Friday, January 13, 2012

A critique of Bain Capital

The film denouncing Mitt Romney's work at Bain Capital, which apparently is playing in South Carolina but is also available here via youtube, may appear at first glance to be longer on story than coherent critique. But in fact it makes a specific claim about Romney's private equity career that deserves broader attention and assessment.

The claim is that Bain's business model under Romney was as follows. They would buy a business and boost its short-term profitability through measures that did not actually increase, and might indeed reduce, its long-term profitability. A specific example mentioned is demanding swifter production at the cost of much lower quality, which could increase sales for the first six to twelve months but then destroy a product's reputation and longer-term sales. Another is slashing wages, where they were previously higher for "efficiency wage" reasons, generating immediate savings but over a longer period reducing workforce productivity (e.g., due to higher turnover costs, change in the quality of the workforce, and morale effects).

The short-term profit jump would immediately be cashed out via higher debt, in many cases accompanied as well by a public stock offering. Bain would then cash out, leaving the business to fail because profits, once they reverted to lower levels, couldn't handle the debt burden.

While I don't know for sure that this story is (at least generally) true, it hangs together and makes logical sense. Note that, in bankruptcy, it might make sense to break up the business rather than simply refinance and keep it going, even if before the arrival of Bain Capital this would not have made sense even with a high debt overhang. Once they have destroyed intangible value (goodwill, workforce in place, etcetera), the company they purchased is no longer optimally using resources.

Obviously, the story requires a healthy dose of asymmetric information and capital market gullibility to get off the ground. (The suckers, after all, are not just the workers but also the lenders and the public offering stock purchasers.) But this is entirely believable. Think of Goldman conning its customers, AIG offering what was effectively an insurance product that it would never be able to make good if the insurance was needed, or mortgage securitizations that offered sham diversification benefits and were priced based on credit ratings that they did not deserve. Bain, under this view, is simply one more member of the rogue's gallery of players that found ways to generate enormous profits by causing the U.S. economy to work worse, not better.

This of course would be a story not of capitalism's "creative destruction," but of destructive destruction and the use of information asymmetries (pertaining here to the short-term profitability jumps that apparently drove the ability to borrow and drain out cash) to undermine the sound functioning of capital markets. And the extent to which it is true certainly deserves serious scrutiny in the months ahead.


Lao Tzu said...

I take this as more a critique of public-prices-converge-to-true-value than of Romney.

Many investors analyse a stock in such a way that the strategy you describe would raise the stock price. That public markets demand quarterly performance improvements is a common gripe.

(Even more: the very fact that any p.e. firm could take a company off the market for a time and increase the stock price must defeat the EMH in one way or another.)

But as far as Romney's behaviour goes: he did what was good for his business. He met the goals he was set toward. Bain Capital's mission was neither to create jobs nor to add economic value.

I would just Romney's likely performance as President based on his observable performance as a Governor. As Governor his responsibilities were to the public, as they would be in a nationally commanding role.

Daniel Shaviro said...

Agreed on all counts except perhaps your last paragraph. Anything in one's career is potentially predictive of how one would perform as president. And the problem with predicting his performance from when he was the Massachusetts governor is that he will be facing very different political incentives. (If being a moderate Republican president was likely to pay off politically for him, my expectations would be very different.

The whole public conversation about his private equity career has of course been very silly. But he started this whole thing, e.g., by implicitly suggesting that his buyouts make him qualified to judge, say, whether Keynesian stimulus can be effective.

Robert West said...

The goal of an executive is never to improve the business, it is to improve his or her personal wealth. Improving the business is generally a good means to that end, but it would be naive to assume that the good of the enterprise is the goal of any hired executive.

Bain's strategy is neither new nor particularly brilliant: it used to be called the "sausage game", from the textbook example: make great sausage, get a reputation, then slowly adulterate it, increasing profits. The goal is to sell the company at a huge markup before demand takes a dive.

Romney himself cited his time at Bain as a qualification, and has called himself a "job creator". It is reasonable to critique whether that is so. I think it likely that President Romney would revert to type: cooking the books and producing programs with short-term and/or illusory benefits but long-term problems.

Brian J said...

I feel as if this post touches on how my thinking has developed in the last week or so.

I don't think all private equity is bad. No doubt some if not most of these companies do play a role in the creative destruction process. However, it doesn't look like the same can be said about Bain Capital when he was involved. For me, it's far worse that he managed to stick the government with the bill for pension costs and whatever else while he still made a profit. At the same time, was anything else to be expected? As Felix Salmon said, "The reality is that Romney would have been in violation of his fiduciary duty to his investors had he concentrated on creating jobs, rather than extracting as much money as he possibly could from the companies he bought." Perhaps the problem is more with the government that lets this sort of thing happen--not the milking of companies by itself, but the milking of companies with the government picking up the bill.

If that's the sort of thing we want to stop, why would we want to put someone in charge who was directly involved with it and seems to have no desire to see the process change?

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