Thu January 19, 2012
'Vulture Capitalism'? How Private Equity Firms Work
Originally published on Thu January 19, 2012 3:06 pm
JOHN DONVAN, HOST:
This is TALK OF THE NATION. I'm John Donvan in Washington. Neal Conan is away. Not all capitalists are Republicans, but all Republicans are capitalists, as a rule, anyway, straightforward enough. But then came the current race for the White House, Republican versus Republican, and now we're hearing there are all different kinds of capitalists. Not unsuccessful/successful, but good guy/bad guy, with fellow Republicans attacking frontrunner Mitt Romney, who made his money as a venture capitalist by calling him a vulture capitalist, a job destroyer, a crony capitalist.
NEWT GINGRICH: But if somebody who is very wealthy comes in, takes over your company, takes out all the cash and leaves behind the unemployment, I think that's not a model we want to advocate.
SARAH PALIN: Governor Romney has claimed to have created 100,000 jobs at Bain, and, you know, people are wanting to know: Is there proof of that claim?
DONVAN: Newt Gingrich on Fox News and Sarah Palin speaking on "Hannity." The charges center on his work at Bain Capital, the firm he co-founded before he went into politics. In a moment, NPR senior business editor Marilyn Geewax will join us to tell us what this all means and to explain how venture capital firms actually work.
But first we want to ask you: If a private firm took over your company using borrowed money, in the end was your company better off, or was it worse off? Tell us your story. Our number is 800-989-8255. Our email address is email@example.com. And you can also join the conversation, also at our website. Go to npr.org, and click on TALK OF THE NATION.
Later on in the program, Mac McGarry, longtime host of "It's Academic," will join us. But first Marilyn Geewax, and her piece called "So, Um, What is a Private Equity Firm" was posted today at npr.org. Welcome back, Marilyn.
MARILYN GEEWAX, BYLINE: Hi.
DONVAN: Hi, and in all of these terms that we're hearing thrown about in the Republican debates by - especially by the now-departed Rick Perry, walk us through it. What is private equity? What is venture capital? And what do they mean by vulture capital?
GEEWAX: Well, let's just take a minute to stop and think about the very big picture here. What we're talking about is there are people and institutions - institutions are things like pension funds and university endowments - these wealthy people and institutions need to invest their money. They're not going to just stuff it in a mattress or take it to the bank where they get very little interest. They need to grow their money.
They can grow it in two different ways. They could go to a public forum like the New York Stock Exchange and buy publicly traded stocks, or they can do it in a private way. And that's where these private equity firms come in, that's what Bain Capital was. It takes a bunch of money, puts it all together and then invests it in companies to hope that they will grow. And they're looking for quick growth.
DONVAN: I was going to ask, for them, the advantage of going private rather than going public is what?
GEEWAX: Well, there are better opportunities sometimes. You know, not every company trades on the New York Stock Exchange. You look around America, I'm sure in any community you'll find middle-market companies that are not really huge, but they're not small. They're good, ongoing companies. And to be able to invest in those, you need to go through these private markets.
And these private equity firms help our - they're kind of matchmakers. They put together the people with the pools of money and the companies that want to get access to that equity. So there are different strategies that these private equity firms can use.
One strategy can be called venture capital, and that is they're capitalists. Capital means money. And they look for a good venture, and they put their capital into that venture, and it grows. Now, a great example of that would be Google. Back in the '90s, there were a couple of really smart guys, they had a great idea, kind of in the dorm room, but they didn't have money.
So in 1999, some very wise venture capital firms gave them money to help them grow. By 2004, Google was a publicly traded company, and today they have tens of thousands of workers.
DONVAN: And nobody's complaining about that.
GEEWAX: Right, that's a popular way of investing private equity, to do a venture that grows very rapidly, and pretty much everybody likes that sort of thing. But then there are other ways that the complaints are that it goes too far. And there's sort of this generic term that's being kicked around now, vulture capitalism, that it's that - that there are these other strategies that are harmful to workers.
And in this idea, you go into a company, and you either charge fees that are far too high, you bid on the company in an auction, maybe you do various things that drive down the price, and you try to get it as cheaply as possible. And then you invest in it, but you invest in it with a lot of borrowed dollars, and you load the company up with too much debt, you charge too high of fees, and the next thing you know, a lot of workers end up being laid off.
