Tuesday, August 21, 2012

Like most investments, private equity firms are good for the economy

Commentary by James H. Shott

The purpose of every investment – however ordinary or unusual; however simple or complex – is to make money through earned interest or dividends, or profiting from sales of items, services or businesses.

Whether it is a passbook savings account or a Certificate of Deposit; corporate or municipal bonds or shares of stocks; your employer’s pension plan that grows in value to fund retirement; investing in a business and working to have more revenue than expenses; or investing in a private equity firm that buys existing businesses and hopes to build the value of those businesses, profit is the reason people invest.

Nearly everyone understands and accepts that they should collect earnings from a savings account or a stock purchase, but many of these same people are horrified when business owners sometimes make a good living or private equity firm partners make significant money in their activities.

Some seem to think that the purpose of business is to achieve social goals, and try to impose all sorts of their favored ideals on the business world. While many businesses do support community or charitable programs, these are secondary activities. Making a profit so they can remain in business is their primary purpose.

Like every other investment, the purpose of putting money at risk by investing in a private equity (PE) firm is to make a profit, and PE firms do that by buying companies and selling them. They don’t buy successful companies because the price of a successful company is already high, and trying to make a successful company even more successful, and therefore more valuable, is mostly a no-win situation.

Instead, they buy companies that are failing or underperforming, because like a house that hasn’t been taken care of and needs a lot of work, these companies can be purchased at a relatively low price.

Perhaps the company needs to upgrade its equipment or processes; maybe management is stagnant, failing to make good decisions or timely decisions; or it spreads production components too thinly over too many products; or sometimes it must reduce employment to save the company. A fresh look by new owners with particular expertise in what the company does may very well turn it into a profitable entity. That is the bet that private equity firms make.

The firm then uses its expertise to recommend steps to improve the operation and performance, and the company most often prospers, grows, and creates jobs. The improved company is naturally more valuable than when it was purchased, thus the selling price is higher, and sometimes much higher. In three to five years the PE firm would sell the company at a profit, making money for its investors.

This isn’t magic. This isn’t criminal. This isn’t greedy. It is purely logical. And, furthermore, it was the intention from the start, along with producing the positive economic benefits it created and the products and services that it produced to satisfy the wants and needs of consumers.

So, the people investing in private equity firms put their money on the line, risking it on the hope that the firm will successfully buy and turn around poorly performing companies, and sell them at a profit.

However, private equity firms do not always succeed in turning around a purchased company, and in such cases the failed company is closed and people lose their jobs, and yes, the investors lose money.

The private equity folks can’t win. They get criticized as greedy when they succeed in turning around a failing company and then selling it for a handsome profit, and when it fails to turn a company around and the company closes and people lose their jobs, they get portrayed as profit-hungry, selfish capitalists.

What many people do not or cannot understand is the fact that the companies PE firms cannot save likely would have shut down had they not stepped in, and likely much sooner if it had not been acquired. And then there are those who use the pain of lost jobs and closed businesses as opportunities to further their political goals.

This is yet another example of how the American public’s abysmal understanding of how the economy works not only impedes the process of implementing favorable policies that will allow the economy to grow, but also arms demagogues with tools to take advantage of us for their selfish purposes.

There are other facts that need to be emphasized. First, if PE firms weren’t successful most of the time, savvy people would not invest in them. And, private equity investors use their own money in these endeavors, rather than taxpayer money, so no public money is lost in the relatively few times that they fail to turn a company around.

In “American Restoration: The Role of Private Equity,” an article on the Heritage Foundation’s website by J.D. Foster, Ph.D., the author explains that private equity firms “don’t always succeed. But their very existence and the [large] profits they reportedly make testify that they succeed far more often than they fail, and a lot of Americans can thank their continued employment to the prowess of these American restorers.”

Cross-posted from Observations

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