What it really is, whom it really helps, and why it really matters to capitalism (Read our companion piece, "The Real Scandal in Private Equity," here)
When Mitt Romney challenged Ted Kennedy for his Senate seat in 1994, Kennedy made Romney's private equity career a primary focus of the campaign. With Romney racking up impressive victories in Iowa and New Hampshire, Romney's opponents are resorting to the "Hail Mary" play of rehashing Kennedy's strategy of portraying Romney as a heartless Gordon Gekko who reveled in destroying jobs for profit.
As economists, we are unqualified to assess the political impact of these attacks. We can, however, state that the academic literature supports the view that the private equity industry serves an important and positive function in our economy.
DEFINING PRIVATE EQUITY
Private equity firms make investments in a wide range of businesses. Most of the investments are in privately held companies, but some involve the acquisition of publicly traded companies. The goal in each case is to create a thriving business so the private equity firm can sell its investment stake at a profit. This simple fact undercuts the claim that private equity firms systematically destroy jobs and loot companies. It's hard to take a company public or sell it at a profit when it's been looted. If private equity firms make money by selling their investment stakes at a profit, and Romney's Bain Capital certainly did, then they are creating thriving enterprises. And, as common sense suggests, thriving enterprises do not hemorrhage jobs.
There is little dispute that private equity firms, on average, provide good returns, although the evidence is not awe-inspiring. One recent study, by economists Robert Harris, Tim Jenkinson and Steve Kaplan, examined the performance of private equity funds, looking separately at buyouts and venture capital. They found that average buyout fund returns in the U.S. exceeded those of public markets for most vintages for a long period of time. Average venture capital fund returns in the U.S., on the other hand, outperformed public equities in the 1990s, but underperformed public equities in the 2000s.
Private equity firms operate in just about every sector. Some of them focus on leveraged buyouts (LBO), in which a firm uses debt, i.e.: leverage, to buy out a controlling stake in a company. Others specialize in providing capital to new ventures, offering growth capital to promising existing ventures, or turning around distressed companies. Bain Capital pursued all of these strategies. Successful venture and growth funds create something out of nothing, and hence, could not be guilty of destroying jobs. But turnaround specialists and LBO centered enterprises, in principle, could destroy jobs and make money at the same time.
Here's why. Labor costs are a large share of total costs for the typical firm, and are often at least ten times larger than the profit a firm makes on a given sale. That is, a firm might sell something for a dollar that cost 93 cents to make, and make a 7 cent profit. If most of the 93 cents is labor cost, then small errors in labor management can have an enormous impact on profits. If management pays labor 7 cents more per dollar of revenue in our example, then profits vanish, and the firm is headed for bankruptcy.
A firm that loses money can also be purchased for very little money. U.S. law allows a new owner to renegotiate existing contracts after a purchase, even to reopen collective bargaining. This sets up a significant profit opportunity. If an investor buys a troubled company, he can squeeze labor, and, with relatively small concessions, turn a loser into a winner. This strategy might be quite profitable, but those profits do not necessarily improve the welfare of workers in the targeted firm.
On the other hand, the strategy exists because labor costs have driven the firm close to bankruptcy. It is quite possible that everyone would lose jobs at the distressed target if private equity did not swoop in and save the day. For these firms, then, it is a tricky empirical question to gauge whether private equity destroys jobs or saves them.
This question reminds us of the challenges that arise in trying to identify the effect of a fiscal stimulus package. President Obama's team has asserted that his plan created millions of jobs, but this assertion is not directly testable because we do not observe how many jobs the economy would have created if we had not enacted a stimulus. Since unemployment is still high, critics assert that the stimulus did not work. It is difficult to say who is right, and to what degree.