How capitalism kills companies

By Felix Salmon
January 12, 2012

As Mitt Romney cruises to his inevitable coronation as the Republican presidential candidate, increasing amounts of attention are being focused on his history at Bain Capital, where he made his fortune. Did he create 100,000 jobs, as he claims? Or is he a vulture and asset stripper?

Glenn Kessler has the definitive take on the job-creation claim, which he says is “untenable”; as he says, Romney’s method of counting jobs created when he wasn’t at Bain or when Bain wasn’t managing the companies in question doesn’t even pass the laugh test. Meanwhile, as Mark Maremont documents, Bain-run companies — even the successful ones — have an alarming tendency to end up in bankruptcy. And I think it’s fair to say that bankruptcy never creates jobs, except perhaps among bankruptcy lawyers.

The reality is that Romney would have been in violation of his fiduciary duty to his investors had he concentrated on creating jobs, rather than extracting as much money as he possibly could from the companies he bought. For instance, Worldwide Grinding Systems was a win for Bain, where it made $12 million on its initial $8 million investment, plus another $4.5 million in consulting fees. But the firm ended up in bankruptcy, 750 people lost their jobs, and the US government had to bail out the company’s pension plan to the tune of $44 million. There’s no sense in which that is just.

Romney’s company, Bain Capital, was a “private equity” firm — the friendly, focus-grouped phrase which replaced “leveraged buy-outs” after Mike Milken blew up. But at heart it’s the same thing: you buy companies with an enormous amount of borrowed money, and then dividend as much money out of them as you can. If they still manage to grow, you can make a fortune; if they don’t grow, they’ll likely fail, but even then you might well have made a profit anyway.

Private equity companies need growth, because they’re built on the idea of buying, restructuring, and then selling. They’re never in any business for the long haul: instead, they want to make as much money as they can as quickly as possible, sell out, and keep all the profits for themselves and their investors. When you sell, you want to maximize the price you can ask — and the way to do that is to show healthy growth. No one will pay top dollar for a company which isn’t growing.

Private equity is by no means unique in this respect: it happens at pretty much every public company, too. John Gapper, today, has a column about the way it destroys values at struggling technology companies:

Most public companies are run by people who hate folding ’em, and instead keep returning to the shareholders and bondholders for more chips…

Few senior executives, when debating options for a technology company in decline, admit defeat and run it modestly. Instead, they cast around for businesses to buy, or try to hurdle the chasm with what they have got. Sometimes they succeed but often they don’t, wasting a lot of money along the way.

It goes against their instincts to concede that the odds are so stacked against them that it is not worth the gamble. Mr Perez would have faced a hostile audience if he’d admitted it to the citizens of Rochester, Kodak’s company town in New York, but its investors would have benefited.

At many companies, then, both public and private, the optimal course of action is a modest one — run the business so that it makes a reasonable profit, and can continue to operate indefinitely. If you chase after growth, you often end up in bankruptcy: that’s one reason why the oldest companies in the world are all family-run. Families, unlike public companies or private-equity shops, don’t need growth: they’re more interested in looking after their business over the very, very long run.

There’s no limit at all to the amount of growth that the public companies will demand: in 2007, for instance, after a year when Citigroup made an astonishing $21.5 billion in net income, Fortune was complaining about its “less-than-stellar earnings”, and saying — quite accurately — that if they didn’t improve, the CEO would soon be out of a job. We now know, of course, that most if not all of those earnings were illusory, a product of the housing bubble which was shortly to burst and bring the bank to the brink of insolvency. But even bubblicious illusory earnings aren’t good enough for the stock market.

If you want to be fair to Mitt Romney, you could make the point that many of the companies he bought were highly risky, and would probably have gone bust anyway; in that sense he can’t be blamed if they eventually did just that. If a company is going to fail, you might as well squeeze the maximum amount of money out of it before it does. But doing that, at the margin, means more job losses, quicker job losses, and — as we saw at that steel company — a willingness to underfund staff pension plans and stiff the government with the bill. Mitt Romney turns out to have a personality which is highly suited to that kind of ruthlessly callous behavior; that’s how he became so incredibly wealthy. It’s an ugly part of capitalism; it might even be a necessary part of capitalism. But the one thing you can’t do is spin it as a great way of creating jobs.


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In high school, you may have run across a “real life application” problem in which you calculate the result of compounding double-digit growth over 40 years?

That is the Wall Street lie. It sounds great on paper, but real-life growth curves don’t look like this: op_graph3.gif

They instead tend to look like this: ogistic.png

If a company acknowledges the slowing growth, it can reach a healthy and profitable steady state. If it doesn’t, it ends up following the blue curve on this graph:

(Guess where the bankruptcy comes in?)