Now, the private equity fund managers may still make a very good amount of money because they'll get fees, and maybe they'll make a profit. But a lot of times the workers really suffer, or at least they - certainly they lose their jobs, and they feel bad about that. So there is this question of, is there - are there forms of capitalism that are just too rough, that result in too big of profits for some people and too much suffering for others?
DONVAN: As the controversy in the Republican discussion seems to be about what - you're talking about this second kind, where companies come in and are perceived as having caused harm - the role of debt, you mentioned that. In other words, the outside buyers borrow a lot of money, buy the company, and then the debt that is owed becomes owed by the company that they bought.
GEEWAX: And that is - you know, let's think about it in terms of maybe if you buy your own home with a mortgage, if you go into a situation where you're buying a house, and you borrow a lot of money to do that, you know, maybe that ends up being a great investment for you over time, and you may profit from it, but when you first take on all of that debt, you might have to do all sorts of things to save money, to cut your costs.
You might have to, you know, stop going out to restaurants. You maybe can't take vacations. You have to do all sorts of things to cut your costs to be able to manage that new debt that you've just taken on. And that's what happens at a lot of these companies: They get a lot of debt, and they have to do something to live within the means, given this new debt, and often that means a lot of people get laid off.
DONVAN: Well, what if there's a company that is perhaps not the world's most profitable company, sitting - I'll work with some bland stereotypes. Pick a Midwestern company, a small manufacturing firm, by smallish I mean maybe it employs 400 workers, it makes a single product, it's owned by a family, and it's cooking along, and it's not actually squeezing every last penny out of the operation that it could. And yet it's employed families for several generations, it supports the local baseball team, it's a good civic citizen, and the owning family really isn't that hungry to squeeze more profit out of it.
Why - what's the argument for not just leaving that alone as opposed to having an outside investor coming in and seeing the opportunity to squeeze more profit, which would result in the layoffs?
GEEWAX: In a lot of cases, there may be a family-owned business that's exactly as you describe. There are actually lots and lots of businesses like that. But maybe the family, the founder of it is ready to retire, he'd like to take his profits and move on. And the company hasn't been quite as profitable as it should have - it could be under other ownership.
That owner may put their company up for auction, and somebody will come in and buy it and say OK, we're here to clean up now. And they will do things like no more sponsorship of the Little League, and, you know...
DONVAN: Because they don't have the connection, they're maybe from thousands of miles away.
GEEWAX: Right, just they're there to make a profit. And the argument is that's what capitalism is, that you come in, and your goal is to make a profit, not to support the Little League team. Your goal is not to have nice, cozy office furniture. It's not to keep the same person employed after 30 years, even if their skills are rusty. You job is to make money for your investors. So that's the way you have to - you know, that a capitalist would look at it.
And the argument is if you don't do that with that business, sooner or later, the customers are going to get fed up with it, it won't be very...
GEEWAX: Well, they may say that the costs are too high. There's competition...
DONVAN: The cost of the product, you mean?
GEEWAX: The price of the product that they make is too high, there's a competitor somewhere in China who can make it more cheaply. So eventually that business is going to go out anyway because they're no longer competitive. So the private equity firm could come in with an infusion of new money and cut to the bone and make it much more profitable.
But it's a - it can be a very painful and brutal process for the people who are at that company. And then they big question really is: Are the profits outsized? Does the private equity firm get too much? Now, at Bain, the example there was during his time at Bain, it's been estimated that he had a pool of capital that was collected up of $1.1 billion, and because of deals that he helped put together, Bain profited - it had gains of $2.5 billion.
Now, one might say that, well, what if their profits were just a little bit less? Would you have to have laid off that many people? And that's really where the argument is, is do you absolutely maximize profits?
DONVAN: We've asked listeners to call in with their stories of going through some of these experiences, and I want to go to Deborah(ph) in Sacramento. Deborah, you're on TALK OF THE NATION. So what happened in your case?
