Mitt Romney has taken quite a hit for his time at Bain Capital. Advertisements were run and movies were made (check out the trailer for King of Bain, if you have not already) depicting Romney as a job-killer.  They portray him as a ruthless, greedy, and absolutely ravenous capitalist.  This view is rooted in a fundamental misunderstanding of the nature of private equity, leveraged buyouts, and their role in a developed economy.  When understood correctly, it is clear that Romney’s time at Bain was actually quite beneficial to the economy.  Private equity keeps the economy flowing, and there is no shame in Romney’s involvement in the business.

So, what exactly is private equity?  Private equity (PE) is simply another asset class (like bonds, stocks, currency, cash equivalents).  Essentially, it deals with equities of privately owned companies, as opposed to equity sold by publicly-held companies on stock exchanges.  Bain Capital is a PE firm which invests in privately held companies, usually using a leveraged buyout (LBO) strategy. The best way to explain this strategy is through an example.

Let’s say that Bain analysts do their research and come across a company which is seriously under-performing.  In other words, this company, referred to as the target company, could be performing at higher levels, but is lagging due to various inefficiencies.  Bain analysts identify these inefficiencies and come together with some report establishing the company’s full potential, its regrettable under-performance, and ideas for improving its efficiency.  Bain then decides to take out a huge loan (hence the term leveraged buyout) of about $5 billion, for example, and combines it with $1 billion of its own money.  It uses the money to buy the majority of the target company’s shares and take charge.  Next, it replaces management.  The new management uses Bain’s ideas and their own creativity to streamline the company. This usually involves liquidating some assets, laying off unproductive employees, “trimming the fat”, etc.  A few years later, the company is running more efficiently and its value skyrockets to $10 billion. Bain then sells the company at this higher price, paying off its debt of $5 billion and an interest on the debt of, let’s say, $1 billion. The profit at the end is $3 billion (10-5-1-1 = 3) which goes directly to Bain as mostly capital gains revenue.

Why is this beneficial to the economy?  Well, properly executed LBOs increase the target firm’s productivity and value. Of course, no PE firm is perfect and is certainly susceptible to making bad investments. Some companies just cannot be salvaged. PE firms like Bain would lose money after investing in such a company. It is in Bain’s best interest for the target to increase in value. PE firms like Bain essentially filter the economy. They look for under-performing firms, accumulate funds to purchase the firm, and improve them in the long run. Private equity firms like Bain are key for economic health. Without them, inefficient companies would not be filtered out of the economy.

This is reminiscent of the concept of creative destruction. A free-enterprise economy is dynamic, constantly changing and developing with time. However, constant regeneration requires destruction. The creation of personal computers and word-processing software destroyed the typewriting industry.  Advances in farming technology killed agricultural jobs.  The emergence of e-readers is slowly killing demand for physical books.  All these advances destroy, but they also create.  If the typewriting industry did not die (and all the jobs with it), the internet would not have developed (bringing even more jobs).  This is capitalism in action.  We are fortunate to live in a dynamic, organic economy which innovates and adapts autonomously.  PE firms like Bain are where the rubber meets the road, so to speak.  They make creative destruction happen.  They mobilize capital and allocate it to the companies which most desperately need it and, simultaneously, improve economic efficiency.

Finally, PE firms are just one class of actors in this investment class.  Angel investors and venture capitalists are also involved in the PE. These are the actors which invest in start-ups and entrepreneurial ventures, not necessarily engaging in LBOs.  They provide funds to companies in their latency, helping them grow to be more innovative and profitable.  Notable companies like Facebook, Google, and Twitter were all jump-started by angel investments.  It is clear that PE is the lifeline of a functioning free-market economy. Without PE, our economy would remain static. Entrepreneurs would have more difficulty accessing necessary capital for their ventures. Opposing PE is equivalent to opposing the very engine of our free-market system.

So why are PE firms like Bain Capital, and Mitt Romney, getting such bad press?  There are a few good reasons.

Remember that loan Bain took out to acquire the previous hypothetical target firm?  It qualified for the loan based on the assets held by the target firm.  In essence, Bain uses the target firm’s own assets against it.  This is simply viewed as devious and cold-hearted.  Second, as stated before, streamlining the target company could involve laying off unproductive employees.  So, it is easy to see how Bain, profiting while laying off workers, can be perceived negatively. Third, the profits Bain makes are legally filed as capital gains, thus subjected to a lower tax rate. This is also perceived to be rather sly and devious on part of the PE firm.  After all, it is making enormous profits whilst being taxed less. Lastly, the most obvious reason is not misunderstanding at all; it is simply a chance for the other Republican candidates and leftists to score points against Romney.  I’m sure part of the criticism Romney faces originates simply from political incentives (let’s not kid ourselves, they matter more to politicians than facts).

Regardless of these conceptions, it is important to understand that the activities of PE firms enhance the economy’s performance by improving inefficient companies.  In the short run, this may kill some jobs.  However, in the long run improved businesses will create jobs and spark economic innovation.  PE firms are constantly renewing the economy, making sure it remains a well-oiled machine while earning a profit.  Mitt Romney was very successful at Bain.  This, in itself, proves that the firm was especially good at picking out target companies.  At any rate, it certainly provides no legitimate basis for criticizing Romney on the economic front.

Arman Oganisian :: Providence College :: Providence, Rhode Island :: @ArmanOganisian

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