Thinking Things Over January 16, 2012
Volume II, Number 2: In Defense of Private Equity (Though Not of Romney)
By John L. Chapman, Ph.D. Austin, Texas
In 1962 the late economist Murray Rothbard of the University of Nevada-Las Vegas wrote one of the great books in 20th century economics, his magnum opus known as Man Economy and State. Among many other seminal contributions to pressing policy controversies of the modern era, the book gives a sound explanation for the role and importance of what Rothbard termed the capitalist-entrepreneur to the process of economic growth. In considering what to make of the brouhaha in Republican Presidential politics that erupted this past week over former Massachusetts Governor Mitt Romney’s tenure at Bain Capital, it is worth capturing the essence of Rothbard’s argument in full:
We shall concentrate on the capitalist-entrepreneurs, economically the more important type of entrepreneur. These are the men who invest in “capital” (land and/or capital goods) used in the productive process. . . . The capitalist-entrepreneur buys factors or factor services in the present; his product must be sold in the future. He is always on the alert, then, for discrepancies, for areas where he can earn more than the going rate of interest. Suppose the interest rate is five percent; Jones can buy a certain combination of factors for 100 [dollars]; he believes that he can use this agglomeration to sell a product after two years for 120 [dollars]. His expected future return is [roughly] ten percent per annum. If his expectations are fulfilled, then he will obtain a ten percent annual return instead of ten percent. The difference between the general interest rate and his actual return is his [economic] profit…[i]n this case, 10 [dollars] for two years, or an extra five percent per annum.
What gave rise to this realized profit, this ex post profit fulfilling the producer’s ex ante expectations? The fact that the factors of production in this process were underpriced and undercapitalized—underpriced in so far as their unit services were bought, undercapitalized in so far as the factors were bought as wholes. In either case, the general expectations of the market erred by underestimating the future [value] of the factors. This particular entrepreneur saw better than his fellows, however, and acted on this insight. He reaped the reward of his superior foresight in the form of a profit. His action, his recognition of the general undervaluation of productive factors, results in the eventual elimination of profits, or rather in the tendency toward their elimination. By extending production in this particular process, he increases the demand for these factors and raises their prices, [thus narrowing profit margins]. This result will [also] be accentuated by the entry of competitors into the same [market], attracted by the ten-percent rate of return. Not only will the rise in demand raise the prices of the factors, but the increase in output will lower the price of the product [lowering profit margins in both cases]. The result will be a tendency for a fall in the rate of return back to the pure interest rate (which, in this example, is five percent).
What function has the entrepreneur performed? In his quest for profits he saw that certain factors were underpriced vis-à-vis their potential value. By recognizing the discrepancy and doing something about it, he shifted factors of production from other productive processes to this one. He detected that the factors’ prices did not adequately reflect their potential [future value]; by bidding for, and hiring, these factors, he was able to allocate them from production of lower-valued to production of higher-valued products. He has served the consumers better by anticipating where the factors are more valuable. For the greater value of the factors is due solely to their being more highly demanded by the consumers, i.e., being better able to satisfy the desires of the consumers.
In a nutshell, in the simple language of the general theorist, Rothbard has just described the function of private equity, in the sense of it being an important institution in a modern capitalistic economy. There is so much confusion about private equity, and indeed vilification of it — borne of ignorance of the above — it is important to understand it fully. And indeed, that is not hard to do, which makes the criticism and pettiness of Messrs. Gingrich, Huntsman, and Perry doubly pathetic. All three of these candidates are Republicans who ostensibly understand the business sector and the economic role of profit, but all three attacked Mr. Romney for his time at Bain Capital: Mr. Perry calls Romney a “vulture capitalist“; Mr. Huntsman accused him of “killing jobs instead of creating them”; and Newt Gingrich assailed the former Massachusetts Governor for “looting companies” (a Gingrich-affiliated Super-PAC has also made a half-hour infomercial attacking Romney’s record at Bain Capital).
This was all unbecoming, and indeed dangerous, because public misunderstanding of private equity feeds the general anti-capitalist rhetoric that buttresses populist calls for bigger government, and for the stifling of the vibrant capital markets that have (or had, until recently) made America the envy of the world. It was further dismaying, then — or shall we say equally pathetic — that the best line of defense that Mr. Romney could muster in explaining 17 years of his life was to equate the Obama government’s take-over of the auto companies to a turn-around deal in private equity: “…in the general election I’ll be pointing out that the president took the reins at General Motors and Chrysler – closed factories, closed dealerships laid off thousands and thousands of workers – he did it to try to save the business.”
