Private Equity Ain’t No Reform Movement

New York Times columnist David Brooks, defending Mitt Romney against a new Romney-bashing ad from President Obama’s re-election campaign, describes private equity as a “reform movement”:

"Forty years ago, corporate America was bloated, sluggish and losing ground to competitors in Japan and beyond. But then something astonishing happened. Financiers, private equity firms and bare-knuckled corporate executives initiated a series of reforms and transformations.

The process was brutal and involved streamlining and layoffs. But, at the end of it, American businesses emerged leaner, quicker and more efficient. […] Private equity firms like Bain acquire bad companies and often replace management, compel executives to own more stock in their own company and reform company operations."

New York Times columnist Joe Nocera, who’s spent decades covering finance for Fortune, the Times, and other publications, and is nobody’s idea of a left-wing ideologue, described private equity somewhat differently in a January appearance on the Daily Show:

Financial engineering is at the heart of what Wall Street now does, what it has become. And private equity firms, [one] of which Mr. Romney ran for quite a while, are at the heart of that. They buy up companies—that’s the investment—they fiddle around with them, they borrow against them, they lay off workers quite often, they pull out money for their fees, and then they bring them back to public market, and if everything goes well they make a fortune, and if everything doesn’t go well, the company goes bankrupt and they still make a fortune because they’ve taken it all on fees.

Brooks concedes that private equity firms “occasionally” will “pile up companies with debt, loot them and then send them to the graveyard.” He also concedes that “the tax code encourages debt.” But Brooks insists that private equity firms couldn’t stay in business if they continually conned banks into lending money to companies that went bust. Given what we learned about banks from the 2008 crash, I’d say that’s at best an open question.

More to the point, Brooks insists that Bain Capital’s purchase of the Worldwide Grinding Systems steel mill in Kansas City, Mo., which eventually went bankrupt, was not—as the Obama campaign ad portrays it—an instance of looting. It was a case of picking up a wounded sparrow fallen from its nest and trying to nurse it back to health. Mother Nature, alas, had other ideas. “The company was in terminal decline before Bain entered the picture,” Brooks writes. “Bain held onto the company for eight years, hardly the pattern of a looter.”

That misstates the problem. Of course private equity firms don’t buy companies with the intent of making them fail. They aren’t like Bialystock and Bloom in Mel Brooks’s The Producers, scheming to succeed by failing. The problem, as Nocera noted, is that when private equity firms manage their acquisitions incompetently, then the pain is felt exclusively by laid-off workers. The private-equity suits don’t suffer at all. This is what economists call “moral hazard” and everybody else calls a rigged game.

According to an authoritative Jan. 6 account by Reuters’ Andy Sullivan and Greg Roumeliotis, Bain Capital’s management of Worldwide Grinding Systems—which the private equity firm acquired in 1993—was a rigged game. Brooks makes much of the fact that Romney was no longer active at Bain by the time GT Technologies, as the company was by then known, went bust in 2001. But Romney was at Bain for most of the 1990s. During that time, according to the Reuters account, Bain was hiring line managers with no experience in the steel business and failing to set aside enough cash for the pension fund. When the company went bust in 2001 the Pension Benefit Guarantee Corp. had to bail out the fund to the tune of $44 million. This covered much, though not all, of the shortfall; according to Reuters, pension benefits “were cut by as much as $400 a month.” Seven hundred and fifty workers lost their jobs.

Bain would have made a lot more money had the steel company succeeded. That it didn’t isn’t entirely Bain’s fault; as Kimberley Strassel pointed out in a Wall Street Journal column, the late 1990s saw a sudden inflow of cheap foreign steel and a steep rise in electricity rates. What’s appalling is that Bain managed to do pretty well even when the steel company failed. Brooks and Strassel both point out that Bain ended up pumping $100 million into GT Technologies. But neither has the bad manners to note that when GT Technologies failed Bain still ended up (according to Reuters) at least $12 million ahead on its eight-year investment. And that doesn’t even count the $900,000 the company annually extracted in management fees through 1999. Such grotesquely unequal outcomes for those at the top and those at the bottom aren’t at all unusual in the private equity business.

Did I mention that the money private equity firms make gets taxed at only 15 percent because it’s capital gains? “Everybody who’s in private equity is really mad at Mitt Romney right now,” Nocera chortled during in his Daily Show appearance. (This was when Romney’s career in private equity was under attack from his primary opponents.) “They’re furious! […] This had been an issue early in the Obama administration—should these guys be taxed like Warren Buffett’s secretary. The issue then faded, kinda went away, and now—hey!—it’s back on the front page again.”

Tax breaks, government bailouts, profit assured even when investments fail. If this is reform, I’d hate to see what corruption looks like.