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Hard Truths About Private Equity, Public Office, and Romney

Daniel Gross

Mitt Romney's candidacy has pushed the private equity industry to the fore of the political campaign. Romney isn't basing his candidacy on his technocratic tenure as the governor of Massachusetts. No, he's fleeing from it the way Captain Schettino fled the stricken Cost Concordia. Rather, Romney is banking on his tenure at the private equity firm Bain Capital — experience that his given him the knowledge to fix the ailing U.S. economy. What the country really needs right now, he argues, is a p.e. guy in the White House.

Detractors and supporters of both Romney and the private equity industry have tossed out a range of arguments, rhetoric and data to support their contentions. And if Romney becomes the nominee, as seems likely, it's also likely that private equity terms of art such as "carried interest," "dividend recapitalizations," and "Further Lane" will fall into common usage. As the debate heats up, here are a few things worth keeping in mind.

Private Equity Pros are People. Private equity executives are not soulless, rapacious monsters who have no concept of how most Americans live. Well, not all of them. In twenty years working in New York, I've gotten to know a bunch of them. I've interviewed most of the biggest names, profiled some, visited their (massive) homes, observed them in their native habitats (Davos, Aspen, charity galas), shared breakfast with a couple who were interested in hiring me as a ghostwriter (I'll never tell), and a lifetime ago worked as a research assistant for a book about one of the industry's pioneers. Private equity firms contain the same mix of personalities and types you find elsewhere in the financial industry, and in the corporate world, albeit with better clothes and a lot more money. There are: Republicans and Democrats; sweethearts and world-class putzes; connoisseurs and philistines; public-minded spirits and greedy pigs. In and of itself, the industry isn't evil or virtuous. It's neither the savior of American capitalism nor the trigger of its demise. It just is.

Doing it for the People. Private equity depends largely on other people's money. And in many instances those "other people" are what Mitt Romney might refer to as the common folk, if you will. From its inception, the private equity industry has relied disproportionately on public employee pension funds for its capital. Oregon's state employee pension plan was one of the first major backers of Kohlberg, Kravis & Roberts and remains a huge investor. Look at the annual report of the California Employees Retirement System. The section that details the pension funds' holdings in "Alternative Investment Management" — i.e. private equity and hedge funds — runs 12 pages and amounts to tens of billions of dollars. (You can see it by clicking on the tab that says "Corporate Restructuring" and then scrolling down). The 2010 CALPERS report shows about $800 million invested in the Blackstone Group's corporate restructuring funds alone. So, yes, private equity firms are trying to make money for themselves, but they're making more money for DMV clerks in San Bernardino and teachers in Portland. The symbiosis between public employee pension funds and private equity firms is one of the greatest unacknowledged ironies in modern finance.

Whatever Works. Like Mitt Romney, private equity pros tend to be highly pragmatic. They don't invest based on an ideology, or a social goal, or a cause. (When they do — i.e., when former Reagan official David Stockman set up Heartland Industrial Partners, aimed at reviving Midwestern industrial companies — they tend to strike out.) All this talk about whether private equity firms, or Bain, or Romney, created or destroyed jobs is irrelevant. Private equity firms exist to make profits. If they can do so by taking a small business and making it much larger and hiring tens of thousands of people, that's what they'll do. If they determine that the only way to turn a profit is to restructure and fire people, that's what they'll do. Raise wages or lower wages. Offshore or onshore. Innovate or milk existing technologies. Pollute the environment or clean it up. They're like the honey badger. They don't care. Methods and optics don't matter. Only the result. Contributing to the public good and being a useful citizen is something you do with the fortune you've made in public equity.

Free Enterprise? Try Fee Enterprise. One of the most ludicrous parts of the private equity debate has been Mitt Romney's efforts to equate an attack on Bain Capital with an attack on the free enterprise system itself. Yes, private equity firms rely on, and in some ways personify, the free market system. But there are plenty of aspects of the business model that Adam Smith might not recognize. In theory, private equity firms live and die based on the returns they generate for investors. They take 20 percent of the profits. Free Enterprise-y!

But fees that are totally unrelated to performance also play a very large role in the business model, especially for the largest firms. Private equity firms charge investors annual management fees of about two percent. The Blackstone Group says it had $37 billion in fee-earning assets in private equity funds as of September 30, 2011. In other words, Blackstone will collect a minimum of $740 million in fees — whether it has an up year or a down year. (Not so Free Enterprise-y!) And that's just the beginning. Some private equity firms charge fees to investors when they execute a deal. Others charge fees to the companies they buy for providing management and oversight services. Again, these fees are paid regardless of performance. (Even less Free Enterprise-y!)

