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How Mitt Romney's Bain Career Will Inflame the Class Warfare Debate

ElectionOracle / US Presidential Election 2012 Jan 19, 2012 - 06:27 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleShah Gilani writes: Last Wednesday a Pew Research Center poll revealed that 66% of respondents think class conflict in American society is "strong" to "very strong."

Now that Mitt Romney is increasingly likely to be the Republican challenger to Democrat Barack Obama this November, that same divide is likely to become even more inflamed.

In fact, Romney's career as the CEO of private equity company Bain Capital ensures the class warfare debate will only get uglier.

That's why it's important to understand what private equity companies really do, what role Romney played at Bain, and how class warfare combatants will size each other up.

The Truth Behind Private Equity
Bain Capital is a private equity shop. What you need to know is that "private equity" is a rebranded name. Private equity companies used to be known as leveraged buyout shops.

But, leveraged buyouts (LBOs) have a bad reputation, so the industry -- or club, which it more closely resembles -- began referring to itself as private equity. It's the same as junk bonds being rebranded as "high yield debt."

A leveraged buyout is really nothing more than a financing technique.

Typically, a public company, a division of a public company, or a closely held non-public company is taken "private" by a group of investors who put up some equity to demonstrate they have skin in the game, and who then hypothecate the target company's assets as collateral for debt they pile onto the target company.

Sometimes borrowed money is raised in the junk bond market. Since the acquirers are leveraging the target company's balance sheet by borrowing a lot of money against the company's assets, lenders demand high rates of return knowing the company is being "leveraged."

The borrowed money is then used to pay shareholders, or as is more often the case, to pay off the "mezzanine" lenders who float enough cash for the acquirers to buy the company initially, and whose short-term loans are paid off from the issuance of junk bonds.

Not all the debt is junk. Sometimes debt issues are better quality. It's all a matter of how much leverage is necessary to make the deal happen and to make it profitable for the acquirers.

Once the target is acquired it's up to management, which often includes existing executives who are part of the buyout team, to streamline the company and make it profitable.

Loaded Down With Debt
Since the target company is now buried in debt, expenses are cut as judiciously and quickly as possible.

For instance, maybe the acquired company has too many corporate jets that are a balance sheet drag. Or, maybe they have too many employees that add to expenses.

Usually it means laying off workers, which is what gave leveraged buyouts their bad reputation.

But, that's not all that creates controversy. LBO shops charge the target company all kinds of fees.

There are investment banking fees for doing the deal, financing fees for leveraging the company, and other fees that go directly to the LBO shop.

Sometimes, the company takes on even more debt to pay a dividend to its new owners. That's a way for the LBO shop to get its equity back quickly. So much for skin in the game.

The LBO shops also pay themselves a 2% management fee out of the capital that their backers, investors like pension funds, endowments and high net worth individuals put into them so they can scour the planet for target companies to leverage up and buy.

And, they take at least 20% of the profits they make, too. It's a nice club to be a member of.

But while leveraged buyouts are the bread and butter of private equity shops, they can also dabble in venture capital financing of start-ups and other capital raising and financing opportunities.

Mitt Romney's Bain Capital Problem
Mitt Romney was a founder of Bain Capital, which grew out of Boston-based global management and consulting giant Bain & Co. He ran the LBO shop from 1984 to 1999.

Romney was very successful running Bain Capital and amassed an estimated fortune of over $250 million.

Needless to say, as Romney gets closer to becoming the Republican nominee, his role at Bain and his claim to have created 100,000 jobs are going to be heavily scrutinized.

Now personally, I'm not against leveraged buyouts.

However, I do think it's fair game to question LBOs that end up turning to bankruptcy protection to shed themselves of their pensions (which are often taken over by the taxpayer funded Pension Benefit Guaranty Corporation) so they can re-emerge under the guise of becoming streamlined companies.

This class warfare debate will find fertile ground in the rich rewards bestowed upon LBO kings who claim to create jobs while simultaneously eradicating others through creative destruction.

In the real world, c reative destruction is just part of the natural and organic birth and death cycle of businesses.

But to claim that layering mountains of debt on the shoulders of companies (companies are people too, you know) to pay private equity companies fat fees so they can generate generous returns for themselves and their investors (many of whom are public sector pension plans) seems inordinately lopsided and more destructive than creative.

Not only will Romney be cast in that dark light, he's also going to have to face the added knock that private equity managers' earnings from their operations isn't ordinary income (obviously not based on how many mega-millionaires and billionaires there are in the PE club), but are taxed at the much lower capital gains rate.

Private equity guys are bankers. So, Romney will be the poster child for everything bad that bankers have been blamed for since time immemorial. Not that he's going to be the first or last banker ever to run for the presidency of the United States.

But, given the politically charged atmosphere in Washington and around America, drawing class warfare lines to make the case for political candidates will be front and center this year.

So far, President Obama and the Democrats haven't had to weigh-in for the fight. Republican candidates are doing a good job on their own bashing each other's capitalist credentials and throwing stones from inside their glass house to the dismay of traditionally stalwart pro-business Grand Old Party regulars.

According to the Pew poll, 55% of Republican respondents, 68% of Independent respondents and 73% of Democrat respondents think class conflicts are strong, or very strong.

You can expect that these political lines will only darken as Romney emerges.
[Editor's Note: If you're fed up with the rampant corruption, double-dealing, and protection of Wall Street by Washington (at the expense of the taxpayers on America's Main Street), then you need to read Shah Gilani's Wall Street Insights & Indictments newsletter. As a retired hedge-fund manager, Gilani is a former Wall Street insider who knows where all the bodies are buried. But unlike most insiders, he's not afraid to tell you where they are. He's also got some pretty good ideas how to fix this mess - and how to protect yourself until the cleanup takes place. Please click here to find out more. The newsletter is free.]


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