Romney, Private Equity, and the Future of American Capitalism

01/25/2012 11:40 am ET | Updated Mar 26, 2012

While Mitt Romney would like to portray private equity (PE) firms, like his own Bain Capital, as examples of free market capitalism, the reality is that the only way many of these entities can make a profit is by manipulating the tax code and lobbying for favorable tax legislation and low interest rates. First of all, Wall Street and related financial institutions have spent millions on campaign contributions and lobbying efforts to make sure that profits made from private equity deals are only taxed as capital gains (15%). In turn, large institutional investors, like pensions and endowments, do not have to pay taxes on their private equity profits if these firms are based in places like the Cayman Islands, which it turns out is true for many of Romney's investments.

Inside the PE Machine

The way that private equity deals usually work is that the PE firm will borrow a large amount of money, and then use this debt to buy a company. The private equity firm next forces the acquired company to restructure by selling off unprofitable parts of the original corporation and by reducing labor costs through layoffs and benefits reductions. Finally, the PE firm forces the bought company to take out loans to finance the original buyout, and this new debt is also used to pay large dividends to the investors and huge management fees to the private equity firm. It is important to stress that this whole system works because PE firms have lobbied Congress to count the private equity loans as an operating expense that can be deducted from profits on tax forms.

Of course private equity firms have to put up very little of their own money because they rely on outside investors, like pension plans, to finance their deals. Furthermore, as Josh Kosman writes in his book The Buyout of America, the PE firm often gets a 20% commission on the fund profits, and so they have a strong motivation to make big deals. In fact, Kosman reports that after you subtract the huge cost of commissions, outside investors usually only make the same rate of return as a stock index fund. Furthermore, pension and endowments help to feed a system where companies are taken over by outside groups whose only interest is to extract money from existing corporations.

Romney's Role in Vulture Capitalism

As Kosman argues, Mitt Romney was a pioneer of this system that invests in companies not to make them more profitable and efficient but to generate commissions for private equity firms and dividends for the investors. One irony of this system is that some pension funds profit from the destruction of companies and the reduction of benefits for employees at these leveraged corporations. For example, as Kosman reports, when Bain Capital under Romney bought out American Pad and Paper (Ampad), it quickly moved to dissolve the workers' union and layoff many workers, and then it offered to hire these workers back at lower wages and reduced benefits. While Ampad continued to lose money, Bain forced it to take out more loans, in part, to pay commissions to Bain and dividends to the investors.

Kosman argues that PE firms force banks to make risky giant loans to failing companies by threatening to take their business away from banks that fail to play the game. In fact, many banks make a great deal of their profits from the deals negotiated by private equity forms. In the case of Ampad, their growing debt forced the company to close plants and move production to Mexico, which only increased layoffs for American workers. Finally in 2000, the company declared bankruptcy.

Another Bain deal detailed by Kosman is KB toys. In order to make this profitable arrangement, Bain followed its practice of getting the corporation to accept the leveraged buyout by promising the executives huge bonuses. However, a few years after this deal went through, KP had to declare bankruptcy and it closed 600 stores and fired 5,000 workers. Of course, Bain and the KP were still able to collect $64 million. So much for being a job creator!

Private equity's reliance on corporate welfare can be seen in how they have lobbied Congress to be able to make tax deductions for interest payments. Since almost everything these firms do requires taking on huge debts, they are able to turn a profit by deducting their interest payments from their profits, and thus they can avoid paying taxes. Moreover, the bought companies are made to look to have profits through the deduction of interest payments, and by declaring a profit, the companies are able to take out more loans and pay higher dividends to investors and commissions to the PE firm.

Romney's America

If we now imagine Mitt Romney as president, we could surmise that he would continue the financialization of our jobless economy, and he would help to increase wealth inequality by pushing a system that reduces labor costs and shifts all profits to executives and financial investors. Furthermore, our tax base would continue to erode as the wealthiest would avoid paying taxes by declaring their income as deferred interest. In this return to a feudal economy, the lords of finance would rule over the impoverished masses, and there would be no job protections, benefits, or organized labor. As more jobs will be shifted overseas, we will witness the complete destruction of our middle class, and the divide between the haves and the have-nots will only increase. Let's hope an emboldened Gingrich steps up his attacks on Romney's vulture capitalism.