The PE Question
March 19 2012 by JP Donlon
It’s interesting how a previously semi-obscure corner of business, private equity (PE), has suddenly become center stage in the media due to one presidential hopeful’s pedigree and his seeming inability to explain what it is or how it works to average voters. With public companies, it’s easy to invest. Just call your broker. With private companies, it’s a little more complicated. In 1984, Bain & Company, a consulting firm founded by the soft-spoken, Tennessee-born Bill Bain, wanted to participate in such investing by starting Bain Capital. (Full disclosure: Chief Executive partnered with the affable Bill Bain in 1987 to host several leadership-focused roundtables—the first featuring our second CEO of the year, Chuck Knight of Emerson Electric.)
In those days, most PE firms invested in existing businesses, leveraging their positions using debt in leveraged buyouts in the hope that the businesses would grow fast and become more successful. These tended to be companies long past their initial growth cycles. The PE professionals typically teamed up with management to get the process moving. Sometimes they replaced managers but only if they felt existing management couldn’t do the job, in which case, they inserted people they believed could accelerate the growth of the business. Intuitively, it makes little sense to buy a troubled company merely to strip it and shut it down. All other things being equal, there’s not much point in paying for a business and losing the inherent value unless one is, say, doing a roll-up and buying up multiple smaller firms in the same industry to consolidate and gain scale. Even then, in many cases, the other parts that don’t fit can be sold to other firms where the fit is perhaps better. Operations that no longer make economic sense are doomed in either case.
There is no point in investing in any particular company unless the PE investor can bring superior skills to the process. This is one of the underlying premises of our private equity roundtable discussion featured on page 60. As Len Tannenbaum, CEO of Fifth Street Finance, said during the exchange, “we have to bring meaningful skills and knowledge to this because money alone isn’t enough to make a business grow and thrive.” PE investors and operating CEOs exchanged ideas on what works best and how either side can get the most out of the partnership, because fundamental disagreements only undermine the purpose of the deal. Yes, it is true that the primary object of the exercise is to secure a favorable return to the investors. However, jobs are created along the way, just as some jobs are eliminated. But when done right, the former should outdo the latter. (Full disclosure: Since 2009, Chief Executive has been owned by a private equity company.) In the long run, value is created and the economy has healthier, more vibrant companies that can sustain more productive employees.
PE investing, however, is not for the faint of heart. There are risks. The economic situation can suddenly change. Top talent can leave or be lured away. When a company is bought, any number of things can go off the rails. In many cases, it takes five or more years before it can be sold in the public markets or more likely, to a larger firm looking for an asset to build upon for its own strategic goals.
Why Mitt Romney can’t get this concept across in terms that anyone can understand would seem to be a curious shortcoming, considering his 25 years experience in private equity. Why his rivals seem bent on distorting a simple truth is another matter for another day.