Politics & Policy

Let Us Now Praise Private Equity

(Roman Genn)
From the February 6, 2012, issue of NR.

Every presidential candidate has to defend himself against accusations of wrongdoing — an affair, abuse of office, campaign-finance impropriety, and so forth. Mitt Romney finds himself in a predictable defensive crouch, too, but the allegation against him is extraordinary: He stands accused of doing his job too well.

As the founder and CEO of the private-equity firm Bain Capital, Romney was a turnaround artist. In that role, the GOP frontrunner says, he restored failing firms to health, usually with great success. He claims to have helped create thousands of new jobs and billions of dollars in new wealth.

Some of Romney’s Republican rivals, particularly Newt Gingrich, haven’t framed Romney’s record in such generous terms. They say Romney was a “vulture capitalist” who used financial chicanery to enrich himself and his cronies at the expense of helpless workers. President Obama and his allies will surely make the same case in the months to come. Indeed, a recent memo from Stephanie Cutter, the president’s deputy campaign manager, accuses Romney of having sought “profit at any cost,” and of believing in “an economy where the wealthy and powerful can rig the game at the expense of working Americans.” Romney’s verbal gaffes, including an ill-considered soundbite professing his love of “being able to fire people,” have made him vulnerable to more demonization still.

#ad#After his victory in New Hampshire’s primary, Romney fought back with unusually strong words. “President Obama wants to put free enterprise on trial,” he said, adding that “we have seen some desperate Republicans join forces with him.” But Romney was only partly right. The plaintiffs against free enterprise are not just a handful of politicians, but a growing number of American voters who think corporate elites have jeopardized a social contract that once guaranteed, as Bill Clinton put it, that “if you work hard and play by the rules, you ought to have a decent life and a chance for your children to have a better one.”

There is some reason to believe that in the 21st century, that contract has expired. Over the last decade, job destruction has outpaced job creation in the private sector. Great American brands like GM and Chrysler went on life support, and others like Kodak died altogether. Today’s corporate success stories, meanwhile, are nimble, brainy start-ups rather than the glorious industrial giants of yesteryear. Consider Instagram, a cellphone-photo-sharing service with 10 million users and, as of late last year, six employees. Even a Silicon Valley behemoth like Facebook, currently valued at over $82 billion, has just 3,000 employees. Kodak had 19,000.

Companies like Instagram and Facebook will hire more — but they probably won’t hire those veterans of Kodak or GM, and they won’t flock to Rochester, N.Y., or Detroit, Mich., to chase after the Next Big Thing. We can blame economic abstractions, such as globalization or skill-biased technical change, for this upheaval of the American economy. Or we can blame those who have profited most conspicuously — the highest-earning 1 percent, and the man who now serves as their political stand-in: Mitt Romney.

Anxious American workers are right to worry about their futures. After the financial collapse, U.S. jobs were destroyed in a labor-market bonfire of a size not seen since the Great Depression. Hiring, job creation, and investment since then have been anemic. Though hiring seems to have picked up slightly, there are still between three and five out-of-work, job-seeking Americans for every opening. This ratio never went above three-to-one from 1951 to 2007, and it only rarely surpassed two-to-one.

#page#The United States now has dangerously low employment, and as workers remain idle, they lose skills and become unhireable by those smaller, more technologically advanced corporations. So the backlash against job destruction, particularly as manifested in the cost-cutting efforts of Bain Capital, is predictable. This backlash, alas, will almost certainly not facilitate job creation. Indeed, if the government tries to make layoffs more difficult, large work forces will cost more to maintain, and the job shortage will stay dire.

The difficult truth that virtually no politician is prepared to acknowledge is that the road to job creation runs through job destruction. Yet it is a truth that workers and voters must understand — and Mitt Romney carries the almost impossible burden of explaining it. The controversy over Bain Capital won’t blow over. The only way forward is to show how his work at Bain contributed to growth, and how the excessive regulation and crony capitalism his fiercest critics advocate is a recipe for stagnation.

