July 17, 2012
Yes, that is what Brooks told readers. His column today mourns the fact that Romney and Bain are being blasted for being capitalists. He then tells readers:
“Romney is going to have to define a vision of modern capitalism. …. Let’s face it, he’s not a heroic entrepreneur. He’s an efficiency expert.”
Brooks is certainly right that Romney is not a heroic entrepreneur, but it doesn’t follow that he is necessarily an efficiency expert either. The private equity folks like to tell stories of how they find poorly managed companies, clean them up, and then sell them for a big profit.
Undoubtedly there are cases where this is true, but these are likely the minority of companies that are taken over by private equity (PE) firms. Finding companies that can be quickly turned around by better management is not easy. After all, if it were easy to find better management, someone would have done it already (economist humor).
What PE is very good at is taking advantage of tax dodges. It’s likely that your stodgy family-run business has not kept up-to-date with the state of the art tax avoidance schemes. However PE companies do, and there can be big bucks in applying these modern tax avoidance schemes to old-fashioned businesses.
To see this, let’s take a simple example. Suppose an old widget company was operating with a ratio of debt to book value of 20 percent. Let’s assume that its book value is $1,000 million and its debt $200 million, leaving shareholders’ equity of $800 million.
For simplicity, assume the combination of before tax profit and interest is 10 percent or $100 million. The company will then pay 6 percent interest ($12 million) on its debt. This leaves before tax profit of $88 million. if it pays a 35 percent tax rate, then its after tax profit is $57.2 million, as shown below.
Now suppose some clever PE types come in. One of the first things they will likely do is borrow a substantial amount, let’s say $600 million. They will use this money to repay much of the $800 million purchase price of company. The interest burden on the higher $800 million in debt ($600 million in new debt plus the old $200 million) is $48 million, leaving $52 million in before tax profits. Assuming that the company still pays 35 percent of its profits in taxes, its after-tax profit as a PE-owned company is $33.8 million.
While this means that our PE folks are taking home less from the widget company than the old-fashioned family owners, it is important to remember that they have gotten most of their money out of the operation. They only have $200 million invested, as compared to the $800 million invested by the previous owner, as illustrated below.
This means in principle that the Romney-Bain folks can find three other widget companies. If they do the same deal with each, they will manage to pocket over $135 million compared to the $57.2 million earned with the same amount of capital by the prior family owner.
Note that this increase in profitability assumes nothing about efficiency. In this story the Romney-Bain gang did nothing to improve the operation of the factory. They just found ways to reduce its tax liability.
This is clearly an overly-simplistic story, but it does illustrate how PE companies can make large profits without doing anything to increase efficiency. This is one of the ways in which PE companies make money. To get the full list, read the work of my colleague Eileen Appelbaum.
But the important point is that PE companies can make lots of money for themselves in ways that do not involve increasing efficiency. In other words, contrary to what Brooks told readers, there is no reason to assume that just because Romney got rich in PE that he is an efficiency expert.
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