[Vision2020] A Financier in Chief

[Art Deco]

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October
18, 2012, *9:13 pm*
A Financier in Chief By PETER
JOSEPH<http://campaignstops.blogs.nytimes.com/author/peter-joseph/>

Mitt Romney stakes his claim to being a better “job creator” than President
Obama largely on his success and experience in the private sector. After
the first two presidential debates, voters say that they trust him more
than the president on the economy and jobs, but it isn’t because Romney has
talked much about what Bain Capital actually does.

Romney has chosen not to try to put the private equity business in a
particularly sympathetic light nor to explain it in a way that would enable
voters to see the connection between his financial activity and his ability
to create jobs. I understand his dilemma. As one who spent close to 25
years as a partner in two private equity firms, I can’t imagine that I
would ever want to try to explain the business during an American political
campaign.

So far, the media has focused on Romney’s wealth, which he earned from
founding one of the leading firms in the business, a firm that maintains an
impeccable reputation. This focus has led to interest in Romney’s tax
returns, which undoubtedly reflect the sound professional advice of experts
in tax and estate planning. Other than identifying practices outside the
experience of less fortunate Americans, the attention has not identified
anything other than compliance with the intricacies of our tax code. One
might feel that Romney should have released more of his tax returns or
should not have been able to exploit an over-complicated tax code, but
those issues are a red herring, in a way. Let’s move past them for the
moment and instead try to understand exactly how private equity
works and how Romney’s experience would inform his presidency.

*It is not the mission of the financier to create jobs. In fact, his
mission is often to do just the opposite.*

The key point, which has been at once over-discussed and misunderstood, is
that the best word for the job Romney did at Bain is financier. He
identified attractive investment opportunities and then deployed capital
(largely provided by others) to generate positive returns on those
investments. For example, imagine that you wish to buy a piece of real
estate and that you are able to get a mortgage for 99% of the purchase
price (this may stretch your imagination — where can I get a mortgage like
this? — but the world of private equity has different rules).

You would have very little money at risk, but an opportunity, with
inflation or appreciation in real estate values, to pay off your mortgage
lender and keep 100% of the gain for yourself. In addition to the skill of
ferreting out an attractive investment opportunity, Romney has
demonstrated the ability to recruit and motivate managers who actually
create value by improving a business, as well as the ability to attract the
necessary capital from banks and institutional investors. In short, Romney
was an intermediary or broker between capital and business opportunity.

It is essential to recognize that there is only one significant benchmark
of performance for a financier: internal rate of return (I.R.R.), which is
basically the rate at which a particular investment grows. An investor who
invests in a private equity transaction only wants to know how the
investment did. When it comes to the means employed, ignorance is bliss.
Unlike in the more public corporate world, where boards, shareholders,
customers and sometimes public activists scrutinize the social implications
of what a business does, a financier’s performance is measured by one
question: what was the I.R.R.?

In pursuit of single-mindedly maximizing the return on an investment, a
financier must focus on how to increase a company’s cash flow in order to
create value, and herein lies Romney’s greatest political difficulty. A
businessman seeking to optimize profitability will look to lower labor
costs by reducing head-count, whether through technology, out-sourcing, or
rationalization. This is right out of the basic playbook. It is not the
mission of the financier to create jobs. In fact, his mission is often to
do just the opposite.

It is also right out of the playbook to maximize cash flow by paying as
little in corporate taxes as possible. This is accomplished by managing the
level of taxable income, most commonly by using deductions like interest
expenses that result from a maximal level of debt. It is the job of the
financier to engage in sophisticated tax-planning, and most business people
understand and sympathize with this. Most American voters faced with a job
recession and a federal budget crisis do not.

Exactly how do financiers like Romney make their money in the institutional
private equity business? When large institutions give investment discretion
over their funds to a financier, they need to assure themselves that the
financier will act as if the money were his own and generally require the
financier to make a significant co-investment with his own funds. This
basic philosophy of aligning the interests of the financier with those
of his investors also gave rise to the compensation structure which has
come to be known as carried interest which, in essence, is a sharing of
the profits earned on the investors’ capital. The carried interest is
performance-based because it is earned only if there has been real benefit
to the institutional investor. Unless the financier makes money for his
investors, he doesn’t make money for himself. In this context, Romney can
point to his financial success as directly attributable to his performance
as an investment manager.

