The phrase “job creation” always makes me a little queasy. The personal computer has probably contributed to the elimination of tens of millions of clerical jobs, yet I think most of us feel that computers are a good thing: they make people more productive, meaning more goods and services for everyone . . . and hopefully the people who lost those jobs will find work doing something else. In boom periods, like the 1990s, it seems to work, at least for most people, but I doubt that there’s any proof that productivity-increasing innovation always increases employment. But this line of thinking quickly leads to questions like whether the invention of the automatic toll booth is a good thing (because it eliminates what must be a pretty unpleasant job) or a bad thing (because it results in the layoff of people who may not have good alternatives), and those questions are above my pay grade.
Anyway, job creation these days usually refers to growing companies, making stuff people want, which tend to hire new workers—leaving aside the question of whether the products they make are causing other people to lose their jobs. This is the kind of job creation that Mitt Romney (and the private equity industry, at least publicly) wants to be associated with.
But private equity, as I wrote about recently, is just a way of taking over existing companies. While it’s possible for a private equity fund to invest in growing companies, they are more likely to invest in mature companies, for various reasons: it’s easier to borrow money against a company that has hard assets; mature companies are more likely to have the kinds of inefficiencies that build up over decades of poor management; you need steady cash flow to service debt, and high-growth companies are often spending most of their cash flow on new investments; and you’re more likely to find undervalued companies in sleepy industries.
Taking one step back, private equity firms are just investors. The contemporary glorification of the investor class is based on the idea that their money is what fuels the creation and growth of dynamic companies. And in principle, that’s true—if the investors are contributing new capital to a company. If you buy newly issued shares of stock in a company, you are giving it cash that it can use to grow (build factories, research new products, hire workers, etc.). The same is true if you buy bonds issued by that company (although the proceeds from the bond sale may be going to by back shares from other investors). But if you buy shares on the secondary market, you are not contributing new capital. (You are providing benefits to the economy, but they have to do with pricing and liquidity, which have an indirect impact on providing new capital to businesses.)
Private equity firms, in general, are buying shares on the secondary market (this is what “taking a company private” is all about), not contributing new capital. They are not increasing the amount of cash available for investment by companies. In fact, since they make money by paying themselves special dividends, they are reducing the amount of cash available for investment. In some circumstances this may be the best thing for shareholders, but it certainly has nothing to do with job creation—especially since we know that the dividends paid back to those private equity funds are only going to be used to buy more mature companies. The goal of a private equity firm is to make its companies more profitable: sometimes that means new products and new jobs, but it can just as easily mean the opposite (eliminating unprofitable product lines and fewer jobs).
So who is investing in new, high-growth companies? In the technology sector, at least, it’s largely venture capital firms. Venture capital and private equity firms have similar structures, they charge the same outrageous fees and share the same ludicrous carried interest exemption, and their partners tend to be very rich, but the similarities end there. When VC funds invest in a company, they usually buy newly-issued stock (convertible preferred shares), which means new cash is available for investment and hiring. In early-round deals, at least, they don’t take money out in fees and dividends. And while private equity firms need to maximize current profits to pay off all the debt they load onto their companies, venture capital firms are often willing to sustain losses for years in hopes of building something new.
Venture capitalists have numerous flaws, of course. In later rounds their interests can diverge from the company’s interest, and they have a tendency to think they know more about running a company than they actually do. (That seems to happen to people who become very rich managing other people’s money.) But the basic function of the industry is to collect capital from investors and funnel it to new companies building new things and hiring people. The same is not true of private equity.
This post originally appeared at The Baseline Scenario and is posted with permission.
One Response to “Private Equity and ‘Job Creation’”
[...] will allow him to create jobs. Let’s take a quick look at his job creation legacy. It is not clear whether his time at Bain Capital created jobs on net or eliminated jobs on net. Either way, they [...]