The private-equity problem with Romney and GS Technologies (UPDATED)

Loading up a company with debt to ensure Bain's own profits

It’s seriously grating to see an Eton and Oxford-educated ambassador’s son who works for the Council on Foreign Relations rant about Obama’s “populist” attack on private equity.

That’s Sebastian Mallaby, who takes to the Financial Times to defend Mitt Romney and Bain Capital’s honor, as well as the honor of the private-equity industry at large. Here’s the top:

Having hit the rich with the promise of a Buffett tax, the Obama campaign is rolling out its next populist gimmick: an attack on private equity. A series of lurid campaign commercials goes after Mitt Romney for his record at Bain Capital, a company that, in the advert’s telling, behaves like a “vampire”. “They came in and sucked the life out of us,” a steel worker says in the first commercial. “It was like watching an old friend bleed to death,” says another.

Never mind the emotional manipulation; the ad is factually wayward. In 1993, when Bain bought the steel plant in the commercial, it was a saviour: in the absence of a buyer, the plant would have closed. Bain provided a transfusion of $100m to update the plant’s machinery - it was a blood bank, not a vampire - and its investment succeeded for a time. Only in 2001, two years after Mr Romney had left Bain Capital, did the plant succumb to foreign competition and go bust.

It’s Mallaby who is factually wayward. He fails to mention private-equity critics’ major beef with Bain’s behavior here: It borrowed scads of money against GS Technologies (the company referred to in the ad) to ensure its own profit—at the expense of GST.

The big problem with private-equity is when firms make profits off companies that go bust, particularly when those profits directly contribute to the companies going under.

Bain bought control of GST for $8 million in 1993. Within months, it had borrowed $61 million to pay off shareholders. Bain itself got most of that—$36 million—more than quadrupling its initial investment (though it would later put about half of this back into the company to acquire another one).

Mallaby insists GST was in serious trouble when Bain and its partners purchased it. So it makes it even more problematic that Bain & Co. et al. (UPDATE: I referred clumsily to Bain Capital and GE Capital here since “Bain & Co.” is the name of Bain’s original consulting firm, which is a separate company) put GST in more trouble by levering the firm up to pay Mitt Romney et al. a dividend.

If you own a struggling business and you’re not a leech, you don’t use cashflow for special dividends that could be used to pay down debt or to reinvest in the business. That’s why it’s so egregious that the Washington Post Company has handed shareholders more than a billion dollars in the last four years even while its namesake business collapses. The New York Times Company, by contrast, has suspended its dividend, which is what responsible companies do when facing a life-threatening rough patch.

GST had very little debt when Bain purchased it in 1993, according to SEC filings. By the end of Bain’s first year of ownership, it had roughly sextupled GST’s annual interest payments. Within three years, and after borrowing to merge with another company, GST’s interest payments had exploded, up 27 times more than the pre-Bain era, while revenue was just 2.3 times 1993 levels and operating profits quadrupled.

GST’s outstanding debt rose from $13.2 million when Bain acquired it in 1993 to $385 million in 1996, and the company went from paying $1.6 million a year in interest to paying $42 million. Taxpayers would eventually get stuck with $44 million pension tab when the company filed for bankruptcy.

So it’s misleading for Mallaby to claim that “Bain provided a transfusion of $100m to update the plant’s machinery - it was a blood bank, not a vampire.” Bain didn’t provide anything. Bain’s banks did. Bain loaded that $100 million onto GST’s balance sheet. It didn’t put its own capital into the company, and it had nothing at risk. It had already paid itself back big time for its original, puny $8 million equity investment.

David Brooks of The New York Times also makes the Bain-as-savior mistake in a wildly wrongheaded column on how leveraged buyouts and corporate raiders supposedly saved American capitalism, an incorrect argument his colleague Paul Krugman, as usual, debunks.

Bain made money while its investment went bust—in no small part because of the debt piled on it to ensure Bain made money—and hundreds of people lost their jobs (this isn’t to mention that the industry games the tax code to make its money and that its profits are taxed at less than half the rate of other workers via the absurd carried-interest tax break).

That’s why elitist (cough) defenses like Mallaby’s and Brooks’s are so flawed.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum. Tags: , , , ,