Here's something that is not at all Free Enterprise-y. To a degree, the incentives of the investment firms and their clients are aligned: The firm gets to keep 20 percent of the profits it generates. No profit, no performance fee. But there's no loss-sharing to go along with the gain-sharing. If a private equity fund makes a series of bad investments, the outside investors' downside is unlimited. But firms don't "share" the losses with their clients, or refund fees.

Some Call it Profits. Private equity funds also have a funny way of defining investment returns. In theory, the model is rather simple: buy low, fix a company, build a business, make it more attractive to investors, sell high and bank the profit. It can take several years, which is why most private equity funds lock up their investors for several years. Historically, that's how the most successful firms have conducted business. That's capitalism. And it can be very hard work.

But in recent years, the industry frequently looked for an easy way out. Try this on for size: Buy a company for $200 million, putting $100 million down and borrowing $100 million. Once you gain control of the company, have it issue $200 million in debt and then use the proceeds to pay a dividend to the new owners -- i.e., you. Boom: a 100 percent return, $100 million in profits. But it has nothing to do with the company's performance. This is known in the trade as a "dividend recapitalization." Bain Capital did it several times, and so has every other private equity firm. The problem? Well, if the underlying business sours, or if market or economic trends turn down, companies may find they can't service the new debt and wind up filing for bankruptcy. And that causes all sorts of problems for lenders, employees, suppliers and the government. Besides, this isn't really capitalism or investing. It's just borrowing money and calling it income. Private-equity-backed companies that do dividend recapitalizations and then go bust are no different than homeowners who take home equity lines of credit on their already mortgaged homes, treat it as income, spend it elsewhere, and then walk away from the mortgage.

Failure is an Option. A certain percentage of private-equity deals fail. Not every investment works out. Many succeed, some tank. That's a trope Romney has sounded time and again, and will likely continue to do, in his defense. But here's the thing: In many of these instances, the investments failed because the private equity backers were simply unwilling to make the sort of efforts that other business owners and consumers do to make their financial ventures succeed. To a degree, the viability of the industry relies on being able to walk away.

Some of the people who fall behind on mortgages or other financial obligations default right away. But most people don't. They do what is necessary to stay current. They cut spending elsewhere, stop saving, sell a car, or silverware, or jewels, or borrow from their 401(K)s, or put their ski house on the market. Private equity firms don't do this. Let's say a portfolio company runs into trouble, and needs $50 million to stay current on its debt, or to meet pension obligations. The company itself may not have the cash. But the guys who own it — the fund, the firm, the individuals behind the firm — certainly do. Cerberus, the private equity firm that sent Chrysler spiraling into bankruptcy, is run by a multi-billionaire, Kenneth Feinberg. Most of the private-equity-backed companies that filed for bankruptcy could have been saved. Their owners could have deployed unused cash in their funds, or sold successful investments within funds to provide new capital. Partners could have tapped into their own massive resources to help. But that's not how they roll. Private equity is a highly unsentimental business, and one in which it is perfectly acceptable not to meet financial obligations. Private equity almost never throws good money after bad. And so we have this recurring dichotomy of companies controlled by private equity firms failing, refusing to make debt payments, ripping up leases, cutting off employees' health insurance, and puking pension obligations onto the Pension Benefit Guaranty Corp. — all while their owners buy new jets, make splashy charitable donations, or spend millions running for elected office.

Taxing Issue. Finally, the special tax treatment that private equity receives is a joke. And it helps explain why Romney is a problematic messenger for a party that wants to cut taxes on the wealthy while reducing services to the middle class. Private equity firms take 20 percent of the profits they generate as a fee. It's a fee they get paid for putting other people's money at risk. But thanks to the "carried interest" loophole, it's taxed at the low capital gains rate of 15 percent. In other words, the government treats this income as if they were putting their own money at risk. As one well-known capitalism-hating, left-wing class warrior tweeted the other day: "Can understand [Occupy Wall Street's] resentment of extreme inequalities, but how about fund managers only paying cap gains tax without risking a penny?" Oh wait, that was Rupert Murdoch.

You have to feel for Romney. He didn't make the rules, or invent the industry. He went into an established field, performed remarkably well, went into public service, and benefits from a tax regime that others put into place. And I don't expect that, if elected president, he would run the country the way private equity firms run their own business. In the "quiet rooms" where he wants income inequality to be discussed, I'm sure he'd agree that it wouldn't kill the industry to be taxed at a higher rate.

Don't hate the player, hate the game. That certainly applies here. But if the game is so unlovable, do you really want to put one of its best players in charge of setting the rules?

Daniel Gross is economics editor at Yahoo! Finance.

Follow him on twitter @grossdm; email him at grossdaniel11@Yahoo.com.