How much risk do private equity investors really take?
This is one of the big questions lurking behind the theatrical debate about private equity raging on the presidential campaign trail. It is really about the ways private equity investors try to limit - or even eliminate - financial risk and whether they shift an unfair burden onto someone else in the process.
Political campaigns have a way of turning complex subjects into competing cartoonish narratives, and private equity got the full experience as soon as Republican presidential candidates challenged the business record of front-runner Mitt Romney, the former chief of Boston’s Bain Capital.
In reality, the people who lead private equity firms are neither rapacious company killers nor daring risk-takers with a gift for growing jobs. They are professional investors trying to make as much money as possible from their portfolios.
But investors do not measure potential financial rewards in a vacuum. Risk is also part of the equation and private equity investors are particularly skilled at limiting their exposure.
Most private equity transactions are leveraged buyouts, and investors borrow as much as they can. Once a sale takes place, the new private equity owners often look for the first opportunity to recapitalize the company - borrowing more against the business to write themselves dividend checks.
Recapitalizations don’t happen all the time and, when they do, the scale of the payment depends on circumstances. But private equity managers certainly look for that opportunity. In years past, they boasted about investments that quickly returned all the capital originally risked in purchases. Sometimes it was a matter of months.
So what about the businesses operating beneath all that debt? Contrary to campaign rhetoric, most private equity investments do not go bankrupt. The catch: Portfolio companies often pile up the kind of debts that remain manageable in good times but become a big problem when sunny forecasts don’t work out. Who pays the price then?
The Bain Capital record on this issue during the Romney era is spelled out in detail in “The Real Romney,’’ a book by Boston Globe reporters Michael Kranish and Scott Helman in stores today.
Overall, that record is mixed. Bain made piles of money, but at least 10 percent of its companies went bankrupt for a variety of reasons during the Romney era. Many others exited the portfolio with much more debt.
One of the most interesting business stories in “The Real Romney’’ isn’t about Bain Capital investments at all. It’s about Romney’s return to the consulting firm Bain & Co. in its darkest hour.
Romney had started his career at Bain & Co., where founder Bill Bain eventually convinced him to launch a separate investment firm that became Bain Capital. Later, Bain & Co. ran into serious trouble because the company had borrowed $200 million so Bill Bain and other founders could cash out part of their ownership.
But the economy went soft, Bain’s revenues went down, and the company that advised clients on business dilemmas faced one of its own making. Bain & Co. could not pay its bills.
Romney agreed to return and try to save Bain & Co. He cajoled some creditors and played hardball with others. He stopped payment on a $1 million check to a landlord. Yes, he laid off Bain & Co. employees, too.
Romney did one other important thing to get Bain & Co. back on its feet. He told the company’s founders they had to give a lot of the money back. In Romney’s toughest negotiation, Bain & Co. founders agreed to return about $100 million - half of their payout.
Romney’s effort paid off. Bain & Co. survived and then recovered. “It was one of his most impressive displays of executive talent and toughness; in some ways it was his finest hour at Bain,’’ Kranish and Helman write.
This is certainly true. But consider the circumstances: Bain & Co. borrowed too much to pay the company’s owners and couldn’t manage the debt in a tough economy, the same kind of jam some businesses owned by private equity investors run into.
Romney revived Bain & Co. by persuading owners to give back millions they had taken out of the business. How often would executives in Romney’s private equity world make the same choice?