#ad#In a healthy economy, failing firms fade away, and their assets — including their work forces — get reallocated to more promising ventures. Over time, job creation has outpaced job destruction just enough to accommodate a growing population, and, in flush times, to create tight labor markets. The decline of the Rust Belt during the early 1980s was followed by a boom in the Sunbelt. Textiles and petrochemicals suffered, but Silicon Valley prospered. In the late 1990s, it was the long-moribund retail sector’s turn to be shoved into the churn, as Walmart drove firms to either sharpen their games or get pushed out of business. Job destruction was constant, but so was the creation of new opportunities.

A May 2011 paper by the University of Maryland economist John Haltiwanger illustrates this dynamic. From 1980 to 2009, Haltiwanger observed, 17 percent of jobs in any given year were accounted for by new or expanding firms, while 15 percent of the previous year’s jobs vanished due to the contraction or exit — a nice way to say “going out of business” — of other firms. This process costs a lot and wreaks havoc. But it has two silver linings. The first is that, until recently, gross job creation has outpaced destruction. The second is that the churning process tends to raise economy-wide productivity. Haltiwanger’s exiting firms are generally less productive than surviving ones, and young ones that survive past their first couple of years have higher productivity levels and higher productivity gains than older ones. A growing firm will open new factories or retail outlets; an unsuccessful firm will close them.

Just months before Romney’s career at Bain Capital became controversial, Americans mourned the death of Apple CEO Steve Jobs. And yet when Jobs returned to Apple in 1997, he returned as an angel of destruction. He fired over 3,000 employees, a move that helped swing Apple from a $1.05 billion annual loss to a $309 million profit. He shut down Apple’s manufacturing facilities and outsourced almost every aspect of production. He swung the axe pitilessly, since he was convinced that survival requires leanness. And in the 14 years after Jobs returned, employment levels at Apple soared. Apple’s manufacturing work force was eventually replaced by engineers, support staff, and — in a move that would have surprised many in 1997 — a vast army of retail employees. The destruction was a prerequisite for the creation, and for the transformation of a wounded technology firm into one of the world’s most valuable public companies.

#page#As Haltiwanger suggests, successful firms such as Apple change the larger competitive landscape by threatening the very survival of competitors. Chad Syverson, an economist at the University of Chicago’s Booth School of Business, found that what separates top firms from bottom firms is, typically, a large difference in productivity, with the top ones producing almost twice as much with the same measured input. This creates an almost irresistible temptation for investors. If Firm X, languishing at the 10th percentile in terms of productivity, could somehow be overhauled to match the productivity levels achieved by Firm A, at the 90th percentile, the potential for profit would be huge. Note, however, that halving “measured input” in order to double productivity will often mean shedding the weakest performers and giving those who remain the tools they need to do their jobs better and faster. Private equity does exactly this.

What Mitt Romney discovered was that American corporations sometimes had to be dragged, wailing and whining, into a state of efficiency. As a management consultant at Bain & Company, Romney had studied successful firms and then told other firms how to replicate their strategies. But those firms had come of age in the fat years of American corporate dominance, when many believed that the Japanese could do little more than manufacture cheap toys and textiles, and many were reluctant to accept his newfangled advice. It eventually became clear that if Romney and his cohort were going to remake American business, they’d have to raise money to make their own investments. Spurred by the senior partners at Bain & Company, Romney and his merry band of consultants established Bain Capital.

#ad#Some of Bain Capital’s early investments were entirely new ventures, like the office-supply retailer Staples. Most, however, were Firm X’s. In 2008, economists Steven Kaplan of the Booth School and Per Strömberg of the Stockholm School of Economics offered a broad overview of the private-equity landscape. The typical pattern, at Bain and at other private-equity firms like it, was to buy a company by spending some portion of their capital (augmented by debt — usually somewhere between 60 to 90 percent of the total purchase price). They would then offer supercharged incentives for top managers, both among the investment professionals at the private-equity firm itself and at the firms they acquired. CEOs of newly acquired firms would be enticed with stock options and performance incentives. When the system worked, as it often did, CEOs started making sums that were unheard of in the 1960s.