This is, with all due respect, a ridiculous assertion, for there is nothing fundamentally similar between what was involved in the U.S. government’s intervention in the auto industry and a typical private equity transaction. Clearly, Mr. Romney has not thought deeply about the very legitimate and important role of private equity as an institutional driver of growth and prosperity in a modern capitalist economy, and while one would expect, say, Nelson Rockefeller to hold this confusing view, it is another mark of potential disappointment in a future President Romney. A brief summary of the private equity phenomenon elucidates its critical role as an economic institution of modern capitalism.
What is Private Equity?
The modern private equity (“PE”) sector has two constituent parts: (1) venture capital (“VC”), which involves the funding of start-up or early-stage companies, usually in newer technologies involving information or communications technologies, or biotech and health care; and (2) later-stage or mature industrial companies in need of restructuring, recapitalization, or growth equity. These latter-type transactions, which often involve a change-in-control, were once referred to as buyout deals, but now are referred to as “private equity” transactions (and hence there is some confusion on this topic, because technically VC deals are a subset of a larger realm of PE-based deals).
Venture capital is beyond our scope here as we focus on the later stage investing that is the source of the Romney controversy, but VC has played a huge role in the advancement of the modern economy and creation of significant real wealth and improving living standards: companies from Apple to Genentech to Facebook have been backed by venture capital. Buyout firms, or, as is now said, private equity firms such as Bain Capital, have also played a huge role in the astonishing improvement to corporate productivity in the last 25 years in the U.S.
Private equity firms are usually organized as general partnerships, in which capital has been raised from limited partner investors, in order to pursue acquisitions or at least minority stakes in mature operating companies in need of capital for strategic or operating reasons. Today there are approximately 2300 PE firms in the U.S. backing some 15,000 companies, with roughly $2.5 trillion in equity capital, under management. In contrast, the combined market capitalization of public equity in the U.S., that is, of the New York Stock Exchange and the NASDAQ market, is about $19 trillion, showing the importance of private equity as a part of the whole.
The Historical Origins and Economic Rationale for Private Equity
When World War II ended in 1945, the U.S. was 57% of the world economy. This dominance continued for at least the next 28 years up to the Arab oil embargo in 1973, although in a relative sense the U.S. share of global GDP had declined to 31% by 1969 on its way to the current 26%. In the aftermath of the devastation of World War II, U.S. industrial and commercial power yielded quasi-monopoly status to the biggest American corporations such as General Motors, Ford Motor Co., Coca-Cola, General Electric, Goodyear Tire & Rubber, and IBM, all of whom became prodigious exporters and/or foreign direct investors in seeking out global markets for expansion. But in the 1950s and especially the 1960s, ’70s, and early ’80s, two things happened: some firms became so big as to become unruly to manage, and a conglomerate-building spree and merger wave swept through American business. Indeed, the two phenomena were often conflated as when, for example, Xerox Corporation, an office machines manufacturer, bought Crum & Forster Insurance, a property and casualty insurance firm.
The literature in empirical corporate finance is strongly indicative on this: there is often a “diversification discount” in the equity value of multiple-division holding companies or conglomerates. There are many theories for this, but as a general matter it is possible that the diversified firm, having less management and strategic focus than single-industry “pure play” firms, causes a loss in overall value (in other words, Xerox and Crum & Forster would be worth more apart than bolted together). And at the least, according to the precepts of modern finance, there is no reason for a firm to diversify when an individual can do so.
Equally troubling were the governance failures in place at the time: corporate managers, who supposedly were agents acting on behalf of disparate shareholders, in fact often padded corporate Boards with cronies and friends who allowed the managers to, in effect, build personal fiefdoms with corporate assets, rather than manage to maximize shareholder wealth. These managers were also often incited to maximize revenues and corporate scale, rather than profits or free cash flow, and as a result, large-cap corporate America became “fat, dumb, and happy” in the thirty-five years after World War II. In nominal terms, U.S. equities were flat for the 16 years between 1966-82, and lost 70% in real (inflation-adjusted) purchasing power.
In terms of corporate strategy and execution, the 1970s exemplified this relative decline in the United States, as profits and corporate investment stalled, and U.S. firms suffered market share declines globally, especially at the hands of resurgent industrial powers Germany and Japan. A key reason for this was simply an inertia in U.S. capital markets due to scale: the market for corporate control was not well-developed for mega-sized firms. But in 1974, the ERISA law included a provision that institutional investors could participate in “alternative” investments that were beyond the usual publicly-traded debt and equity securities (e.g., private equity, hedge funds, commercial real estate, timberland); this provided the funding platform for what was to become the leveraged buyout (LBO) and venture capital wave of the 1980s and beyond.
