In Defense of Private Equity Firms

by Rick Gould, CPA, JD

Private equity has become a hot topic this election season. As it will continue to be one well into the general election, I feel compelled to express my personal perspective and insights.

To put my ruminations in context, I should disclose that I have been extensively involved with private equity firms and investment banking during the past year. This first-hand involvement will continue throughout 2012 in relation to a major transaction in the works.

In a nutshell, Private Equity (PE) has transformed business in the U.S. PE firms are a vital and positive force in stimulating our economy. Many PE acquisitions are “investments” in companies that are on the verge of bankruptcy or are consistently unprofitable. Companies in desperate need of capital infusion often find renewed life in this manner.

A PE firm typically invests in struggling or stagnating companies needing financial support, management expertise and creative thinking. This investment strategy includes both high risk and high potential reward.

PE firms reorganize companies with the goal of creating value and profitability. Additionally, jobs are saved that would otherwise be lost if the company went south. Jobs are even ultimately created if PE firms turnaround and/or grow the company. In many cases jobs are trimmed to cut costs, and then the organization is rebuilt with many more jobs in place than when the company was acquired. Human capital is generated with the goal of long-term, sustainable value.

Investors in private equity firms can include college endowment funds and teachers’ pension funds, which, in turn, represent ordinary people. This area is not necessarily as out of reach from the general public as some might think.

Creating value drives our capitalistic free-market economy, which does indeed have far-reaching impact on ordinary people. Many successful mainstream companies - Sports Authority, Staples, Duane Reade, Domino’s Pizza and Seely Mattress (all from Mitt Romney’s Bain Capital) are perfect examples. And what about Target, Macy’s, Federated, Hertz, Dunkin Donuts, Home Depot? All name brands that have been launched and funded by private equity firms.

And in the realm of premier PR firms, the same labor-intensive and expensive process of selecting target firms, performing due diligence, executing audits and negotiating lengthy legal contracts should be followed as in the PE arena. Even in the PR agency industry, this same discipline is imperative if the goal of making the firm profitable for investors is to be achieved. Bain Capital- Blackstone Group, Carlyle Group, KKR, TPG, Apollo, CVC Capital Partners may be in different industries than PR, but they all go through a structured investment analysis process to ensure that risk is mitigated and potential reward is maximized.

PE firms do inevitably have some unprofitable investments…. but isn’t the “L” in P&L reserved for firms “losing” money? Whether private equity is backed or independent, some firms will lose money. That is the truth of capitalism.

PE firms only make money when the firms they have acquired are profitable, unless they are taking out large management fees that are the ultimate cause of losses. Losses due to management fees should not happen if the PE firms do it right. Management fees should be reduced or deferred until a profitable turnaround of the firm occurs.

In thinking this through further, private equity firms should ultimately generate more jobs with higher wages in the long-term. Jobs may need to be cut in the short-term, though. Being in the financial arena I fully grasp the concept of “operational change”.

I am a true believer in the position that any service business should and can realistically have 20%+ of operating profit. PE firms promote this. They monitor results against benchmarks that are realistic and attainable. If certain line items don’t come close to the pre-determined benchmark, then the red flag goes up and the reason for the difference can and should be analyzed, explained and corrected.

As mentioned earlier, a typical private equity investment is in an undermanaged or poorly managed company. The PE firm acquires the company (often financed through substantial debt) for less than calculated value. The hope is to sell the company down the road, when it is healthy, for a substantially higher price than the PE firm paid for it.

It is then, at the liquidating event, that the PE firm gets their return-on-investment. Buying low and selling high is the goal, as it should be. PE firms take all the risk. They went through the pain of transforming the acquired company and deserve the reward.

In conclusion of my discourse on the subject, I make a case that capitalism works. Free enterprise works. From my perspective, private equity firms are a positive and permanent part of our free-enterprise system.