We can trace the enormous increase in compensation among top earners to this embrace of performance-based compensation among the CEOs of privately held firms. This relation between huge paydays and the work of private equity is one of many reasons the field is so controversial. Equally controversial is the use of debt. Having bought a company with borrowed money, private-equity firms had to extract the mortgage payments, as it were, out of the company’s cash flow. This was a new expense for management, and it was also a source of discipline: If you couldn’t make the payments, you’d kiss your performance incentives goodbye, and you might even end up going bust. But loading up a company with debt could also hasten its demise, especially if management failed to cut costs.

#page#This brings us to the question at the heart of the Bain controversy: Have private-equity firms destroyed jobs with a vengeance, while creating none in return? Recently the economists Steven Davis, John Haltiwanger, Ron Jarmin, Josh Lerner, and Javier Miranda surveyed private-equity transactions between 1980 and 2005, covering 3,200 target firms and 150,000 establishments, to measure job losses before and after acquisition. In “Private Equity and Employment,” they compared target firms to control firms, i.e., firms that resembled the targets of private equity in age, size, industry, and growth, but for whatever reason were not acquired. Identifying controls is difficult — it is possible that private-equity firms were able to identify some hard-to-define X factor that made target firms riper for acquisition than others. Indeed, a recent Wall Street Journal analysis of Bain Capital’s track record suggested that under Mitt Romney’s leadership, the firm tended to gravitate towards particularly hard cases.

Regardless, “Private Equity and Employment” offers a good starting point for assessing private equity’s impact. The authors find that in the first five years after a buyout, employment levels at private-equity targets do decline more rapidly. Yet those targets start new factories, retail outlets, and other establishments at a considerably higher rate than control firms — and so net job losses at target firms are less than 1 percent greater than net job losses at control firms. Those target firms get whipped around in a much more violent churn than control firms, as they rapidly shut down or sell old establishments and open up or acquire new ones. This is a disruptive process, and private-equity outsiders sharply accelerate the pace of restructuring.

#ad#Consider the experience of UniMac, a laundry-equipment manufacturer in Marianna, Fla. UniMac plays a prominent role in When Mitt Romney Came to Town, a 28-minute documentary heavily promoted by the pro-Gingrich PAC Winning Our Future. According to the film, Bain Capital took over UniMac and wrecked it. If you believe the ominous narration, Bain’s managers fired workers such as Mike Baxley and Tracy and Tommy Jones as they slashed costs and eventually shut down the plant. According to a report by Elizabeth Williamson in the Wall Street Journal, however, the three employees actually flourished and were promoted under Bain. Only after Bain sold the plant to the private-equity arm of a Canadian teachers’ union did the plant close. After that shutdown, UniMac’s operations shifted not to some emerging-market sweatshop but to Ripon, Wis. The three workers parlayed their experience at UniMac into a new washing-machine sales-and-service business. Far from being crippled by UniMac’s demise, the workers upgraded their skills and plunged into the new entrepreneurial economy. This experience was no doubt harrowing, but it’s not an obvious instance of the evils of vulture capitalism.

These messy facts didn’t make it into When Mitt Romney Came to Town. And Romney has so far proven incapable of defending private equity with stories like this one. If Romney secures the Republican presidential nomination, he’ll have to offer his own narrative about the churn, a narrative that shows how it fosters prosperity rather than destroys it.

#page#Private-equity firms have taken the process of turning around failing businesses and made it into an industrial process. The hostile reaction to this industrialization of corporate cost-cutting evokes the revolt of the Luddites, the 19th-century textile artisans who sabotaged the mechanical looms that threatened their familiar way of life. These artisans had no objection to buying and selling textiles — that was how they made their living. Rather, they objected to the scale of the new factories, their speed, and the rate at which they were displacing skilled workers. The balance of power had shifted from a few skilled artisans to the owners of capital and the managers of the new factories, who could now draw upon a much larger labor pool. Management is no longer the work of artisans. Just as the young consultants at Bain & Company hoped, it has evolved into a rigorous, unsentimental, data-driven enterprise dominated by sophisticated investment professionals.