The early buyout funds were to take great advantage of this new law by soliciting pension funds, life insurance companies and the like as institutional limited partners in order to develop pools of capital in order to pursue acquisitions of undervalued companies. The LBO era, in fact, may be dated to the Kohlberg Kravis Roberts & Co. (KKR) buyout of Houdaille Industries in 1979, and led to the 1980s and ’90s explosion in buyouts — and indeed, it might be said, to the development of a highly efficient market for corporate control in the United States. 1980s-era deals were an efficient response to the governance problem mentioned above: here now, for the first time, was effective buying power to pursue target public companies, usually in “going-private” transactions, in which the company could be re-organized and restructured. The result often involved breaking up multi-division holding companies or selling off certain constituent parts, shuttering unprofitable operations, and having a more focused, leaner company re-emerge after a public offering. (Beyond the scope of our theme today, newly-emerging innovations in U.S. capital markets such as the high-yield bond market developed by Michael Milken during the buyout wave were also instrumental in improving the market for corporate control.).
The development of a relatively liquid market for corporate control, thanks largely to private equity, is one of the great reasons for the economic boom that began in the U.S. in 1983 and continued largely unabated for 25 years. Private equity-backed firms create value via improvements in governance (e.g., small expert Boards, alignment of incentives via management equity, decision control rights given to those with the best incentives and knowledge to effect correct moves), strategy (e.g., growth equity for expansion, consolidation of fragmented industries to achieve scale economies), and operations (e.g., capital investment in productivity-enhancing equipment), and were so successful in solving the inherent conflict caused by the separation of ownership and management control that the very existence of the PE sector has over time meant that publicly-traded companies have had to be more efficient. And in more recent years, having largely solved these principal-agent problems and forced shareholder-first zealotry on the part of the managers in corporate America, PE investment has turned to providing expansion capital as well as assisting in industry restructurings.
One of the other significant value-adding features of the PE sector as well is the liquidity it has created for the universe of privately-held companies, often of fairly small scale. Prior to the 1980s, and more realistically the 1990s, the owner of the proverbial “widget” company worth less than $10 million in, say, Peoria, Illinois, had a very hard challenge when seeking an exit due to, say, old age. These owners were often forced to contact direct competitors or at least industry-related participants in order to offer their business for sale; this had obvious drawbacks to it in terms of lost confidentiality. Or, they were at the mercy of fate, somehow leading to a chance meeting with an entrepreneur looking to buy a “widget” company in the Midwest.
The well-developed “middle market” and lower-end market for deals in the PE world has been a tremendous source of growth for smaller privately-held companies. And in many cases, here, too, these small firms are in fragmented industries that can be consolidated, promoting macro efficiency in the process.
Mr. Romney and Private Equity
The Wall Street Journal reported this week that Mr. Romney oversaw 77 PE deals in his 16+ years as head of Bain Capital. During this time 22% of them went bankrupt, and another 8% were liquidated with Bain losing its entire equity investment. In fact, only 10 of the 77 deals produced almost all the gains from the portfolio during Mr. Romney’s leadership. Overall Bain invested $1.1 billion during his tenure, returning $2.5 billion in gains to its limited partners, making Bain a top quartile PE firm during this time — a tremendous achievement.
Mr. Romney’s equation of his investments at Bain Capital with the U.S. government take-over of moribund auto companies is non-sensical. Bain Capital operated in an at-risk environment, in which non-performance by the firm would cause them loss of jobs and professional reputation — and ultimately collapse of the firm if the losses were severe. The transactions were also voluntary in every way, both with the limited partner investors parting with their funds in hopes of higher returns, as well as the target acquired companies. The U.S. government acted in a political environment with taxpayer funds, however, in an involuntary way. What Mr. Romney should have said is essentially what Rothbard says above with respect to the heroic and intrepid “capitalist-entrepreneur.” PE professionals peer into an uncertain future and place bets based on a perceived reconfiguration of demand later on, or upon the need for restructuring of current asset configurations in the face of anticipated change in conditions. If the PE capitalist-entrepreneur is correct in his assessments, he is rewarded with profit, as Rothbard details; if not, he is punished with losses and will eventually lose command over the scarce capital resources of society in favor of those who are more astute.
More generally, private equity, as an economic institution, provides risk mitigation, liquidity, and information generation services to a host of economic agents, all of which are wealth-creating for the economy at large. At its essence, the capitalist economy is very efficient at solving society’s most fundamental challenge: coordinating the scarce resources at our collective disposal. And PE is a big part of the reason why those coordinating processes are more effective here than anywhere else in the world — PE is in its infancy both in much of Europe (though not the U.K.) and all across Asia – and thus in turn why our standard of living is so much higher here than elsewhere.
An easy way to judge the efficacy of an institution in any economy is to picture the economy without the institution. If the private equity sector did not exist, we might never have left the 1970s, and corporate America would be one giant morass. It is a shame indeed that the former Governor of Massachusetts does not seem to apprehend this thesis, or is at least unwilling or without the courage to defend it.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com. The views expressed here are solely those of the author, and do not necessarily reflect those of colleagues at Alhambra Partners or any of its affiliates.
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