Friday, October 19, 2012

Should America Elect A Financier To Create Jobs?

Mitt Romney has successfully argued that he should be elected because of the business acumen that he  acquired by running Bain Capital.  This article, written by a private equity manager, explains how private equity firms operate.  In the first place, private equity firms are really financial businesses, they raise money from investors, which they use to purchase assets that they hope to sell later at a higher price. When that happens, the investors and Bain Capital share in the profits.  Bain Capital also makes makes money by charging the firms that they acquire fees for a variety of services.  The investors do not benefit from the fees paid to Bain Capital.  In fact, there is an adverse relationship between the fees that Bain collects, and the interests of the investors.  The fees paid by acquired firm may make the firm less profitable.

Private equity firms have no interest in creating jobs.  They are primarily driven to increase cash flow.  This is done by cutting costs.  Since most of the cost of running a business is the cost of labor, private equity firms engage in a number activities to reduce the cost of labor.  That may involve the outsourcing of jobs to low wage locations or other ways to reduce costs.  It is also done by using a variety of methods to reduce taxes.  That is one of the reasons why the acquired firms borrow a lot of money.  The interest paid on the loans is deductible from their income. However, the borrowed money is not always used to invest in productive capital.  Sometimes it is used to pay dividends to the private equity firm.  The dividends paid enable the private equity firm to get a faster return on its investment than they would otherwise achieve.  On the other hand, the increased cost of debt service may make the acquired firm more vulnerable to adverse changes in their business model. 

Private equity firms have become very popular with investors because they may provide a higher yield on their investments than more traditional investments in stocks and bonds.  Pension funds, including government pension funds, are one of the majors sources of funding for private equity firms.  Many of them need higher yields in order to provide pensioners with the payments that they have committed to them.  Private equity firms have benefited from government pension funds who need to take greater risks in order to get a greater return on their investments.

The question raised in this article is whether a successful financier, who has been good at cutting jobs to reduce the cost of labor, is the person that we need to create jobs. Financiers are not necessarily evil.  They are just doing their job when they cut costs to increase their return on investment.

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