But a third way Romney made his fortune was through his participation in a
highly lucrative fee structure that includes any management, monitoring,
transaction, financing and other fees generated and taken by Bain for its
services. Unlike performance-based compensation, these fees create an
adverse interest between the financier and his institutional investors.
They solely benefit the financier and, to the extent they diminish the
value of private equity investment, they are detrimental to the
institutional investors.

Over the course of the last decade, the scale of the private equity
business has exploded in response to the search by institutional
investors for ever-higher returns. As a result, private equity increasingly
became an asset management business, virtually risk-free to the financiers,
rather than a shared-risk business as it was originally conceived. The
management and other fees that bring in millions of dollars regardless of
investment performance have overshadowed the performance-based compensation
for many firms and have created unimaginable wealth for private equity
firms, little of which has been shared by the people providing the
money. As a Bain founder, Romney has undoubtedly benefited from the immense
growth in the value of Bain’s franchise, even though he has not been
actively engaged in the business during this recent period.

Perhaps the most uncomfortable aspect of private equity for Romney to
explain is the role of capital from the public sector in driving its
growth. In recent years, state and local public employee pension funds have
had greater and greater trouble keeping pace with projected obligations to
their beneficiaries. The causes of these potential shortfalls vary:
unreasonable actuarial assumptions in calculating future benefits,
substandard investment performance, inadequate government support, and the
unwillingness of politicians to constrain benefit levels. Whatever the
reason, the managers who run these pension funds have responded to the
anticipated funding gap by seeking investments that offer ever-higher rates
of return. In other words, the management of the nest eggs of teachers,
police, firefighters, prison guards and other public employees has
increasingly been handed over to the captains of private equity.

Although Romney is unlikely to admit it on the campaign trail, his
much-vaunted private sector success was based in significant part on the
savings of public sector workers. Romney constantly derides big government,
but government is made up of individuals, whose pension funds helped make
him and Bain unimaginably
rich<http://www.nypost.com/p/news/opinion/opedcolumnists/look_who_parks_their_cash_at_bain_88KSQrw8BXciEidja2ZQXN>.
There is no doubt that these pension funds sought the higher returns
offered by private equity investing. But as the private equity business
grew, the public pension funds and other capital providers have gotten the
short end of the stick. They have not completely shared in the value of the
franchise that is created in part by their investment in the industry.
It seems odd to hear Romney criticize big government without any
acknowledgment that he has made much of his fortune managing the retirement
funds of many public employees.

Mitt Romney argues that his time at Bain has real significance in terms of
his qualifications for the presidency. Many on Wall Street and in the
business community argue that he developed a keen sense, absent in today’s
White House, of the concerns of the private sector. But voters need to
consider whether the time he spent in single-minded pursuit of profit as a
financial intermediary has prepared him to tackle the complex problems
facing America, which can’t be reduced to a financial model.

Romney’s financial success is admirable and enviable, but it came by
following the mantra of increasing cash flow, cutting jobs and minimizing
taxable income. Though the Obama campaign has tried to exploit this with
millions of dollars in anti-Bain ads, the real issue is how Romney’s
experience relates to a president’s need to balance budgetary
responsibility with the heavy lifting required to address our collective
concerns, our common obligations. We have heard a lot about pragmatism and
practicality, but I can assure you that compassion and broader social
concerns rarely make it into an investment memo. If Romney really wants to
push his Bain experience, Americans will have to decide whether the answers
to the problems facing them are best provided by a financier president.

*Peter Joseph is a private investor, with more than twenty-five years in
the private equity business. He co-founded two private equity firms and
invested on behalf of many leading institutional investors.*


-- 
Art Deco (Wayne A. Fox)
art.deco.studios at gmail.com
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