Mitt Romney, Taxes, and Private Equity

Mitt Romney released his tax returns the other day, and the results were unsurprising.  Over the last few years, he's paid around 15% of his income in taxes (around what most of the middle class pays, if not less).  He likely kept some money on deposit in the Caymans for tax purposes.  And, like all good Mormons, he donated a chunk of his money to the Church.  None of that is, legally or morally speaking, wrong.  Romney paid all the taxes he owed.  It does invite scrutiny of the ridiculous 15% tax rate for "carried interest" that private equity execs like Romney pay (even most PE folks privately admit that it's ridiculous that their gains aren't taxed as ordinary income), but that's not the purpose of this post.  Rather, Romney's tax returns invite a welcome discussion of the private equity industry, how it works, and what skills its practitioners have.

Romney's been running for President on his business background.  And there's no doubt that he's been a successful PE executive.  While author and former Lazard and JPMorgan banker William Cohan had an interesting piece a few weeks ago suggesting that the way Romney ran Bain Capital bordered on unethical by Wall Street standards, Bain nevertheless regularly generated outsize returns for its investors and employees.  The real question, though, is whether this success is an asset for a President running a country.  Now, first and foremost, I'm very skeptical of the idea that running any business somehow qualifies someone to run a country.  Paul Krugman had an exceptionally persuasive piece more than 15 years ago arguing as much.  The reasons are pretty simple-- whereas businesses focus on maximizing profits and competing with other businesses, economics is by no means a zero-sum game; businesses sell to the broader public, while countries primarily produce for their own citizens, meaning that, where a company can freely lay off workers without impacting its bottom line in a negative way, laying off workers in an economy necessarily diminishes the consumer base.  There are also operational reasons countries and companies have next to nothing in common (a CEO has a lot more control over a company's agenda than a President has over a country's policies), but that's also not the purpose of this post.

What I'm focusing on, rather, is the narrow claim of the private equity executive as job creator that Romney is seeking to sell.  And that's an image that is patently pretty false.  To begin with, one has to understand what precisely PE firms do.  PE is a re-branding of the old leveraged buyout (LBO) business that began to boom in the 1980s.  The process is rather straightforward-- a fund pools money from investors (pension funds, mutual funds, and rich folks), then looks for companies that it thinks are managed inefficiently.  The fund then puts up a small chunk of equity (its own money), then takes out a heavy dose of debt.  But the debt, rather than being taken on by the fund, is taken on by the acquired company.  In essence, the PE fund takes out a mortgage on a company in the same way you take out a mortgage on a house-- it borrows against the company's value, pledging the company and its assets as collateral for the loan it takes out to buy the company.

It then gets to work "streamlining" the company.  This involves a few steps.  Workers are fired, divisions are spun off or sold, costs are cut, and, when the process is over, the company is either taken public again, sold to another company or fund, or, more likely, declares bankruptcy.  All the while, the PE fund is taking fees.  There are fees for completing the purchase transaction, fees for "managing" the portfolio company, dividends declared on the stock owned by the fund, etc.  So even if the company declares bankruptcy, the PE fund still comes out ahead in essentially every case.  If the company defies the odds and goes public again, the PE fund makes a HUGE bonanza.  But even bankrupting a company makes PE funds a hefty chunk of change, so it's essentially a win-win for them.  Crucially, stockholders also come out ahead.  To do an LBO, stockholders have to sell out, and selling out means the acquiring fund has to pay a pretty heavy premium over the market price of publicly traded stock.  Typically, this premium is at least 25%.  So shareholders get paid around a $5-8 a share premium on a stock trading at $20 a share and (mostly) go home happy.

So who loses?  Well, simply put, the employees.  Leveraged buyouts involve "streamlining operations", and "streamlining operations" is a nice euphemism for "firing people."  The other losers are creditors. If we had perfect credit markets, no one would lend money to a company that could be a takeover target.  But... as we've seen over the last decade or so, lenders do dumb things.  So the result is a transfer of money from creditors and workers to private equity execs, their investors, and shareholders.

The final issue is the claim that the PE industry "creates value".  That is, amid all this shifting, the fundamental question is whether the economic pie is made bigger by the presence of the buyout funds.  If it is, then there's a pretty good case to be made for their existence.  If there isn't, there's a case to be made that these people are making hundreds of millions of dollars essentially to move money around.  The evidence on this count is disputed, but Andrei Shleifer and Larry Summers had a pretty compelling piece almost 25 years ago arguing that leveraged buyouts amounted to a wealth transfer in which little to no value was created, involving the breaking of covenants between the acquired companies and their creditors and workers.

Even if all of these problems are accurate, there's no easy fix for it, from a regulatory perspective.  But at the least it invites scrutiny of Romney's claim that running a buyout fund is some kind of special qualification for an aspiring President.

Chelsea and the problem with relying on African players

This morning I watched Chelsea put together another frustrating 0-0 outing against a middling team (to a team that's allowed more goals than anyone outside the bottom 5).  It highlighted what's become a semi-annual theme for this team: the January lull.  And the reason for that, I think, is the way Chelsea's teams have been constructed.  More than any other big side in Europe, Chelsea relies on African players as core pieces.  Now, when most soccer fans think of Chelsea's success in the Abramovich era, they think of John Terry and Frank Lampard.  And those two have certainly played a valuable part.  But I'd argue that the most indispensable pieces haven't been Terry and Lamps, but rather Didier Drogba and Michael Essien.  The case for Drogba is pretty straightforward-- he's an absolute beast.  On his day, he was (and still is, really) unplayable.  Drogba is big, he's great in the air, he moves exceptionally well for a guy his size, he has one of the best shots in Europe, and he can create opportunities out of thin air.  Essien's case is a bit harder to make now, since he seems to spend 2/3 of every season injured.  But, 3-4 years ago, you could make a pretty good case that he belonged in the top 10 players in the world.  Essien was fantastic-- he covered a ridiculous amount of ground, was a very good tackler, got forward well, scored goals, and could play any position, from attacking center mid, to right back, to center back.  Most guys who can play that many positions are at best decent at all of them-- Essien was passable as a center-back, good as a right-back, and easily one of the 5 best central midfielders in the world.  He was a special player.

So why is relying on these two guys such a huge problem? The answer is, simply, the Africa Nations Cup.  The ANC is the worst tournament in global soccer.  Where most international tournaments occur every 4 years (World Cup, Euro) or, at worst, semi-irregularly (Copa America), the ANC happens every other year. And, where rational tournaments play during the summer, the ANC is in January.  In other words, smack in the middle of the season for all of Europe's biggest leagues.  Meaning that, every other year, top teams ship all their African players (because just about every African player good enough to play for an elite European club is also playing for his national team) away for the month of January.  For most clubs, that meant, at worst, 1 central player, and maybe a peripheral player or two (Barca in its day would lose Samuel Eto'o and, for a brief minute, Yaya Toure and/or Seydou Keita; Arsenal would lose some combination of Emmanuel Adebayor, Alex Song and Kolo Toure, who were never all key players at the same time; etc.), Chelsea would lose 2 of its most important players, plus a few guys who were in and out of the first XI (John Obi Mikel, Salomon Kalou).

This post isn't really as responsive to today's match as it is to the last few years (Essien didn't go to Africa this year, as he's retired from the international game, and just came back from a knee injury anyway), but the idea hit me over the head again today, as I watched Chelsea struggle to unlock a pretty weak defense and wondered what might have been different if Drogba, instead of the struggling Fernando Torres had been leading the line.