How To Succeed in Business Without Adding Value

Private equity firms claim they help create jobs and improve businesses, but that is not the whole truth

David Moberg

Bain's founders, including Mitt Romney, made "creating value" part of the company's 1984 mission. But it hasn't really worked out that way. (Getty Images)

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.

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.

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.”

David Moberg, a senior edi­tor of In These Times, has been on the staff of the mag­a­zine since it began pub­lish­ing in 1976. Before join­ing In These Times, he com­plet­ed his work for a Ph.D. in anthro­pol­o­gy at the Uni­ver­si­ty of Chica­go and worked for Newsweek. He has received fel­low­ships from the John D. and Cather­ine T. MacArthur Foun­da­tion and the Nation Insti­tute for research on the new glob­al economy.

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