This week’s Newsweek contains an excerpt from David Stockman’s forthcoming book, The Great Deformation: How Crony Capitalism Corrupts Free Markets and Democracy. Stockman is no leftist; he was Ronald Reagan’s budget director and remains an advocate for free-market capitalism. He has worked in private equity firms himself for many years. That makes his critique of Bain Capital all the more powerful. His article is available online at The Daily Beast.
The centerpiece of Mitt Romney’s presidential campaign is his assertion that he knows how to create jobs because of his experience as CEO of Bain Capital. Stockman is hardly the first to question whether Bain’s private equity investments had very much to do with job creation, but his conclusion is especially blunt:
Mitt Romney was not a businessman; he was a master financial speculator who bought, sold, flipped, and stripped businesses. He did not build enterprises the old-fashioned way–out of inspiration, perspiration, and a long slog in the free market fostering a new product, service, or process of production. Instead, he spent his 15 years raising debt in prodigious amounts on Wall Street so that Bain could purchase the pots and pans and castoffs of corporate America, leverage them to the hilt, gussy them up as reborn “roll-ups,” and then deliver them back to Wall Street for resale–the faster the better.
In a leveraged buyout, a private equity firm such as Bain Capital buys a company by putting up some of its own capital and borrowing the rest. The ratio of debt to equity can be very high, often 90/10 or more. The assets of the acquired company become collateral for the debt, and debt payments are made from the company’s cash flow. This arrangement limits the potential losses of the private equity firm, since it can only lose the equity it put in. But the potential gains are much larger, since any appreciation of company value goes to the new owner, not to the lenders, in the same way that appreciation on your home goes to you when you sell, not to the bank that lent you the money to buy. Acquire a $100 million company using only $10 million of your own money, and if it appreciates by 10% your gain is 100% of your investment–that’s leverage!
In theory, a leveraged buyout can result in a win-win. Ideally, the new owners come in and turn the company around, increasing its assets and cash flow and creating new jobs. When they eventually sell, perhaps taking it public with an IPO, they make a profit. The lenders get all their money back with interest. If that’s what happened most of the time, LBOs wouldn’t come in for so much criticism. But often, the private equity business is more like flipping real estate than building new companies. In what’s called a “buy, strip and flip” operation, the new owners don’t keep the company long enough to make real improvements in its long-term profitability. They just weigh it down with debt payments, extract as much cash as they can by cutting costs and selling off assets, maybe use an accounting trick or two to spruce up the balance sheet, and then unload it before its true financial condition becomes obvious. Stockman argues that government policies such as low tax rates on capital gains and the loose monetary policy of the Federal Reserve under Alan Greenspan enabled this corrupted form of capitalism. Flipping assets is most profitable when borrowed capital is readily available, capital gains are lightly taxed, and enough investors are playing the game to create asset bubbles with steadily rising prices.
Stockman places Bain capital squarely in that context:
Bain Capital is a product of the Great Deformation. It has garnered fabulous winnings through leveraged speculation in financial markets that have been perverted and deformed by decades of money printing and Wall Street coddling by the Fed. So Bain’s billions of profits were not rewards for capitalist creation; they were mainly windfalls collected from gambling in markets that were rigged to rise.
Romney’s time at Bain Capital coincided with “the first great Greenspan bubble, which crested at the turn of the century and ended in the thundering stock-market crash of 2000-02.” During that time, most of Bain’s deals earned a lower return than an investor could earn in an S & P 500 index fund. But the company’s ten best deals returned a profit of $1.8 billion on an investment of only $250 million. Four of those ten best deals ended in bankruptcy for the acquired company, indicating that Bain’s success did not depend on the success of its acquisitions. For example, Bain bought a lot of department stores and clothing chains that were threatened by the expansion of big-box stores like Wal-Mart. It had one of its acquisitions, Stage Stores Inc., in turn acquire another endangered chain, C.R. Anthony. Bain then touted the combined operation as a successful, expanding company, and quickly sold its stake at a $175 million profit (18 times what it invested) as soon as the stock went up. When the company, heavily laden with debt and still facing with the same competitive pressures, went bankrupt, about 5,000 jobs were lost.
Bain invested in more successful companies as well, but it rarely made as much on the deal. It provided $5 million in seed money for Staples, from which it made a $15 million profit. Staples went on to become the retail giant of the office-supply business, with a workforce of 90,000. Stockman notes, however, that this mainly represented a transfer of jobs from smaller stationery and office-supply stores that Staples either acquired or put out of business. (He also notes that about 45% of the jobs at Staples are now part-time.) Stockman’s point is not to blame Bain for the transition from small retail stores to big-box stores, which has produced economies of scale and lower prices for consumers. The point is that the Bain business model was indifferent to job creation. Bain could “buy, strip and flip” the losers or invest in the winners, making money either way. Knowing how to play this speculative game for short-term profit is not at all the same as knowing how to create new jobs in a competitive global economy.
Liberals will probably feel that Stockman places too much of the blame for deforming capitalism on government monetary and tax policy, and not enough on corporations’ own tendencies to pursue private profit at the expense of public good. But both liberals and conservatives may agree with Stockman’s main contention, that experience with this peculiar kind of capitalism isn’t a very good qualification for the presidency:
In short, this is a record about a dangerous form of leveraged gambling that has been enabled by the failed central banking and taxing policies of the state. That it should be offered as evidence that Mitt Romney is a deeply experienced capitalist entrepreneur and job creator is surely a testament to the financial deformations of our times.