The Washington Post, among many other outlets, is now covering the special tax arrangements Gov. Romney and other Bain Capital employees enjoy. In particular, Gov. Romney and others were permitted to invest high-risk, low value shares of companies in which Bain had invested in their IRAs. As those shares increased in value (often astronomically), the tax-free growth in the value of the IRA grew.
There is one question that these pieces have not addressed. I am not an investment or tax expert. I hope those here that are can address this question.
The Post notes that Gov. Romney and other Bain associates were able to invest shares of Bain investments in their IRAs. When these shares appreciated in value, so too did the value of the IRAs. The returns on these investments could then be used to re-invest in other Bain investments (or elsewhere). There is no problem with this, none of it is illegal and the practice is available to any IRA investor.
What determines an IRA’s growth is the performance of the investments, and Bain enabled Romney, its other employees and its partners to score big on that front. It was not uncommon for senior Bain executives to accrue IRAs valued at tens of millions of dollars, according to former and present company employees, by buying into Bain investments at very low prices and then reinvesting the returns in other low-priced Bain investments after the initial investments appreciated.
Whether average investors have access to low-price, high-risk, early stage shares of companies is a separate question. Any IRA-holder can reinvest profits from investments in their IRA into new opportunities.
This is also a smart public relations move for Bain, as the strategy allows Bain to claim that employees were rewarded based on the performance of the companies they ran. Pay for performance is a good strategy in many industries, particularly financial management.
My question arises from the way in which investment decisions were made by Bain employees. The Post describes the investment strategy as follows:
These “A-shares” were priced by Bain at a fraction of another category of stock known as “L-shares,” which functioned like preferred stock, paying dividends and getting priority for payouts. The A-shares, or common shares, were riskier and thus priced lower, so it was possible that a relatively small IRA investment could buy significant amounts of the A-shares in some companies. The use of a dual-share structure is not unusual in the financial industry, and under financial accounting rules the A-shares must reflect a true market value of the underlying assets. Often, the value of these initially cheap A-shares soared, along with the company’s value.
Consider the example of Physio-Control, which was bought by Bain in 1994. The company, a maker of defibrillators, saw its business take off in the following years, with Bain’s initial investment multiplying 21 times. Under the dual-share structure, the rewards were heavily tilted toward the A-shares. The value of an A-share purchased in 1995 multiplied 445 times in just three years, according to a person familiar with the transaction who spoke on the condition of anonymity. In other words, a $10,000 investment in Physio-Control A-shares would in theory have returned $4.45 million.
Not all deals worked out so well. Bain bought US Synthetic, a maker of bits used in oil and gas exploration, in 1998. By the time the company was sold in 2004, the original Bain investment had multiplied a modest 1.2 times. Under the terms of the company’s dual-share structure, A-shares lost all their value.
It is not unreasonable to assume that Bain employees were thrilled at the opportunity to invest in Physio-Control. A 445X investment in three years is spectacular. But how many Bain employees invested in US Synthetic? Since Bain managed US Synthetic, it naturally had access to material, non-public information about the firm's prospects. At what point did Bain employees have the opportunity to invest in low-priced A shares? At what point could they sell them? Because of access to inside information, did Bain employees simply not invest at all in US Synthetic, knowing full well that these shares would ultimately prove worthless?
Did Bain employees invest in all Bain acquisitions, to "put their money where their mouth is" as the Romney campaign is happy to point out? Or did inside information guide investment decisions, so that spectacular returns could be realized (and accrued tax free), while the poor performers (of which there were many) were avoided (and passed off to other Bain investors)?