DEBORAH: In our situation, it was 1987, and our company was a family-owned company out of Salt Lake that was a Western trucking company. It's been a profitable business for 80 years. And we were purchased by some venture capitalists as the founder of our company became old and, as you say, could no longer manage the company anymore.
And they bought the company, they took us on the tarmac in the seven Western states and said be assured, send your kids to college, we're here to stay, nothing's going to change. And within a very short period of time, we were closed.
The company was asset-rich, they sold off all of our assets, our real estate in Las Angeles, Salt Lake City, Sacramento, Oregon.
DONVAN: Why do you think, Deborah, they told you don't worry, and then it turned out you had to worry? Do you think they changed their minds, or do you think they were misleading you in the first place?
DEBORAH: They misled us. After 10 years of litigation and growing very old over the subject, I had hoped that these kind of shenanigans would have ended. But no, there was a design and a method in place to leverage us out, take the asset, gut the company, sell everything off, and then a very small handful of people became very wealthy.
And it leaves in its path a wake of destruction that is extremely harmful for society as a whole. It's not a matter of being good business. That's bad business.
DEBORAH: Entities collapse under this kind of pressure of not having people shopping at the supermarkets, not being able to make their car payments, not being able to pay your mortgage.
DONVAN: All right, I want to give Marilyn a chance to respond to that, and we're going to have some other guests, but we're going to take a break just before we do that. We're talking about venture capital firms. In the latest political back-and-forth, some of them are calling them job-killers, others job creators. NPR senior business editor Marilyn Geewax is helping us to navigate these complicated waters.
So if a private firm took over your company using borrowed money, tell us again: Was your company better off or worse off as we just heard? Our number is 800-989-8255. Our email address is firstname.lastname@example.org. I'm John Donvan. This is TALK OF THE NATION.
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DONVAN: This is TALK OF THE NATION from NPR News. I'm John Donvan. There are more than 2,000 private equity firms headquartered in the U.S. backing more than 14,000 companies, and that's a lot of cash, and it's also a lot of jobs. But most of us rarely hear about venture capital, except in this political season, the term is being hurled at Mitt Romney by his opponents as an insult.
GEEWAX: He co-founded Bain Capital before he went into politics, and Rick Perry took to calling him a vulture capitalist. Today we're talking about venture capital firms actually do and how they do it and why at this particular moment they've become controversial.
DONVAN: If a private firm took over your company using borrowed money, we want to know: Was your company better off or worse? Tell us your story. Our number is 800-989-8255. Our email address is email@example.com, and you can join the conversation at our website. Go to npr.org, and click on TALK OF THE NATION.
Marilyn Geewax is our guest. She's a senior business editor at NPR. We've posted a link to her latest piece, which explains venture capitalism, at npr.org.
And now we want to turn to two people with very different views of the industry. Joining us now via Skype from his office in Chicago is Steven Davis, he's a professor of international business and economics at the University of Chicago Booth School of Business. Welcome to the program, Steven.
STEVEN DAVIS: Thank you. Thanks for having me.
DONVAN: Thanks for joining us. And also joining us in Studio 3A is Eileen Appelbaum. She is a senior economist at the Center for Economic Policy Research. Nice to have you with us, as well, Eileen.
EILEEN APPELBAUM: Glad to be here.
DONVAN: And Eileen, you heard what we just heard from the caller a few minutes ago, telling the story of her experience with a venture capital firm being disastrous for the business she had worked with and for, for years. Is that the norm, or is that the unusual bad apple case.
APPELBAUM: So first let me just help make a distinction between venture capital and private equity. Venture capital invests in early stage companies like Google and takes an equity stake. They don't load these companies up with debt because what would you use as an asset on these newly forming companies?
So it's a very different model than the private equity model. The private equity model deals with more mature firms. It purchases them by putting up a little bit of equity and borrowing a lot of debt. And the important point, Marilyn made the point about buying a house and having a mortgage.
When you buy a house, and you have a mortgage, you are responsible for paying the mortgage. When a private equity firm buys a business, it is the business that puts up a little bit of equity and finances the rest, just like a mortgage, but it is not the private equity firm that has to pay that mortgage. It is the company that they've acquired.
DONVAN: So if Private Equity Firm A buys Company B with debt, Private Equity Firm A is never liable for that debt? It's only the first it has bought?
