What is private equity for?

Following his landslide win in the Florida primary election last night, it now seems certain that Mitt Romney will be the Republican party's presidential nominee. Romney will be the first presidential candidate to have spent most of his career in the financial sector, specifically private equity, a sector many view with suspicion and fear. Romney's opponents have made much of the fact that he succeeded at his job by "firing people". Although I'm not much of a Romney fan, this is a slur caused mainly by the confusion surrounding private equity.

Writing in the National Review, Reihan Salam has a great piece on what private equity is and why firms like Romney's Bain Capital are so important to modern economies:

Successful firms such as Apple change the larger competitive landscape by threatening the very survival of competitors. Chad Syverson, an economist at the University of Chicago’s Booth School of Business, found that what separates top firms from bottom firms is, typically, a large difference in productivity, with the top ones producing almost twice as much with the same measured input. This creates an almost irresistible temptation for investors. If Firm X, languishing at the 10th percentile in terms of productivity, could somehow be overhauled to match the productivity levels achieved by Firm A, at the 90th percentile, the potential for profit would be huge. Note, however, that halving “measured input” in order to double productivity will often mean shedding the weakest performers and giving those who remain the tools they need to do their jobs better and faster. Private equity does exactly this.

What Mitt Romney discovered was that American corporations sometimes had to be dragged, wailing and whining, into a state of efficiency. As a management consultant at Bain & Company, Romney had studied successful firms and then told other firms how to replicate their strategies. But those firms had come of age in the fat years of American corporate dominance, when many believed that the Japanese could do little more than manufacture cheap toys and textiles, and many were reluctant to accept his newfangled advice. . . .

The typical pattern, at Bain and at other private-equity firms like it, was to buy a company by spending some portion of their capital (augmented by debt — usually somewhere between 60 to 90 percent of the total purchase price). They would then offer supercharged incentives for top managers, both among the investment professionals at the private-equity firm itself and at the firms they acquired. CEOs of newly acquired firms would be enticed with stock options and performance incentives. When the system worked, as it often did, CEOs started making sums that were unheard of in the 1960s.

We can trace the enormous increase in compensation among top earners to this embrace of performance-based compensation among the CEOs of privately held firms. This relation between huge paydays and the work of private equity is one of many reasons the field is so controversial. Equally controversial is the use of debt. Having bought a company with borrowed money, private-equity firms had to extract the mortgage payments, as it were, out of the company’s cash flow. This was a new expense for management, and it was also a source of discipline: If you couldn’t make the payments, you’d kiss your performance incentives goodbye, and you might even end up going bust. But loading up a company with debt could also hasten its demise, especially if management failed to cut costs.

When people like Ed Miliband talk about "predator capitalism" and "asset strippers", this is usually the sort of thing they have in mind. And, in Ed's case at least, they're usually utterly, desperately uninformed about what they're talking about. Private equity is, essentially, management outsourcing. Anybody who understands how markets work will realize that a successful streamlining of a company saves it from eventual extinction. Bringing in new ideas and new structures to a company is often rough on the workers, but in the long run it's what preserves the jobs they have. As Salam says: 

Private-equity firms have taken the process of turning around failing businesses and made it into an industrial process. The hostile reaction to this industrialization of corporate cost-cutting evokes the revolt of the Luddites, the 19th-century textile artisans who sabotaged the mechanical looms that threatened their familiar way of life. These artisans had no objection to buying and selling textiles — that was how they made their living. Rather, they objected to the scale of the new factories, their speed, and the rate at which they were displacing skilled workers. The balance of power had shifted from a few skilled artisans to the owners of capital and the managers of the new factories, who could now draw upon a much larger labor pool. Management is no longer the work of artisans. Just as the young consultants at Bain & Company hoped, it has evolved into a rigorous, unsentimental, data-driven enterprise dominated by sophisticated investment professionals.

The only downside? The more sophisticated an industrial process becomes, the more opaque it is to outsiders; the more opaque something that might threaten your job is, the louder the cries that "something must be done".