Private Equity 101: A Mitt Romney Primer

There’s been a lot of nattering in the news lately about Mitt Romney’s private equity (“PE”) history with Bain Capital. A whole lot of the conversation is distortion, lies, and poor understanding of exactly what comprises the PE business.

Individuals or institutions invest money in -- among many other investment vehicles -- the stock market (“Public Equity”) and in privately held companies. Investments in privately held companies come in several “rounds” of investments. Early rounds (generally venture capital) of investment are in companies that are just getting off the ground and which may not have any revenue or profits at that time (or for several years). Generally, later rounds are invested in companies that already have revenues and may be profitable.

Investors in both public and private companies are taking a risk that the business of the company (and to some degree the markets for securities, either in general or specific to the company’s industry) will grow enough to improve the price of the securities that were purchased at the time of the investment in order to provide an adequate return. The earlier in the company’s life cycle, the riskier the investment -- in other words, the more likely that such an investment could be a partial or total loss. The later in the life cycle (phases are determined by time in business, size, profitability, industry acceptance or how well-suited the business is to its niche, and a host of other factors), the less “risky” the investment tends to be.

With public companies, it is easy to buy and sell ownership shares: just call your broker. With private companies, it is far more difficult to liquefy the investment.

Bain Capital was formed by a group of professionals at Bain & Company/Bain Consulting (a very well-regarded firm) in the mid-1980s. The company intended to participate in a whole new subcategory of PE firms engaged in a practice called a “leveraged buyout” (“LBO”). An LBO, in short, is a buyout of a company (public or private) using both debt and equity (investment) capital. LBOs rely on using a lot of debt relative to the equity investment to generate acceptable rates of return.

Because of their constraints of repaying any debt used in an LBO, PE firms will generally invest in businesses that are already growing and successful, companies long past the initial venture capitalizing phase of their life cycles. Most PE professionals team up with existing management, but often install their own management team to work to accelerate the growth of the business.

What do growing businesses generally do? Yes -- they create jobs! The new employees are needed to handle the growth in the business, which then helps the economy grow.

There’s no reason for any PE firm to want to own a troubled company unless it believes that its particular skills could turn the business around and -- wait for it -- for those improvements in operations to help it grow and add jobs.

Bain has been (inaccurately) characterized as having bought companies merely to break them, with tongue-waggers claiming that the Bain method was to sweep in, fire all the employees, and unload the assets in a quick fire-sale in the name of “restructuring.”

So very false! This makes little sense intuitively, as successful companies aren’t broken up and sold (generally speaking, why would anyone do that?), and companies in trouble are, well, they are in trouble.