Private Equity (and Jobs) For Dummies

There’s been a lot of talk about Bain Capital and private equity and and jobs lately, and since many Americans may not be familiar with how they are related, here’s a brief primer.

Private equity funds consist of money that has been collected from individuals who are usually wealthy and from pension funds, including public employee pensions.  These funds are actually not much different in concept from a mutual fund.  All these people  and pension funds pool their money and let a private equity (PE) firm manage it.  There are hundreds of such firms in the US alone.  The manager will often take a 2% management fee and 20% of the profits the fund generates.  Investors place their money in PE firms in the hopes of generating greater returns on their investment than they might get in the stock market, or in bonds, or other investments.  PE investments tend to be much riskier (as we’ll see), and thus the return on the investment should be higher.

PE firms invest in all kinds of things.  Very often they invest in “middle market” businesses.  These are companies that have been in business for awhile, have started to generate a profit, but now need big money to bring them to the next level.  They are willing to borrow money from PE firms at comparatively high interest rates — maybe 12% to 25% and give up some ownership stake in the company in exchange for this investment.  As the company expands aggressively, they start to hire more and more people.

That’s right – they hire people because they are expanding with this new investment.

Other PE firms may see a company in financial trouble, maybe because management isn’t doing a very good job.  The business may be burning through what cash it has yet not making a profit.  The business itself may have much more potential or perhaps a hidden asset, such as J.C. Penney, which owns much of the real estate that its stores sit on.  A PE firm may make an investment that permits them some control over the company, and allows them to begin to turn the company around.  Regrettably, this may mean that some people lose their jobs at this company.  The company may have many inefficiencies that need to be cut back.  Or they need to consolidate and conserve cash.  In the long run, however, the PE firm hopes to turn the company around and make it more successful so it can expand again – and hire back those people that got laid off and hire even more people on top of it.

These are all very risky investments.  So much can go wrong in any business that does not properly execute.  Think about a restaurant you enjoyed that went out of business.  Why did they go under?  Something about the business failed in its execution.  Now imagine an incredibly complex business such as manufacturing or technology.  That’s why it’s so risky.

If the PE firm does its job, it ends up with a business worth much more than it was when they first made the investment.  Then they sell it to someone else and exit with a big gain. This, by the way, is why the government taxes investments held over one year at 15% — known as a “long term capital gain”.  It’s because the government wants to encourage people to take risks and invest money in job-creating businesses.  Investors do this because part of the reward associated with this risk is that gains are taxed a lower rate.  If the tax rate were higher, people would be getting less reward for their risk, and be more cautious about investing those dollars, which means less money is available to invest, so fewer jobs get created.

About Bain:

So what about Mr. Romney and Bain Capital?  I challenge readers to do their own research.  What you will discover is that Bain has been phenomenally successful, not only for its investors, but for the companies that it has invested in. Since inception, it has invested in or acquired hundreds of companies, including such notable companies as AMC Entertainment, Aspen Education Group, Brookstone,Burger King, Burlington Coat Factory, Clear Channel Communications, Domino’s Pizza, DoubleClick, Dunkin’ Donuts, D&M Holdings, Guitar Center, Hospital Corporation of America (HCA), Sealy, The Sports Authority, Staples, Toys “R” Us,Warner Music Group and The Weather Channel.

That’s not a bad track record.  And those investments have created a lot of jobs.  There have been a few mis-steps along the way, but again, I challenge readers to name them in any significant number.

How Obama Has Killed Jobs:

As I’ve written before, I speak with PE firms on a daily basis because I broker deals for them.  There is some $2 TRILLION of PE capital that is sitting on the sidelines.  This capital strike is the result of President Obama’s instituting enormous numbers of costly new regulations across numerous industries.

If you run a PE firm with other people’s pension and hard-earned money, and you see all these regulations being passed and in the pipeline, do you keep making investments?  No.  You stop.  You wait for clarity.  Or you wait for a change in the White House.

If you, the PE fund manager, sits on his hands, then investments do not get made.  No investment means no business growth means no new jobs.

And it isn’t only PE firms that are sitting on cash.  So are many public companies.

Don’t believe me?  Then explain this: PE fund managers get paid for making winning investments.  Why would they sit on the sidelines and not invest money when they get 20% of every dollar they make, using other people’s money?

Those Jobs Numbers:

Is it starting to become clear why unemployment remains a problem under this President?  So let’s look at just how bad things really are.  You often hear about the “unemployment rate” in the news, and it presently is 8.2%.  This is the percentage of people who are out of work, but are still pounding the pavement looking for a job.

That is different from the more important number, called the Labor Force Participation Rate (LFPR).  This number represents all of the people in the entire workforce who can even look for work if they tried.  When people give up looking for work, they exit the workforce.

Here’s the really bad news: The LFPR is at its lowest level since 1978.  It has fallen by 1.9% points — the largest drop of any president since the Bureau of Labor Statistics started keeping track.  This also explains why the unemployment rate has been declining.

Let’s say you are in a town with 100 people.  That’s your labor force and everyone is looking for work.  70 of those people are working, and 30 are not.  So you have a Labor Force Participation Rate of 100%, employment of 70%, and unemployment of 30%.

Now 10 people get frustrated and give up looking for work.  Now you have a Labor Force Participation Rate of 90%.  70 people are working, 20 are not, and 10 have given up.  Now you have 77% employment and only 23% unemployment!  Yeah, but you are no longer counting those 10 dejected people who gave up.

That’s where we are today.

As a final note, when President Obama says he has “created 4.3 million new jobs”, that’s fiction.  The Bureau of Labor Statistics tells us exactly how many people are employed from month to month.  As you can see, in January of 2009 there were 142,187,000 people employed.  Today it is 142,287,000.  That is a net job creation of only 100,000 jobs, not 4.3 million.  Perhaps what Mr. Obama refers to is the change from Dec. 2009, when 137,968,000 people were employed, to today.  That, of course, conveniently glosses over the 4.3 million jobs lost between Jan. 2009 and December, 2009.  Oops.