Check Your Premises on Capitalism and “Private Equity”

Some people argue that questioning the details of Mitt Romney’s actions at Bain Capital, or any actions by “Private Equity” firms, amounts to questioning capitalism itself.  Such people argue that Mitt and others engaged in Private Equity are essentially entrepreneurs engaged in the “turnaround” game, buying weak companies and reorganizing them back to profitability. The argument goes that that some turnarounds succeed, some fail, and it’s an essential part of Capitalism to rejuvenate older companies or move them in new directions, even if some workers have to be laid off in the process.

But is defending every action of Private Equity really the same as defending Capitalism? As Ayn Rand was famous for saying, “Check your premises.”

First, let’s consider how Ayn Rand defined Capitalism:

“Capitalism is a social system based on the recognition of individual rights, including property rights, in which all property is privately owned.” “When I say “capitalism,” I mean a full, pure, uncontrolled, unregulated laissez-faire capitalism—with a separation of state and economics, in the same way and for the same reasons as the separation of state and church.”

Rand explained that capitalism is the only moral economic system because it is the only just economic system:

The moral justification of capitalism does not lie in the altruist claim that it represents the best way to achieve “the common good.” It is true that capitalism does—if that catch-phrase has any meaning—but this is merely a secondary consequence. The moral justification of capitalism lies in the fact that it is the only system consonant with man’s rational nature, that it protects man’s survival qua man, and that its ruling principle is: justice.

Rand also explained that, above all, justice requires that no one give or take the unearned:

Capitalism does not tell men to suffer, but to pursue enjoyment and achievement, here, on earth—capitalism does not tell men to serve and sacrifice, but to produce and profit—capitalism does not preach passivity, humility, resignation, but independence, self-confidence, self-reliance—and, above all, capitalism does not permit anyone to expect or demand, to give or to take the unearned. In all human relationships—private or public, spiritual or material, social or political or economic or moral—capitalism requires that men be guided by a principle which is the antithesis of altruism: the principle of justice.

All admirers of Ayn Rand and capitalism ought therefore be able to agree that we defend capitalism because it is just, and actions that are unjust are not capitalism, whether such actions are strictly legal or not.

Now let’s turn back to Mitt Romney. Romney’s supporters wants you to believe he is qualified to be president because his work at Bain Capital taught him how capitalism works. His web pages states: “Mitt is not a career politician. He has spent most of his life in the private sector, giving him intimate knowledge of how our economy works.”

Since capitalism rests on justice, the question before us is not whether Romney’s business decisions at Bain were legal, but whether they were just. And that question cannot be answered without looking at the details of what Bain under Romney actually did.

One of the best sources of public information about Romney’s activities at Bain is Josh Kosman’s 2009 book: “The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis.” Chapters 1-5 of this book describe the background and methods generally used by firms in the Private Equity business such as Bain Capital. Chapter 6 focuses on Romney and Bain:

“For people not familiar with Romney’s background as the owner of Bain Capital or with his relationships to other private-equity firms, the irony of this advice might not have been immediately clear. PE firms during the 2003—7 buyout boom often had their companies use increased short-term earnings that came from reducing customer service, raising prices, and starving them of capital—not to reinvest or pay debt, but instead as the basis to borrow more money, which they then gave to their PE owners through dividends. Many of these businesses are now stuck with enormous debt and falling earnings.”

“Mitt Romney was a pioneer of this strategy. His private-equity firm, Bain Capital, was the first large PE firm to make a serious portion of its money not from selling its companies or listing them on the stock exchange, but rather by collecting distributions and dividends, which in this context is the exact opposite of reinvesting in a company. Bain Capital is notorious for its failure to plow profits back into its businesses.”

“Traditionally, cash-rich public companies have paid dividends to lure and reward investors. They distribute some of the profits that they are not reinvesting as a way to say they have surplus funds and expect to have them in the future. These dividends generally amount to cents or a few dollars per share paid quarterly. But when private-equity firms take distributions, they typically do not tap excess profits. Instead, they increase the pool of available funds by having their companies borrow money—on top of the original debt taken on to finance the LBO.

Mitt Romney used this strategy in the 1990s as part of his private-equity playbook, long before it became common practice during the 2003—7 buyout boom. The credit crisis that started in mid-2007 limited the practice, as it became difficult for companies to borrow funds to pay the dividends. But the scale back was purely a function of credit availability, not of any backing off by the PE firms. Just as venture capitalists rushed to get their businesses listed on the public markets in 1998 and 1999 to take advantage of the IPO frenzy, private-equity groups used dividend payments in this decade as a way to profit from the cheap-credit bubble. If Bain’s experience is any indication, many of the companies that borrowed money to issue dividends will not be able to survive.”

