino.

General partners also benefit from the notorious ​“carried interest” loophole. It allows their pay for managing the fund, which would be taxed as regular income, to instead be taxed as capital gains at a rate less than half of what most would otherwise pay.

Sometimes private equity firms do ​“add value” to a company by improving business operations, increasing skills or adding new equipment, but that story isn’t typical. While New York Times columnist David Brooks portrays Romney as taking ​“companies that were mediocre and sclerotic and try[ing] to make them efficient and dynamic,” Appelbaum’s research shows that most private-equity takeover targets are successful companies growing faster than average before the buyout; less than 3 percent are distressed or ​“mediocre.”

Appelbaum also finds that when private equity firms take over, they do not create jobs faster than comparable businesses, but they do destroy jobs faster. (So much for ​“job creation.”) Meanwhile, Shaxson reports that a Bain internal study concluded that there is ​“little evidence that private equity owners, overall, added value” to the companies they took over.

All this means that even when a private equity firm ​“succeeds” (usually after buying an above-average business), much of their gains are reaped simply by transferring large amounts of wealth to themselves. The losers are usually the companies they acquire, their investor partners, taxpayers, government agencies and workers – ultimately, the entire economy.

This article orginally appeared as a sidebar to our September cover story ​”The Bain Legacy.”