When politics and the economy collide: What is fair game?

Posted Tuesday, May 29, 2012 in Analysis

When politics and the economy collide: What is fair game?

Obama, speaking to reporters at the NATO summit in Chicago.

by Gina Hamilton

In the last few weeks, as the political silly season ramps up, the focus of the Obama reelection campaign has been increasingly on Gov. Mitt Romney's tenure with the venture capital firm, Bain Capital.  Bain Capital's role was and is to take ailing companies and either make them solvent, or if that can't happen, to liquidate them quickly. 

The problem comes with how companies like Bain Capital try to make them 'solvent'.  Despite claims that no thinking venture capitalist would drive a company into unsustainable debt, followed by bankruptcy, that is in fact the Bain business model.  After bankruptcy, the companies typically shed all or many jobs.  The venture capital company exits with its share, and leaves the rest of the shareholders and the employees behind in a wake of devastation.

Basically, this is how it works.

It can be quite profitable for private equity firms to drive the companies they take over into debt, regardless of whether those companies then end up bankrupt. By taking over companies and having them borrow a lot of money, private equity firms create a slush fund of cash, some of which they can direct their own way in the form of management fees and dividends.  Interest on the debt is tax-deductible, so the day of reckoning is kicked down the road. This is exactly what happened with some of the companies that Bain Capital took over. Bain managed to make a huge return on its investments even in cases where companies failed. Creation of new debt made those profits possible.

When Bain took over a company, it forced the company to go into debt.  The owners, shareholders, and partners would put up some of the funds; Bain would force the company to sell shares for the remainder.  Let's look at a hypothetical example.

Company A is having a hard time making payroll.  Enter Bain Capital.  It gives $1 million up front, which makes Company A look a little better on paper.  Then Bain insists that the owners and partners reinvest that money, basically as a loan.  Now there's a $1 million on the books as an asset, even though it's a loan. 

Because the company looks 'good', it can begin to sell shares at a higher price to unwitting shareholders, and in some cases, to its own pension fund if there is one.  In Company A's case, they sell $5 million in shares, $1 million of that to the pension fund and distribute $1 million into an employee profit sharing account.  The remaining $3 million goes to other shareholders, who might be part of mutual funds.

Now the company has $6 million.  Bain forces Company A to give all of that in dividends to shareholders, of which Bain is majority stakeholder.  So Bain gets a little more than $3 million for a $1 million investment, in addition to the fees and other moneys the company has been forking over to Bain for its 'help'.

Now the company is $6 million in debt.  It still can't meet its payroll, and the price of its shares are sinking like a stone.  The company files for bankruptcy, lays off its employees, which have already lost most of their pension fund and their profit sharing.  As the value of the shares continues to tank after the bankruptcy announcement, Bain leaves the firm, which closes its doors.

Bain is $2 million ahead, plus whatever fees it managed to squeeze out of the company, but Company A is no more, and its 100 employees are jobless and without their profit sharing and health care, and the government is forced to pick up their pension plan, for which taxpayers will ultimately be on the hook.

Sometimes, as absurd as it sounds, this approach actually does help the company survive.  But it is an unusual company that can prosper by going into debt.  Bain isn't trying to make the company healthy; it is trying to make money itself, which it does quite well. 

The question is, are the questionable business practices of venture capitalists like Bain (and Bain in particular, since a presidential candidate is touting his 'job creation' experience based on his experience with Bain) fair game for the other guy?

Obama said he is making Bain an issue because Romney’s “main calling card for why he thinks he should be president is his business experience. . . . When you’re president, as opposed to the head of a private-equity firm, then your job is not simply to maximize profits. Your job is to figure out how everybody in the country has a fair shot. Your job is to think about those workers who get laid off, and how are we paying for their retraining. Your job is to think about how those communities can start creating new clusters so that they can attract new businesses.”

The president is taking on private equity firms, and that will likely rally American anger at Wall Street and their unfair and unpopular business practices.  It will probably cheer the tech industry capitalists, who are tired of being linked with the "1 percenters", and it will no doubt make the left-leaning Democratic base, which has begun to despair of the centrism of Obama's first term, take notice.

But does Obama risk looking like he is taking on capitalism itself? And how will Obama's campaign populism translate into a second term of re-establishing rational regulation of the most egregious of the financial services and commodities futures industries?

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