Kosman then proceeds to show how the histories of Dade Behring, Ampad, KayBee Toys, and others – a total of 6 companies that were bankrupted under the influence of Bain – fit this pattern.

What are we to make of these allegations? This blog would turn into a book itself if it attempted to delve into the details of these transactions, but that book is already written – and Kosman has done a great job of it. Over the coming weeks and months these details will be endlessly investigated, and links to the details will be posted here. But during this process no one – not even the most ardent fan of Ayn Rand – should believe that scrutiny of the Private Equity game involves an attack on capitalism.

As the chairman of the Ayn Rand Institute, Yaron Brook, recently stated:

And indeed what we’re seeing is some–certainly not as many as the media would lead you to believe–some businessmen, some CEOs are pursuing short-term self-gratification at the expense of long-term profit, long-term happiness, and the long-term success of their shareholders, to whom they owe a fiduciary duty. Ayn Rand would be disgusted by this behavior-but she wouldn’t be surprised. She portrayed this kind of CEO in Atlas Shrugged, in characters such as Orren Boyle and James Taggart.

Here are some of the questions to ask yourself to decide if Romney was really a turn-around specialist, or something quite different:

  1. What is the evidence that Romney’s firm injected value — expertise, ideas, creativity, new directions, capital, or anything of value — into the company in exchange for the massive amounts of capital it took out?
  2. What creative changes did Romney make to grow the company and help it survive?
  3. What business plan was put into effect to pay back the massive debt that Romney ordered the company to incur?
  4. Was Mitt Romney honest and up front about his intentions for dealing with the companies he purchased? Did he tell the former owners, the employees, and the other stakeholders of these companies that his primary focus was not making the company succeed as a going concern? IF HE WASN’T, were his actions instead a misrepresentation of the truth to people who acted in trust that Romney was really trying to turn around the company for the long term? Operating a business with the intent of loading it with unsustainable debt, de-capitalizing it, and bankrupting the remainder might be something that can be done within the law, but operating that way is not consistent with justice or capitalism.  Was that done in each of the companies in which Bain was involved during Romney’s tenure?  We don’t have all the facts to know at this point, but it is not a criticism of capitalism in general to ask for answers to these specific questions.

Ayn Rand herself said:

Capitalism demands the best of every man—his rationality—and rewards him accordingly. It leaves every man free to choose the work he likes, to specialize in it, to trade his product for the products of others, and to go as far on the road of achievement as his ability and ambition will carry him. His success depends on the objective value of his work and on the rationality of those who recognize that value. When men are free to trade, with reason and reality as their only arbiter, when no man may use physical force to extort the consent of another, it is the best product and the best judgment that win in every field of human endeavor, and raise the standard of living—and of thought—ever higher for all those who take part in mankind’s productive activity.

Were Romney’s activities at Bain something that qualify him to be president of the United States? Or, as one blogger said, was Romney:

“[getting his] money back by leveraging up the company and sucking out fees and dividends, then maybe selling it publicly. They leave the debt burden with the company and its investors as they move on to the next target. So this is really like anti-matter to matter … they don’t capitalize and strengthen, they de-capitalize and weaken. The LBO era added junk debt, and companies paying off debt paid few taxes. Capitalism isn’t the problem, leveraged junk debt is the problem after decades of excess easy money.”

If the leading defenders of Capitalism give up on the job of drilling down to the details before they evaluate Mitt Romney, then we’ve lost Capitalism already.

But we still have time to search out the truth — it’s not too late to check your premises.

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  1. #1 by sarah on January 23, 2012 - 9:25 pm

    I was referred here by Professor Jacobson at Legal Insurrection and am so glad I clicked through. Wonderful article and an extremely interesting blog. Thanks!

  2. #3 by Dynamism on January 23, 2012 - 10:13 pm

    I also landed here via Professor Jacobson’s Legal Insurrection blog.

    Glad to see a site on this topic. I figured I’d share a response I’d been passing around on the matter:

    Too many people are defending Romney as just being a good little capitalist, when this isn’t really the case—rather, he was a private equity manager playing shell games and essentially committing fraud with investors. I think most would agree that there should be restraints against somebody selling watered-down gas… so why not against dishonest debt instruments? I think most agree that if a minority shareholder uses company money to issue himself a big paycheck, this is embezzlement from the other shareholders. But when Romney does this via multi-million dollar consulting fees, this isn’t different? (Note: These are rhetorical points on the business ethics involved—I’m not advocating that the government should step in and regulate any of this. I’d rather prefer they didn’t, and that such matters be resolved in civil courts as common law disputes, etc.)

    Now the crux of this problem is of course the government. Their corporate limited liability laws unfairly rip up contracts between creditors and debtors. Making debt financing tax deductible, but not equity financing, has seriously skewed the corporate structure. And lastly, the Federal Reserve issuing so much debt (largely indirectly) and then bailing out said debt (→ moral hazard) is a significant problem in aiding and abetting the private equity craziness of reckless LBOs, etc.