Posted by TFF | Report as abusive

I don’t follow your argument. You say that Romney and his partners at Bain Capital invested in risky, failing businesses, and then you criticize him for firing employees of those businesses…which you indicate were failing in any event. If a business is failing of course its employees are going to lose their jobs.

Posted by DaveFriedman | Report as abusive

Fans of private equity would argue that the firms are actually run better because they have so much debt, and that net-net all this extra efficiency makes up for the losses from the firms that end up in bankruptcy.

Posted by guanix | Report as abusive

“There’s no limit at all to the amount of growth that the public companies will demand:”

This depends on P/E. If a stock has a 10 P/E, the market is typically content with flat earnings. If it has a 20 P/E, you need to show 15% YOY earnings growth each quarter.

When a stock has a 50+ P/E, it is doomed.

Posted by TFF | Report as abusive

In my mind, chasing growth and failing is also known as creative destruction, without with the economy as a whole can’t grow, oddly enough. Growth occurs when companies fall to new and more vibrant companies with better ideas.

I can’t disagree with much of what you said; Romney is no doubt using the jobs card because it’s even more laughable for a career politician to do so.

Posted by Curmudgeon | Report as abusive

“Romney would have been in violation of his fiduciary duty to his investors had he concentrated on creating jobs, rather than extracting as much money as he possibly could from the companies he bought.”

This is an absolute myth, that executives have a fiduciary duty to maximize the profit of the company. There’s no law that says that, it’s an excuse for executives to maximize their short term compensation. they have a fiduciary duty to do what’s best for the company, and making as much money as possible in the short term is not always what is best for the company.

If this were the case, then Wal-Mart wouldn’t have gave away truckloads of water to Katrina victims, because it lowered profits for that quarter. Intel wouldn’t have spent money on developing and promoting the USB interface, because they made no direct profit, and it cost them tens of millions of dollars, if not more. Google wouldn’t have offered Android for free. And countless businesses wouldn’t have made charitable donations to all kinds of non-profit organizations, because they don’t maximize profit. Yet all of these expenditures were made with the long term health of the company in mind.

Executives don’t have to justify every decision with proof that it will create profits, they just have to be able to say those decisions will be best for the company in the long term. Romney would not have violated any fiduciary duty by making decisions to create jobs, for usually it’s difficult to grow companies and increase value without hiring people.

While companies may fire CEO if they don’t meet their profit goals, that has nothing to do with fiduciary duty, just incredible shortsightedness of the board (of which there seems to be an endless supply).

And it’s not capitalism that kills companies, just bad execution or misinterpretation of a company’s value.

Posted by KenG_CA | Report as abusive

Not sure where to start, as there’s a whole lot of half-truth’s in here about fundamental matters including the nature of bankruptcy, why firms grow, and how private equity operates. To take one – you write about bankruptcy as if it equals liquidation of a firm, which is obviously not the case. In theory, Chapter 11 filings for firms that Bain Capital previously levered up to pay itself dividend recaps are just transfers of money from the debt holders who funded those recaps to Bain and the other equityholders. In practice, I’ll concede that the situation isn’t the clean, as a bad balance sheet usually has some negative impact on a company’s operations, but I stand by my point that a company isn’t liquidated because of a bad balance sheet, it reorganizes in bankruptcy.

Regarding your points on growth, you underestimate the risks of the alternative. Yes, companies do sometimes create risks by trying to grow to fast. In many industries, a small family-owned firm trying to “run the business so that it makes a reasonable profit, and can continue to operate indefinitely” eventually doesn’t operate indefinitely because some other small family-owned firm does grow and eventually puts it out of business. Look at retailing, where Wal-Mart’s impact on other retailers is one obvious example, but the trend is the same across most categories of retailers (pharmacies, department stores, grocery stores, etc.). In theory this process should happen in any industry that is subject to economies of scale.

I’m really confused by your concern that “struggling” companies attempt to turn things around. If they are in decline, isn’t that the alternative to laying off workers, milking the business for cash, and eventually liquidating? And, if it’s OK in that case for shareholders to take cash flow out of the business as it slowly declines, why is it wrong for them to lever up a business to pay shareholders a dividend when times are good? Mr. Gapper’s arguments are interesting, but there are some real problems in trying to run a shrinking business. One key one is employee morale and retention – who wants to work at (or run) a business where the explicit plan is to shrink gradually?

So, yes, businesses do sometimes run into problems by trying to change (I’ll use a broader term to encompass both revenue growth and efficiency gains). In a world that’s dynamic, however, you’re greatly overestimating the wisdom and applicability of “let’s keep doing things the same as last year” as a strategy.