APPELBAUM: That is correct, and so the most the private equity can lose is its initial down payment. So I just wanted to clarify that point. And in terms of the caller, there's two issues here. One is the initial founder of that company founded that company to last for as anybody could see. It lasted many decades under that person's leadership.
And what we know from our research, I come to this not out of finance but as a person who has studied organizations and what goes on inside of them, the kinds of policies and practices that make organizations profitable and sustainable, what we know is that you have to have a certain level of trust.
You have to have relationships with all kinds of stakeholders, and your long-term viability depends on those relationships with the community, with your workers, with your suppliers, with your vendors and so on. Private equity comes in, and the Sacramento case that we just heard seemed to go under pretty quickly.
Typically they hold a company for six years, on average that's what they hold a company for, and they need to be profitable in that timeframe. The example that she gave - so it's not a generalizable(ph) example, but when private equity comes into a firm that has assets, such as retail, for example, or nursing homes or the case that we heard, typically they divide that company into two companies: a property company and an operating company.
And all of the valuable assets go into the property company. They can sell that property company, make back their initial investment, maybe even make a profit on it, pay off the debt, and private equity has no more skin in the game. So whether the operating company succeeds or not, whether that trucking company succeeds or not...
DONVAN: All right, I want to bring in Steven Davis in the conversation, but just before we do that, I want to bring in one more caller who's going to share his story. I want to ask Matt(ph) in Cincinnati to join us. Matt, you're on TALK OF THE NATION.
MATT: Thanks. Yes, I worked as a financial - for a health care company, a home health care company in Arizona, and prior to being taken over by a private equity company, it was very undisciplined, we really weren't very profitable, mainly because there wasn't a lot of discipline in the employees.
And about three months after the company took us over, there was a lot of discipline, and we became very profitable within two years. We grew three times our revenue, and five years later, we were sold. And I credit the private equity group a lot with bringing that level of discipline to us because prior to that, the founder made about $60,000 a year or whatever, a salary, but there wasn't a lot of emphasis on growth or making more money.
DONVAN: Is it your sense, Matt, that the company would have gone under sooner rather than later if the outside company hadn't come in?
MATT: Yeah, because there were a lot of competitors coming in and taking away the nurses, the good nurses, and leaving us with all the bad employees and such.
DONVAN: All right, let me bring in Steven Davis, who's a visiting scholar at the American Enterprise Institute and many other credentials. Steven, you know, respond to the story Matt's sharing with us from Cincinnati.
DAVIS: Well, it's interesting. You know, we've heard two stories now, both fairly vivid, and one paints a negative picture of private equity, and one paints a positive picture. And in fact much of what we think we know about private equity is based on stories and anecdotes like this, and there's a shortage of systematic study of a scientific sort that looks at outcomes in the wake of private equity buyouts and compares them to firms that are otherwise similar in an effort to draw some type of inference about what the net effect of the private equity transactions are overall.
And that's how I approach this topic, and that's how my co-authors and I approached our study. So we wanted to get beyond anecdotes and stories and try to characterize, in a systematic way, what seems to happen broadly on average, in the big picture.
DONVAN: Well, let me ask Eileen Appelbaum: Do you agree with Steven on what the big picture is?
APPELBAUM: Well, let's have him tell us what he thinks it is, and then we'll see.
DONVAN: All right, Steven, what is your big picture?
DAVIS: So our study looks at most of the private equity buyout transactions that occurred from 1980 to 2005, and we found that the firms acquired by private equity did involve the loss of more jobs at a faster pace than firms that are otherwise similar in terms of industry, size, age and prior growth but that they also created more new jobs at a faster pace than these otherwise similar firms.
So there was both more destruction of old jobs and more creation of new jobs at - in the aftermath of these private equity transactions. The net effect on employment was actually fairly modest. Depending on exactly how you measure it, one to percent of initial employment over two years.
DONVAN: Went down.
DAVIS: Yes, went down, yes. So that would be kind of the first headline from our study.
APPELBAUM: Well, I do have a problem with that. I've looked at Steve's work very carefully, and I agree that it is probably the best that we have. It's a really large-scale, careful study. But my problem with his conclusion is that he is looking, not just at jobs created at the companies that are taken over or other jobs destroyed at the companies taken over relative to others, at branches or stores or factories that were closed and at (unintelligible) plants that were opened.
