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Evaluating the Merits of Private Equity

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Mitt Romney's career as a private equity manager has suddenly become a hot issue in a party that normally avoids any criticism of the business community. We've heard Rick Perry describe private equity as "vulture capital." Newt Gingrich has painted Romney's former firm as a business equivalent of the Grim Reaper while subtly connecting it to the '08 bailouts.

A wild and weird Republican primary season just keeps getting wilder and weirder.

Sean Hazlett who writes at Reflections of a Rational Republican is an investment banker and analyst. He's put together a fantastic explanation of what private equity is and why it's an issue.

Why private equity is seldom an option for middle income investors:

Anyone can gain access to the public equity markets, but only those with a high net worth or annual income can invest in private equity transactions. The American people can thank the United States government for these restrictions, which set criteria for "accredited investors". In other words, the government has erected barriers to entry for people to invest in this asset class based entirely on net worth and/or income. However, that is a topic for another day.

The objectives of private equity firms:

Both venture capital and buyout firms have an exit orientation. In other words, they can only truly make money for their investors by selling the companies they help fund or turnaround. They can either sell these companies to other private equity firms or public companies or to public market investors by floating shares in an IPO. If the company turns out to be a dud, they can liquidate that company's assets, often for pennies on the dollar.

Hazlett goes on to explain how different types of private equity players might approach a particular business and why some may be more resented than others. On the merits of private equity he reaches the conclusion:

In most cases, buyouts still likely save more jobs than they destroy for the simple reason that many mismanaged companies would have gone out of business in the absence of a buyout firm's rescue. Of course, there will always be exceptions, but in the end, the buyout side of private equity can be either a force for good or evil, depending on how one uses its tools.

The GOP candidates who criticize Romney over his involvement with Bain are largely missing the point. The interesting question isn't whether Bain created or destroyed jobs. It did both at different times and under varying circumstances. The greater concern is that we may have built perverse incentives into our business law and the tax code that reward liquidation over business development.

The fact that Republicans are debating (or almost sort-of debating) the merits of certain business practices is a ground-breaking development all by itself. Hopefully it will build into some wider soul searching about economic assumptions that have gone unquestioned for too long.