Posted by realist50 | Report as abusive

“.. you buy companies with an enormous amount of borrowed money, and then dividend as much money out of them as you can.” In any other context that behavior would be called “Rape & Pillage”. That is what is in this context too. It doesn’t matter how you try to gloss it over.

Posted by Woltmann | Report as abusive

Nor is any of this any qualification to be President of the US. What a President does and what a private equity person does are in no way similar.

Posted by Chris08 | Report as abusive

Wait, on the one hand, private equity levers up and dividends out as much as possible, and growth is just gravy but not necessary. On the other hand, private equity companies need growth? Which is it? Need growth, or don’t care about growth?

Also, wouldn’t it start to get somewhat more difficult to find buyers of bonds in companies you take over if you stiff the bond-holders every time? Seems like there might be an incentive structure there, and it might lead to trying to generate growth.

Wait, you say Romney’s a Republican? In that case, I think you’re being too kind. It’s obvious that his motivation wasn’t even to make money by leaching out dividends. He just likes firing people.

Posted by Podunk | Report as abusive

The dirty little truth that Wall Street wants to keep ordinary people from figuring out, is that MOST of what takes place on Wall Street is of little benefit to society at large. While asset managament, M&A, venture capital, retail banking, and market making all arguably provide benefits to the public-at-large, but proprietary trading, which over time has become a larger and larger percentage of Wall Street activity, certainly does not.

Posted by mfw13 | Report as abusive

From every angle I’ve looked at PE, I keep coming back to the tax treatment of dividends vs. interest as the core issue. CFO’s of public companies face a lot of issues in levering companies up to their maximum extent. At a certain level of leverage, longtime shareholders would rather have a lower chance of bankruptcy than the increased cash flows from tax deductions.

Meanwhile, private owners can lever up the company as much as the market will bear. The levering increases the Beta for the equity dramatically, but also increases alpha.

There is also the general issue of the banks who put up the secured portion of an LBO and the institutions (pension funds, insurance companies, etc.) who buy the unsecured junk bonds to fill out the transactions. The high interest on these junior debts enables managers who are looking to the next bonus instead of long-term capital growth. Since the leveraged company will almost certainly pay the high interest until the principal is due in five years or so, these managers enjoy high paper gains.

From this angle, I have a very hard time seeing how PE adds any social value. The Financial Engineering side of it certainly does not add any social value. The private management might add value, but there’s no requirement to use junk bonds to take a company private.

Posted by mwwaters | Report as abusive

Great post, Felix. Those companies may or may not have survived without Bain Capital. But they sure were a lot more vulnerable when Bain loaded them up with debt, extracted cash for itself, and then loaded the company up with Bain consultants at $40,000/month per person. Biologically, this is parasitical behavior, and of course, when a host has lost a lot of blood to the parasite, it is much more vulnerable to infection, interruption in food supply, etc.

“Skimmers.” I really want to revive the term. It certainly applies to LBOs.

Posted by Dollared | Report as abusive

Felix, “US government had to bail out the company’s pension plan to the tune of $44 million.” By the goverment I’m assuming you mean the PBGC, a goverment agency funded entirely by insurance premiums paid by private companies. tes.html

While I share you disdain for any private equity deal that leaves the company in chapter 11 and the PE firm with profits… it is unfair to say that the goverment bailed out the pension plan.

Berkshire Hathaway is basically a big insurance company that invests nearly all of its assets in private equity. The only difference between Berkshire and Bain is Berkshire never sells. You want to whine about the 15% capital gains rate for private equity…. Berkshire’s gains rate is ZERO because 99.9% of all the capital gains they have ever had are still sitting on their balance sheet unrealized.

Posted by y2kurtus | Report as abusive

Economics has many parallels with Ecology, particularly so in the areas of Ecosystems = A country’s Economy and individual companies equating to different species competing with each other for the resources of the ecosystem. Nature has a way of maximising the returns of any ecosystem that economies have not yet figured out.

For instance, a family business at some time has succession issues: the influence and sense of ownership of the business declines as their number of founder-descendant shareholders increases. At some point a big capital sum from outsiders seems a lot more attractive than the small dividends the company regularly pays out. Debt is much smaller than the balance sheet could have supported as the founders knew that survival had to be achieved through the bad times as well as the good, and large levels of debt payments represent significant risk to long term survival.

The Private Equity players see such companies as easy prey, take them over, load the Balance Sheet with the debt the founders refused to take on, but instead of reinvesting in long term growth projects while maintaining a steady dividend stream, some just squeeze the life out of the company and it dies.

The family run company is like a herbivore, there are always more of them and they don’t change much over time. If they retain too many resources, the predator pounces and takes them away; if the predator takes too much, there won’t be enough left for tomorrow and he’ll starve too.

