Hello Everyone,

Ever since last November, when it was clear to me that Gov. Romney would be the Republican nominee, I have intended to write a commentary on so-called “private equity” investing since he asserts that his experience with it will make him better able to “create jobs,” if he wins the presidency.

Many of you know a lot about private equity – some much more than I do – but many don’t. For the latter group, if you want to understand why I make this assertion, it will take some work. So here goes.

Maximizing Returns, Not Jobs
In summary, Gov. Romney’s leadership of Bain Capital had little, if anything, to do with job creation. His job at Bain Capital was to increase productivity to produce returns for his firm, himself, and his investors, not to create jobs. In fact, those objectives – productivity and jobs – are, by definition, in tension.

While it is never this simple, maximizing returns for investors is largely, although not exclusively, a function of maximizing productivity – that is output per man hour. There is every incentive to increase the numerator and decrease the denominator. The fewer man hours required to do a job, the better the result for investors.

Bain Capital Does Mostly Leveraged Buyouts
“Private equity” is a catch-all term for a certain “asset class” or a particular type of investment management firm or investment strategy. Some define it to include “leveraged buyout (LBO),” “venture capital,” and “growth capital” investment strategies, all of which involve the purchase of equity securities which are privately issued, not publicly traded, hence the term “private equity.”

All of these strategies play a very legitimate and useful function in a capitalist economy. Some of my friends in these types of investment firms are among the brightest, most earnest, and most generous people I know. Those characterizations probably also apply to Gov. Romney.

While some define private equity firms broadly, I tend to think of them primarily in terms of their particular underlying investment strategies, be it LBOs, venture capital or growth capital. Bain Capital primarily pursues an LBO strategy, as I understand it.

 Bain Capital apparently also makes some venture capital investments — investments in emerging companies like The Home Depot once was. That is a decidedly different activity. While the motivation is the same – maximizing return on investment – young companies do so by growing. And, if they grow, they will naturally “create jobs.” But, do not be confused — that is a by-product of growth, not an objective of the business. And, most importantly, Bain Capital neither owns nor controls these companies. Therefore, it cannot claim to have “created jobs” through them.

Leveraged Buyouts
LBOs probably started in a very small way in the 1950’s. One entity would buy most or all of the equity or stock, usually of a publicly-traded company, using generous amounts of debt, or “leverage.” This investment strategy got a big boost in the 1980s when Michael Milken was instrumental in popularizing what were then called “junk bonds.” Generally, they were bonds issued by publicly-traded corporations which were rated “less than investment grade” – the loose equivalent of “sub-prime mortgages” today. They later assumed a less pejorative label – “high yield bonds.”

Today, investment companies which employ an LBO strategy, like Bain Capital, raise funds from investors, usually in the form of limited partnerships, to buy controlling interests in what are usually described as “underperforming” companies. In order to boost the investment returns to themselves and their investors, these LBO firms will usually, but not always, cause the companies they buy to borrow amounts several times their net worths – that is, take on substantial amounts of “leverage.” Hence, the “leveraged buyout” label.

They will also usually change the management, reorganize the business, frequently sell certain operations, and seek to improve business processes, among other things, all to improve the company’s productivity, both to produce fees for the LBO firm and ultimately to maximize the return on its and its investors’ investment.

Productivity is a “Jobs Killer”
A simple way to think about productivity is to consider the now-ubiquitous and humble Automated Teller Machine, or ATM. When it was first introduced, most bankers predictably jumped at the opportunity to increase productivity. There may have been some bankers who, in order to save jobs, resisted replacing some human tellers with machines. But, that didn’t, couldn’t, or shouldn’t last long. ATMs are good for investors and the economy. All of us can think of innumerable examples of similar productivity improvements which have inevitably cost jobs.

Therein lies the fundamental flaw in Gov. Romney’s claim that he “knows how to create jobs” by dint of his LBO experience. As the leader of an LBO firm, he was quite properly focused on improving productivity to maximize returns on investment. That’s a legitimate and useful activity in a market economy. But, its objective is not to “create jobs.”

In my more than three decades in investment banking, and my many years as an investor, I never saw a single business plan or a public offering prospectus which included “job creation” as a business objective. Their objective is to maximize the investors’ returns by, among other things, improving productivity. Overall, that is healthy – actually an imperative – for the economy. It’s just bad for employment. Because job creation and productivity are always in tension – a healthy tension – but in tension nonetheless.

Non Sequitur
President Obama understands this. He’s not calling Gov. Romney a failure as an investor or immoral as a person because his investment firm’s purpose was to produce investment returns, not to create jobs. President Obama is simply pointing out the non sequitur – Gov. Romney’s central claim that because he was an LBO investor he “knows how to create jobs.”

If you want to delve deeper, look at how President Obama answered a question about Gov. Romney’s experience at a press conference last month (see Attachment A). I, like many, would prefer that his campaign commercials refrained from inappropriately demonizing private equity or LBOs. As an amateur, I can only presume that the pros think that voters will not take the time to consider the more complex type of argument I’m making here. They’re probably right. And, what is the difference from Gov. Romney’s campaign demonizing, usually inaccurately, “Obamacare,” or assailing President Obama’s “abysmal economic record,” when knowledgeable people know that no president can “fix the economy,” let along do it quickly after a financial crisis?

If you want to go even further, I have annotated a recent David Brooks’ (my favorite columnist, as my long-time readers know) piece on this subject to clarify some things I think that even he doesn’t understand (see Attachment B).

My fundamental point here is a simple one. Gov. Romney’s experience in leveraged buyouts at Bain Capital is simply not a basis for claiming that he “knows how to create jobs.” He does know how to produce returns on leveraged investments, but that’s a different kettle of fish. And, running an LBO firm is not a primary qualification for being president. But, his best qualification – governing as a “Massachusetts moderate” – would have barred his nomination. Now, he’s left to run on a non sequitur.

Please, as always, pass it on. And, remember that previous Obamagrams are stored on www.obamagrams.com

Chuck

adobe pdf fileAttachment A – Press Conference – 5-21-12

 

adobe pdf fileAttachment B – How Change Happens – Brooks – NYT – 5-21-12

 

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