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Bad Debts, Big Profits: How Private Equity Firms Turn Red Ink Into Gold

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One big question at the center of the private equity debate is whether firms like Bain Capital intentionally set out to burden the companies they take over with debt -- or whether things just sometimes go sour amid failed turnaround efforts.

Defenders of private equity say that piling up debt is nobody's idea of a good business model. People like David Brooks, who yesterday depicted private equity firms as heroic reformers of a bloated business sector, seem unable to imagine that "vampire capitalism" could yield much of a payday.

But, of course, if we have learned anything over the past few decades, it's exactly the opposite: predatory behavior with no productive purpose often does pay in an era of advanced financial engineering and perverse incentives. The leveraged buyout artists of the 1980s famously discovered this and made vast fortunes. Private equity firms, the rebranded heirs to the LBO movement, have found the same thing and one path to riches, it turns out, is by creating bad debt.

The financial reporter Josh Kosman has documented how this works in great detail in his book on private equity, The Buyout of America. Kosman covered the private equity world up close for years as a writer and editor for Buyouts Newsletter, The Deal, and Mergermarket.com. He had exceptional access to leaders in the private equity world and a ringside seat to numerous private equity deals.

A key point that Kosman makes in his book is that, in fact, it can be quite profitable for private equity firms to drive the companies they take over into debt, regardless of whether those companies then end up bankrupt. By taking over companies and having them borrow a lot of money, private equity firms create a pile of cash, some of which they can direct their own way in the form of management fees and dividends. And because interest on the debt is tax deductible, the consequences of reckless borrowing can be kicked down the line. This is exactly what happened with some of the companies that Bain Capital took over. Bain managed to make a huge return on its investments even in cases where companies failed. Creation of new debt made those profits possible.

David Brooks scoffs that "banks would not be lending money to private equity-owned companies, decade after decade, if those companies weren't generally prosperous and creditworthy." But, again, if we have learned anything in recent decades it is that financial institutions are happy to hand out easy money when well-connected insiders who stand to profit are pushing hard for that cash and somebody else can be left holding the bag. We learned that from the S&L scandal, when banks made billions in bad loans so insiders could profit and taxpayers paid the tab; we learned that from the Long-Term Capital Management meltdown when a bunch of "genuises" lost a fortune in borrowed money and almost wrecked the financial system; we learned it from the Internet bubble, when venture capitalists invested in anything with a .com suffix, cashed out after IPOs, and clueless investors took the hit; and we learned this hard lesson yet again from the real estate bubble.

Borrowing lots of money and incurring bad debts is not how real businesses make money in a normal world. But we don't live in such innocent times. Modern American capitalism is rife with sophisticated financial intermediaries who exploit flaws and complexity in the system, as well as insider connections, to make profits off of predatory behavior -- which brings us back to why the attacks on Bain Capital are both accurate and fair.

When Bain took over GS Technologies, the Kansas City steel firm, it put up $8 million of its own money, according to PolitiFact. The rest was put up by partners. Once it controlled the company, Bain had GS Technologies borrow $125 million by issuing corporate bonds. Bain then had the company pay out $65 million to shareholders -- including a $36 million dividend to Bain. GS Technologies then borrowed another $125 million, much of which was spent on modernizing its operations. Bain also reinvested nearly half of its earlier dividends.

The story gets more complex from there, according to PolitiFact, but the bottom line is this: When GS Technologies finally went bankrupt in 2001 it had $554 million in debt. Bain ultimately invested $24 million and ended up with a $50 million return, according to the Los Angeles Times.

PolitiFact's verdict: The Obama campaign's claim that Bain loaded GS Technologies with debt and hurt the company is "mostly true."

Something similar happened with Ampad, another company Bain took over and another focus of Obama attack ads. As Politico has noted, "The company went into bankruptcy in 2000, holding a debt load of more than $400 million. Bain's return on its $5 million investment was $100 million."