In any other year, Mitt Romney’s financial experience might be a selling point for his political campaign. Anyone in finance knows the private equity business, and many more know the firm Romney led – Bain Capital.
But now Wall Street has a marketing problem. Given America’s love-hate relationship with the wealthy, his experience in private equity is a tough sell.
Private Equity 101
Private equity is one of the main money centers of modern finance. Private equity firms raise funds – not all that different from mutual funds, really – from wealthy individuals, pensions, and other investors to buy out underperforming firms as a private owner.
The difference is the fund’s short life cycle. Typically, funds are opened and closed within a decade. Within this short period of time, private equity managers buy out whole companies and resell them years later, often after stark improvements in the company’s business model.
There are a few inherent benefits to the private equity model:
- All or nothing ownership – Owning a whole firm is naturally much more valuable than being one of many shareholders. As a sole owner, a private equity shop can implement changes it wants to see without any pushing back by Wall Street. While shareholders do have the right to submit proposals for a vote for most public companies, proposals that receive a majority vote by shareholders are not legally binding. But, if you buy a whole company – you own it.
- Synergy – Not just for sales pitches and resumes, synergy allows private equity shops to use their newly purchased firms as effectively as possible. To give an example, a private equity firm might purchase a company for $300 million that has business processes, talents, or patents and trademarks worth $1 billion or more to another company in its portfolio.
- Leverage – A controversial feature of a small segment of private equity, the leveraged buyout allows private equity managers to buy multi-billion dollar firms with less than a few hundred million dollars in cash.
In one classic leveraged flub by Bain Capital, it purchased retailer KB Toys for more than $300 million. Bain leveraged the position, putting up only $18 million in cash to buy the company. Within the year Bain paid itself a cash distribution of $85 million, making a return in excess of 300% in a single year. Later, over-levered and without enough liquidity to attempt a turnaround, KB Toys would file bankruptcy.
Bain’s creditors were caught holding the bag. Employees went from routine paydays to unemployment lines. Bain Capital, of course, came out with a massive return for its investors.
Bain Capital’s Brain Capital
Bain Capital was a pioneer in hiring brains over brawn. The private equity management company believed that if it could hire really intelligent people – even people with limited experience – their creative capacity could make for a much better performing company and fund.
Mitt Romney was a perfect recruit. He graduated in the top 5% of his class at Harvard Business School, and had an interest in improving and designing new business models.
A story from the Economist highlights why Bain’s brains made it such a powerful force in private equity. It also leads into why this story is such a negative story for Romney’s campaign. The article states that before Bain, most companies believed in the idea that “management was just a matter of applied common sense.”
A New Kind of Capitalism
Imagine a Midwestern manufacturing company run by a 40-year veteran of the company who worked his way from the graveyard shift to the CEO’s desk. He probably knows everyone’s names, their favorite color, and even the names of their children and grandchildren. He greets everyone by the first name, and expects the same of his workers. He’s been there and done that; he knows his company, his business, and the people involved in it.
Now imagine that same company ran by the best 20-something engineering and economics students from world-class universities from the Northeast.
This might just be the very definition of a culture clash. Economists and engineers have no tolerance for inefficiency. Lost profits take over the feeling of “doing good” by workers. Why bother manufacturing a product in the United States when it can go overseas?
The old boss might have kept an under-producing arm of the company so as not to create strife with a family he’d see at church later that week. As for the new boss from miles away and with no connection to the firm? He sees inefficiency, lost profits, and the potential for a blockbuster turnaround for his newly launched private equity fund.
Romney’s Effective 14% Tax Rate
Adding insult to injury for many people is Romney’s effective tax rate on his earnings from Bain funds and later investments. Seeing as the fund was a buyer and seller of companies, earned income from the funds is passed on to investors like any other financial distribution. The earnings aren’t income; the earnings are dividends, and thus taxed at the favorable 15% rate.
Early in his career with Bain Capital, Romney would enjoy capital gains taxation rates even without fund investments of his own. As a partner, he stood to make millions in fees for his active participation in buying and selling companies. Even as active as Romney was in the business, his income is not personal income in the accounting sense, but capital gains. Yes, this includes the money he earned in fees as a partner of each private equity fund.
(Read: Romney certainly worked for much of his income, but he didn’t and does not pay into the traditional income tax brackets for working wages.)
In an election year of tax discussion, Romney’s light tax bill won’t win him too many voters. I, for one, pay 15.3% on my non-interest income just to cover Social Security. Romney managed to pay an effective tax rate of 13.9% in 2011, meaning his last dollar was taxed at a lower rate than my first dollar earned. Overseas holdings allow Romney even better returns and lower tax bills thanks to accounting and legal teams.
Should private equity partners enjoy low capital gains tax rates on income they earn in fees?
If Romney and I both worked for a living in any given tax year, why should his earnings be taxable at the capital gains rate and mine at the appropriate federal income tax bracket?
Article by JT at MoneyMamba, a blogger who wouldn’t mind being part of private equity’s big paydays.