How Private Equity Firms Like Bain Capital & Berkshire Hathaway Make Money

There has been a media uproar about Mitt Romney and Bain Capital and how evil private equity firms, like Bain Capital are and how they "prey" upon other companies that are less fortunate. The media and others are claiming that Bain destroyed jobs and businesses and represent evil bad capitalists. Yet Warren Buffett and Berkshire Hathaway are heralded as the epitome of "good" capitalists, even though there is no difference between what Buffett's job is with Berkshire and what Romney's job was with Bain.

It is this utter simplistic ignorance with which people haphazardly wonder through life reeking intellectual havoc that creates controversy where there is none. Unfortunately, those talking about private equity are either intentionally lying to you, such as the case with Newt Gingrich or they have absolutely no clue as to what a private equity fund does within the scope of the financial services industry, such as the case is with Barrack Obama.

The question is not some quaint socialistic concept about a business' responsibility to society in creating jobs. It is instead the fundamental capitalistic Darwinian proposition of whether or not private equity companies created value for the shareholders. Because if they are creating value for their shareholders, then definition they are also creating value for society.

Many claim that private equity firms are evil Wall Street companies when in fact the vast majority of private equity firms are not located at Wall and Broad. Instead they are located all over the country in places such as Wyoming, Florida, California, Nebraska, and offshore in countries like the Caymans or the British Virgin Islands.

Private equity are the cowboys that risk capital to build or rebuild companies. And by doing so they often times create jobs. In fact, without private equity there would be approximately 60 to 70 percent fewer jobs created every year. Furthermore, there would be virtually no new companies created. Therefore, there would be no competition and in short there would be no capitalism.

Private equity covers a broad spectrum of different types of companies and investors. Types of private equity groups are hedge funds, venture capital groups, angel investors, and family offices. Within each of these groups there are a variety of business models. All private equity funds exist to invest money, make profits and protect capital for clients

The hedge fund manages the money and invests their client’s money based on their business model. Some hedge funds are created to invest in other hedge funds. These companies focus on buying stocks and bonds or commodities. They may focus on large cap blue chip stocks only or diversify into acquiring extremely well managed profitable medium and small cap companies. Some may focus on growth companies, while others seek value or companies that have been beaten up or that may be takeover targets in mergers and acquisitions (M&A). And still some hedge funds may be M&A funds that buyout distressed properties.

The venture capital (VC) groups are those that invest in startup companies. These guys take big risks to fund a company that banks will not fund. Between 60 to 70 percent of American jobs are created by entrepreneurs starting their own businesses and it is the VCs that take the risk and fund these companies. