Mitt Romney's Bain Capital has been labelled, correctly, as "vulture capitalism." But that makes us think, wrongly, that Bain Capital was mostly engaged in venture capitalism. Don't fall into that trap. It was a private equity firm.
Venture capital, private equity, what's the difference, you say. It's all high finance, you say, sticking it to the little guy.
Not so fast. Venture capital brings us good things like Google. Private equity brings us bad things like layoffs. Follow me over the squiggle for a simple explanation.
Venture capital is what funds all those Silicon Valley startups. Private equity is corporate raiding.
Here's how venture capitalism works: Somebody has an idea for a company. They have a business plan, and they probably have prototypes, maybe a few employees. What they lack is money to expand: money to hire more people, money to buy equipment. So they go to the venture capitalists (VCs). They explain why their potential business could be lucrative. If the VCs agree, the entrepreneurs sell part of their nascent business to the VCs in return for large checks. Usually, the VCs also find and install some management for the baby company, to protect their investment. The entrepreneurs use the money to grow the baby business, and, if the entrepreneurs and VCs are hardworking and lucky, everybody-- entrepreneurs, VCs, and, at least in Silicon Valley, employees of the growing company, make lots of money. Of course, usually the businesses fail, and the VCs lose their money, but when they win they win big.
So, for example, these two grad students at Stanford, Larry Page and Sergei Brin, had this idea for a way to search the web. But they needed money. They went to Silicon Valley VC John Doerr. He gave them some money, and they gave him some ownership of baby Google. After a few years (and the involvement of other VCs), Google went public, and everyone involved, including every single Google employee, made tons of money. Tons. Google made dozens, maybe hundreds, of Google employees into millionaires, including the chef in the kitchen. And the whole world benefited by having this great search engine. And, of course, the VCs made a pile. Everybody won.
Right now, VCs are funding Facebook, Zynga, Groupon, and tons of other successful and unsuccessful startups.
Now let's talk about private equity. With private equity, the investors buy an already mature business, with employees, a existing, often profitable business. The investors use some of their own money, and borrow a lot more, to buy the company. The spent a lot of money, and they want it back.
But the company wasn't producing lots of money right now. If it had been, the private equity firm wouldn't have been able to afford to buy it. Here's the questionable part: the private equity does "financial engineering" to squeeze money out of this existing business. They take out huge loans. They sell off assets. They fire people. They loot (excuse me, underfund) the company's pension fund. And they use this money to pay themselves large fees, huge fees, enormous fees.
Obviously, you can't just keep borrowing more and more money, firing people, selling off assets, and keep the business going. Not to worry. If the company ends up in backruptcy, hey, no problem, the private equity firm made their zillions of dollars. Who cares about bankrupt companies and employees out of work?
Oh yes, and also, all this money the private equity firm squeezed out of the company it bought is taxed at a tiny rate, much lower than workers pay.
Let's go through two examples
with our favorite private equity firm, Bain. You probably have heard of Harry & David, the fruit-basket company. They used to send you catalogs at Christmas, right? BainA different company, not Bain, bought Harry & David in 2004. At the time, Harry & David was a thriving business. BainThe different, not Bain, company loaded up Harry & David with debt the next year and paid itself $100 million in "management fees," giving themselves a 23% profit.
Bain the private equity firm. Not so great for the rest of us. Last year Harry & David "defaulted on its debt and dumped its pension obligations," according to James Surowecki in this New Yorker article, from which I got the Harry & David /Bain story.
A second example is GST Industries. In 1993, while Romney was in charge of Bain, it bought GST, loaded it up with debt and paid itself big "management fees." While the Bain-backed executives were taking out those big loans and shoveling money into Romney's pockets, they were not funding their pension fund adequately. Eventually, GST couldn't pay back the enormous loans, and it went bankrupt. But because GST hadn't funded the pension fund (even though they had had plenty of money to pay Romney and his cronies), the government Pension Benefit Guaranty Corp. had to pay the employees' pensions. But employees ended up with smaller pensions, and worse benefits, than their contract guaranteed.
So here's how it works: Bain buys a company, and right away takes out enormous loans. They use the loans to pay themselves large "management fees." Then, later, the company discovers that, goodness gracious, it can't pay back the loans and has to go out of business. Bain ends up with millions, and everyone else is screwed.
For more, check out this McClatchy article(strange link, persevere) and this MSNBC article on Bain. Paul Krugman(behind NYT paywall) points us to Larry Summer's scholarly paper on why private equity firms "create little or no social value," merely "enabl[ing] shareholders to transfer wealth from stakeholders to themselves more so than to create wealth."
Edited to reflect the fact that a different company, not Bain, bought Harry & David. I very much regret the error, and my sloppiness that led to it.