The problem is balance. Every economy has a carrying capacity of resource use in each market segment. The problem with the typical anglo-Saxon Economic model is that it doesn’t try to reach balance with resources, it always tries to go beyond – which is why we have booms and busts.

In Germany things are a little different. Far more family owned businesses, far more long term thinking, and less boom and bust. Surprise, surprise, their debt levels are less than the UK or the US, they actually have a current account surplus compared to the massive and growing Trade Deficits we have.

Look at Japan: cast off as a ‘basket case’ with no growth, yet personal wealth has increased since 1990. Electricity consumption has doubled, life expectancy has risen, unemployment is half that of the US. And they still have a current account cash surplus even though govt debt is massive, highest in the developed world. When times get tough, they don’t lay people off, they cut wages; when times get better, wages go up again. It produces more social cohesion.

One Japanese small business owner interviewed on BBC Newsnight this evening was asked why did he reduce wages rather than lay people off. He looked confused, as if the answer was obvious but then said “…but I don’t have any bad people…!”

If only all companies in the West thought like that. We’d need less social security, have more stable economies, and more efficient companies which did not need to constantly train new people.

Posted by FifthDecade | Report as abusive

y2k, You can’t say the only difference between Berkshire Hathaway and Bain is that BH never sells. BH isn’t 95% leveraged, like most PE deals. They are more like a holding company than a PE firm. And while it’s true they own a lot of insurance companies, their profits are from operations, not trading.

Posted by KenG_CA | Report as abusive

KenG_CA you are right that Berksire uses much less leverage than Private Equity firms. Berkshire is only about 60% levered. Some P/E firms are good stewards… Dunkin Donuts did an IPO in 2011 after being privatly controled for many many years.

Posted by y2kurtus | Report as abusive

KenG and y2Kurtus, you are hitting the nail on the head. 95% leverage only exists to enrich the PE player while piling all risk onto all other stakeholders. The difference between Warren Buffet and Romney is that one is an investor, the other is a thief.

Posted by Dollared | Report as abusive

But why are people lending the companies the money for such risky deals? What have they missed?

Posted by theamblerx | Report as abusive

The assertion that most buyout deals are 95% leveraged – meaning 5% equity – is way off the mark. The average equity contribution – this stat is from S&P Leveraged Lending – was 39% in 2011 and at similar or higher levels from 2008 to 2010. From 1999 to 2007, equity contributions usually averaged between 30% and 40%, though the average did drop down to 29% in both 2000 and 2005.

It always makes me laugh if the same commentator mentions responsible, conservative homeowners who buy with a 20% down payment and criticize buyout firms for gorging on debt. Buyout firms use more equity in their purchases!

Posted by realist50 | Report as abusive

Theamblerx, the two-part answer is that (i) most of these companies don’t go bankrupt, but it’s only news when they do and (ii) in bankruptcies creditors almost always recover soemthing, which varies widely but in some cases can be close to 100 cents on the dollar. Look up default and recovery rates on leveraged loans and high yield bonds. These asset classes are certainly not solely buyout deals, but buyout financings are a meaningful subset so the averages are a reasonable proxy for what debt investors earn financing buyout deals.

Posted by realist50 | Report as abusive

realist50, of course, not all PE firms are 95% leveraged. Just the ones who buy companies and load them with so much debt that they go bankrupt.

I invested in some PE funds because I had this image of them buying failing companies, cleaning them up, and turning them around, but that seems to be the exception, not the rule. So many of the large PE funds buy healthy (but undervalued) companies with little money down, then have the company borrow money (because they are healthy) to pay the PE firms a dividend, which is used to pay off the loan used to buy the company. The company then suffers under a huge debt load, and has layoffs or goes out of business.

Maybe not all PE firms should be dismissed as parasitic leeches that add no value to society, but enough of them extract all of the value they can out of profitable companies, leaving nothing but a carcass, to make a lot of readers here question their usefulness.

Posted by KenG_CA | Report as abusive

Yes, socialism is the true creator of jobs Felix. I hate it when people are successful. We should resent them.

Posted by dbird82 | Report as abusive

So much truth in one little essay. I have watched the process Mr. Salmon describes, up close. It was an ugly ending for The Little Company That Could. But FifthDecade has a good point. A functioning ecology does not operate by the ethics of Count Dracula. Why not? Because it would not remain a functioning ecology for long if it did. So why are Germany and Japan better at this, FifthDecade? Maybe because you have to start, fight and lose a major war to learn humility in a world overrun by our species.

Oh well, nothing lasts forever! Eight centuries of global human growth have been a great ride.

After us, the deluge.

Posted by Ralphooo | Report as abusive

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