Sunday, January 29, 2012

"What Debt Did for Romney"

As companion to the post below, "Unions Hate Private Equity, but They Love Its Profits", here's another angle to the private equity story. PE is the least intellectually challenging field of investment, a smart monkey with a spreadsheet and long lines of credit can do it in the right circumstances. In the current environment it is much tougher but its practitioners are ill-equipped for the higher order stuff e.g. distressed debt/company investing à la Wilbur Ross, so they keep trying. Or they come public for one last cash out.
Why do I think of the Bain & Co. (the consultancy) senior partners doing their $200 mil. recap?

From The New Yorker:
The most interesting line in the G.O.P.’s official response to the State of the Union address was Mitch Daniels’s assertion that the United States is in big trouble because “no entity, large or small, public or private, can thrive, or survive intact, with debts as huge as ours.” Unsurprising as the attack was, its phrasing inadvertently underscored the curious reality of this year’s election; namely, that the same party that loves to inveigh against the dangers of excessive borrowing is now likely to nominate for President a man whose entire career, and entire fortune, was built on debt. Leveraged-buyout firms like Bain Capital, which Mitt Romney ran between 1984 and 1999, routinely borrow massive sums in order to make their acquisitions, leaving companies with debt loads equal to twice their annual sales or more. (Last year, for instance, the L.B.O. firm Apex Capital borrowed five billion dollars to acquire the medical-technology firm Kinetic Concepts, a company with annual revenues of around two billion dollars.) And they do so while borrowing at much higher interest rates than the federal government has to pay.

L.B.O. firms do borrow less these days than they did in the nineteen-eighties. But they still typically borrow sixty to seventy per cent of the value of the deals they do, and it’s difficult to overstate the centrality of debt to their business model. As a study of a hundred and fifty-three large buyouts showed, companies acquired by L.B.O. firms borrow more than similar public companies. In that sense, one the core advantages of L.B.O. firms is simply their willingness, and their ability, to borrow huge sums of money.

The debt helps juice the firms’ investment returns—as with any investment, the less you put down, the higher your returns will be (assuming things don’t go bust). It also makes them dependent, to a great degree, on credit markets—when credit is loose, as it was for most of the aughts, it’s easy for private-equity firms to make their returns look good (at least in the short run). When credit gets tighter, as it did after 2007, it becomes much harder to do so. As one private-equity manager says in a recent paper by Ulf Strömberg, Tim Jenkinson, Per Axelson, and Michael Weisbach, “Things are really tough because the banks are only lending 4 times cash flow, when they used to lend 6 times cash flow. We can’t make our deals profitable anymore.”

Debt is also valuable to private-equity firms because the government subsidizes their borrowing—corporate interest payments on debt are tax-deductible, while dividend payments (which you can think of as payments on equity) are not. And this tax-subsidized borrowing has been a key part of their success over the years. The University of Chicago’s Steve Kaplan, arguably the leading researcher in the field and an unabashed defender of private equity, recently wrote a piece extolling private-equity firms’ performance, and attributing their superior returns to their ability to better incentivize and supervise management and their ability to introduce operational improvements. What Kaplan strangely fails to mention are the advantages created by all the debt these firms take on, even though, in a paper co-authored with Per Strömberg, Kaplan himself wrote that the debt subsidy alone for L.B.O.s in the nineteen-eighties may well have accounted for ten to twenty per cent of the value these deals created. Even if private-equity firms are, in some circumstances, able to do a better job of managing companies, a substantial portion of their superior returns is due simply to the fact that they exploit the U.S. tax code better than most public companies do....MORE