    Specifically how the system works: A bank overflowing with money they created from low Fed Reserve interest rates meets with a private equity firm to talk about taking over firm. The bank provides ~80/20 the money and they together purchase the take over target. The PE firm immediately loads up the acquired firm with debt for the bank to get their money. The debt is structured as a huge balloon payment set to self-destruct in about 5 years. The bank realizes this is ticking time bomb, so unloads this debt ASAP to other banks, hedge funds, insurance companies and pension funds. The smarter investors realize this is a hot potato and keep passing it around. Recently they’ve been hiding this bad debt in CLOs (almost identical in concept to real estate CDOs). Hidden amongst other debt, people have no idea the mess they purchased. The PE firm on the other hand wastes no time in borrowing HEAVILY again to finance corporate mergers (they don’t want to do it from the PE firm directly because they could be liable for the debt). They also borrow heavily to finance huge dividends that more than make up for what they paid for the firm. They justify the dividend legally by jacking up short term profits (price increases, job cuts, quality reductions) that threaten the long term health of the company, and by money saved from tax deductible interest as well. If possible, the PE firm tries to dump their acquired firm before the balloon payment comes up… but even if they’re stuck with the firm they usually do very well given all the consulting fees they charge and the huge dividends they give themselves.

    As ZeroHedge also explains in a nutshell:

    “Lately, Bain founder and GOP presidential candidate Mitt Romney has found himself in a spirited defense of the private equity industry, doing all he can to spin decades of data which confirm, without failure, that PE Leveraged Buy Outs are nothing but “efficiency maximizing” transactions whose only goal is the “maximization” of EBITDA in the pursuit of dividend recap deals, IPOs or outright sales, while loading up the company with untenable amounts of leverage. All this with a 3-5 year investment horizon, which ignores the long-term viability of a company and seeks to streamline (read fire as many as possible) operations as quickly as possible in the goal of maximizing short-term returns. We wish him luck in his endeavor.”

    Also note that Romney relied on corporate welfare. Take a walk down the list here:

    A comparison of the 1999 Bain portfolio obtained by the Los Angeles Times to the information in the Subsidy Tracker database my colleagues and I at Good Jobs First created (as well as other sources), yields examples such as the following:
    Steel Dynamics Inc. In 1994 this company, among whose financial backers at the time was Bain, got a $77 million subsidy package—including grants, property tax abatements, tax credits and reimbursement for training costs—for its steel mill in DeKalb County, Indiana (Fort Wayne Journal Gazette, June 23, 1994).
    GS Industries. In 1996 American Iron Reduction LLC, a joint venture of GS Industries (which had been taken private by Bain in 1993) and Birmingham Steel, sought some $20 million in tax breaks in connection with its plan to build a plant in Louisiana’s St. James Parish (Baton Rouge Advocate, April 6, 1996). As the United Steelworkers union noted recently, GS Industries later applied for a federal loan guarantee, but before the deal could be implemented the company went bankrupt.
    Sealy. A year after the 1997 buyout of this leading mattress company by Bain and other private equity firms, Sealy received $600,000 from state and local authorities in North Carolina to move its corporate offices, a research center and a manufacturing plant from Ohio (Greensboro News & Record, March 31, 1998). In 2004 Bain and its partners sold Sealy to another private equity group.
    GT Bicycles. In 1997 GT, then owned by Bain and other investors, decided to move its manufacturing operations to an enterprise zone in Santa Ana, California. Being in the zone gave the company, which was later purchased by Schwinn, special tax credits relating to hiring and the purchase of equipment (Orange County Register, July 9, 1999).

    • #4 by Isaac1 on January 23, 2012 - 10:34 pm

      Thanks Dynamism. Just the kind of post I’d like to put out for discussion.

      • #5 by Dynamism on January 24, 2012 - 12:00 am

        Sure, no problem. Feel free to borrow from the post in whole or in part.

        Like I said, I’m glad to see these issues being raised, because I think they’re vital for sake of an intellectually honest discussion of capitalism—as opposed to the typical defenses I’ve been seeing as of late, which conflate capitalism with corporatism.

        Which reminds me, I think you’d appreciate this article if you haven’t seen it yet: Capitalism Isn’t Corporatism or Cronyism. Very topical for this blog.

      • #6 by Isaac1 on January 24, 2012 - 12:52 am

        Thanks again, I’ll add a link to that!

      • #7 by Isaac1 on January 24, 2012 - 12:59 pm

        Dynamism, do you know a good link for information on what is known about how Romney got his START at Bain capital? (the FDIC loan forgiveness issue)? thanks

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