What Is Private Equity?

The Presidential campaign's focus on Mitt Romney's record at Bain Capital suffers from a confusion about what private equity is. Steven Rattner starts to lay this out in a NYT column, but I think the issue could still benefit from some clarification.

The rubric private equity covers a number of very different investment strategies. It is sometimes used to refer to venture capital--funding of small, young, privately held companies that are looking to grow. Many of these companies fail (think of the vast graveyard of failed Internet startups, including my own), but expansion is the goal. 

Alternatively, private equity can refer to investment strategies that involve taking public companies private and restructuring the company with a goal of taking the company public again several years in the future. This is the leveraged buyout or LBO strategy. The acquisition of the target company is done via a tender offer financed by a small (or occasionally no) equity contribution from the LBO sponsor (e.g., Bain) and a lot of bank debt, whic his secured by all the assets of the target company. The sponsor ends up owning the target and puts its own management team in place.

Unlike a VC investment, which is looking to grow a company, an LBO sponsor is typically looking to slim down the target company and make it lean and mean--which it has to be in order to service the very high debt load incurred in the LBO. And that often means firing people. Thus, even when an LBO works, it doesn't necessarily result in job creation. When and LBO fails--the target company isn't able to service its debt--the result is usually bankruptcy. What happens to the employees then really depends, but I wouldn't want to be in their shoes. 

To grossly oversimplify, we might think of VC as a more socially benign type of investment than the LBO. The best case for the LBO socially is that it is akin to culling a herd to make the rest more viable. It's tough love. A longer normative post on this is to come, but I think it's important to get the definitional issue squared away.  

What confuses the private equity definitional issue with Bain is that Bain did not do either strategy exclusively. Rattner explains that Bain shifted from VC investment to LBOs. Romney likes to emphasize Bain's VC work, Obama likes to emphasize the failed LBOs. I think the more interesting issue is why Bain shifted from VC to LBOs. That's something to take up in the normative post, however.