If you look only at those, you find a much larger loss of jobs than the headline figure he just gave you. The way he gets that headline figure is he also includes acquisitions. So when private equity takes over some of these smaller companies, it grows them by acquiring other companies. Now, when they acquire those other companies, they acquire their employees. There's no net job creation.
DONVAN: Eileen, I hear what your point is, and I want to let Steven respond quick.
DAVIS: Yeah, I don't think that's quite right. I gave the one- to two-percent range earlier, and the one-percent figure comes about, as Eileen suggested, when you take into account both acquisitions and divestitures. The two-percent figure comes in - is what we call organic job change. In other words, excluding the acquisitions and divestitures.
So she's right that it does make a difference, we highlight this fact in the study, in fact one of the main advances of our study over previous work is we're able to actually draw that distinction. And I agree with Eileen that it's an important distinction to draw.
But the difference between the two headline numbers, with and without acquisitions and divestitures, is not all that large, especially when you think about this over a two-year period.
DONVAN: All right. Let's return, however, to the land of the anecdote and bring in Sherry(ph) in Richmond, Virginia. Sherry, you're on TALK OF THE NATION.
DONVAN: You're on the air. Go ahead, please.
SHERRY: Yes. I was - my company was a victim of vulture capitalism in 1985, Carl Icahn, the corporate raider, the movie "Wall Street" was made about him, greenmailed my company. I - most of us flight attendants were out of work for two and a half to three and a half years. We came back at a reduced salary. He sold off our London routes, and he used this to begin his career in investing by using our pension funds of which I never - we never recovered them. He used 75 percent of the flight attendants' pension funds. I don't think this is too constructive.
DONVAN: Well, I guess the question again is, what would have happened in the absence of Carl Icahn coming in? What was happening to TWA at the time? And I want us - Marilyn, are you familiar...
SHERRY: Well, it wasn't properly managed, and it was worth a lot more than the stock was selling for (unintelligible).
DONVAN: Well, let's bring in NPR's Marilyn Geewax.
GEEWAX: This is why these arguments can be so complicated because there were lots of airlines that got involved with various takeover kinds of plans and mergers. That's certainly true of the steel industry, too. But a lot of those businesses would have gone out of business anyway. And some people would argue that when the funds that made money from either taking away their pension plans or laying off workers or whatever that created new profits that could be invested in new and more profitable ventures.
So how you pull back far enough to look at the really big picture: Did money that some company made in its profits by shutting down some old steel mill that created a new pool of capital to put into a Google and ultimately it created more jobs or is it just vicious and it just crushes people? Those are awfully tough to get enough data to - and stand back long enough to see the big picture. So that's why it's so debatable.
DONVAN: Which - and as you say, debatable, I guess, that's why it's rhetorically so available to Rick Perry out there. It's an easy enough slogan to throw around without having to pin down on either side.
DAVIS: Can I jump in here, make two points?
Very quickly, Steven, because we're (unintelligible).
First, I just want to endorse - I largely share the view that Eileen just expressed that it is hard to evaluate these issues. The second point I wanted to make is because many of the private equity companies acquired by private equity are in some distress...
DONVAN: Steven, I'm sorry I need you to wrap in 15 seconds.
DAVIS: OK. There's a lot of scope for cherry-picking good cases and bad cases, and I think we see that on both sides of the issue.
DONVAN: All right. Thank you very much for your time, all of you. Eileen Appelbaum is a senior economist at the Center for Economic Policy Research, who joined us in Studio 3A, and Steven Davis, professor of international business and economics at the University of Chicago Booth School of Business, who co-wrote the article "Private Equity is a Force for Good," which ran on theatlantic.com on Monday. And thanks as always to Marilyn Geewax, NPR senior business editor. You can find a link to her piece "So, Um, What Is A Private Equity Firm?" at npr.org and click on TALK OF THE NATION. She also joined us in Studio 3A. Thank you, Marilyn. You're listening to TALK OF THE NATION from NPR News. Transcript provided by NPR, Copyright NPR.