Private equity has experienced ups and downs. During the late 1980s, the junk-bond market — the source of much of the debt financing for private-equity firms — crashed, and the number of publicly held companies that went private plummeted. Within a few years, however, private-equity activity expanded yet again, mainly through the purchase of mid-sized, privately held firms. But over time, the low-hanging fruit started to disappear. When Syverson reported the two-to-one average productivity gap between firms at the 90th percentile and firms at the 10th percentile, he also noted that the gap was more like five to one in China and India. That’s partly because for the last three decades, American private-equity firms have been gobbling up inefficient firms and spitting out profit-making machines, while the process is still in its infancy in the rest of the world. And private equity hasn’t transformed corporate America through direct action alone. The threat of a leveraged buyout also forced many companies to get their acts together — that is, to do to themselves what private-equity investors would otherwise have done.

#ad#So private equity has had broad and positive effects that have kept America dominant. In a 2010 paper, the economists Nicholas Bloom of Stanford and John Van Reenen of the London School of Economics offered evidence that differences in management practices explain a great deal of why some countries are more productive than others. One key difference between the United States and other countries is that it has strikingly few badly managed firms. Moreover, U.S. firms are aggressive about using performance incentives, in part because labor markets are relatively lightly regulated.

Both distinguishing characteristics can arguably be traced to the transformative role of private equity. Bloom and Van Reenen posit that there are two ways countries can improve their management practices and thus their aggregate productivity. The first option is to improve management within each firm, possibly through better management education. The second is to accelerate the reallocation of resources from poorly managed firms to better-managed firms — a role private-equity firms were born to play.

But what good are well-managed firms if employment levels remain dismal? Corporate profits now represent 12.6 percent of GDP, the highest level in 60 years. Yet U.S. firms remain reluctant to hire or to expand at home. This could be because U.S. firms assume that the domestic market is no longer where the action is. Back in 2010, Robert Gordon of Northwestern University argued provocatively that U.S. productivity growth would slow markedly over the next two decades. Per capita GDP growth would slow to 1.5 percent, far lower than the 2.17 percent the U.S. enjoyed from 1929 to 2007. This would represent, in Gordon’s words, “the slowest growth of the measured American standard of living over any two-decade interval recorded since the inauguration of George Washington.” This is the stagnant future that Romney has been warning against on the campaign trail, and it is fast becoming reality.

#page#Gordon is pessimistic in part because he sees the productivity gains of the last decade as fundamentally unsustainable. He suggests that the collapse of corporate profits after the recession and the accounting scandals of the early 2000s sparked savage cost-cutting, including large-scale layoffs. This in turn increased productivity. But after 2003, profits recovered and the pressure to step up productivity relaxed considerably. Even then, however, firms didn’t start hiring. Indeed, there is good reason to believe that the labor-market recovery after the 2008 recession was driven by hiring by state and local governments and an expanding (and heavily-subsidized) health-care sector — not by private-sector job growth. According to Gordon, the wretchedness of the private-sector employment landscape stems in part from the changing balance of power between management and labor. As organized labor has weakened in the private sector, the value of the minimum wage has deteriorated in real terms, competition from imports has intensified, and less-skilled immigrants have become a larger share of the work force, the bargaining position of management has improved. So when the housing bust and the 2008 financial crisis hit, workers could be shed with relatively little difficulty.

#ad#Many who embrace Gordon’s view conclude that labor must be empowered through stronger unions or regulations designed to limit layoffs. In this sense, Gordon is in line with the Obama administration’s buttressing of organized labor and labor-market regulations. This approach, however, has arguably led firms to accelerate the substitution of technology for labor. In addition, it may stymie the reallocation of resources from failing firms to successful firms that is so essential to achieving sustainable productivity growth.

There is another aspect of Gordon’s hypothesized productivity slowdown. As Tino Sanandaji and I have discussed, the increase in educational attainment in the United States has reached a plateau. Workers now retiring actually attained higher diplomas than workers just entering the work force, a phenomenon that in part reflects the changing demographic composition of America’s prime-age work force. Gordon attributes the slowdown in educational attainment to rising tuition levels and a lack of fellowship support for the poor. Others would draw attention to the high-school-dropout rate and the failure of public K–12 schools to prepare children (particularly those from single-parent families) for college. All told, Gordon assumes that the improvements in labor quality that drove productivity growth for the last century will hit zero over the next ten to fifteen years. Defenders of a dynamic market economy, Romney foremost among them, need to place heavy emphasis on this fact.

As many on the left and right have argued, the central problem with the U.S. educational system is that its productivity growth has lagged behind that of other sectors such as manufacturing. That is, we spend far more on education today than we did 40 years ago, yet educational outcomes haven’t improved commensurately. The quality of teaching may have even deteriorated in some respects. President Obama has highlighted the productivity challenge facing education and other government-dominated sectors. In an interview with Bloomberg Businessweek at the start of his presidency, he offered the following observation. “The last lunch that I had, I guess we had the CEOs of Xerox, AT&T, Honeywell, and Coke. We talked about the fact that, in the 1980s, when everybody was afraid Japan was going to eat our lunch, a lot of companies did a 180 in terms of quality improvement, efficiency, increasing productivity. There was a change in corporate culture that significantly boosted corporate productivity for a long time and helped create the boom of the ’90s. What they pointed out was, there were a couple of sectors that were resistant to that: health care, education, energy, and government.” With this in mind, the president suggested that government-dominated sectors needed to undergo a similar cultural shift.

#page#But this “change in corporate culture” didn’t come from roundtable discussions. It flowed from the private-equity-driven reallocation of resources — the messy, disruptive process of shutting down inefficient factories and firms and shifting their resources to innovative new models that can withstand competition. And when the “change in corporate culture” came, the business establishment didn’t embrace it; in many cases, it howled in pain. The change came from outsiders universally derided as “corporate raiders” who used debt financing as their weapon of choice to force old-line industrial companies out of complacency. Innovative business models have since emerged in education and health. Yet at every turn they run into regulatory barriers and opposition from public-sector unions and their allies in government. What these sectors need, Romney should argue, is the same data-driven transformation that saved America’s industrial economy.

#ad#In the end, private equity and job destruction aren’t the source of our employment woes. Rather, it is the clampdown on innovation. This clampdown is most obvious in the education and health-care sectors, which bitterly resist every effort to shift resources from conventional schools and hospitals to lower-cost alternatives. But the resistance is present in almost every sector. In telecommunications, for example, a handful of large firms that can afford access to the airwaves dominate the market, even though we have the technological means to radically lower this barrier to entry. Software patents have led to a dramatic slowdown in innovation, as firms such as Google, Microsoft, and Apple wage pointless, productivity-draining legal battles. Regulations designed to protect workers and consumers raise compliance costs for scrappy start-ups, thus entrenching the advantages enjoyed by incumbent firms. When Romney criticizes regulations now, he emphasizes how they hurt existing employers. He must instead emphasize how they prevent entrepreneurs from starting and growing the new businesses that will create new jobs.

Status quo Democrats and Republicans aim to stimulate job creation by inducing incumbent firms — made extremely lean through successive rounds of cost-cutting — with tax incentives, direct subsidies, and other giveaways. But tax breaks don’t create jobs. Innovative businesses create jobs by dreaming up new products and processes. And innovative business models are embraced only when incumbent firms, whether they manufacture steel or educate kids, fear going out of business.

Our defensiveness, our eagerness to protect the firms and the jobs we have now, is an inevitable reflection of our relative stability and affluence. Societies that believe that their best days are behind them are naturally risk-averse. This dread of change, most vividly illustrated in the fear and loathing of private equity, is the disease of stable societies barreling towards decline. But if America is going to have a bright economic future, we must fight against complacency and nostalgia, and eagerly embrace job destruction as job creation’s necessary twin.

— Reihan Salam writes The Agenda and is a policy adviser at the economic-research firm e21. This article appears in the February 6, 2012, issue of National Review.

Reihan Salam is president of the Manhattan Institute and a contributing editor of National Review.

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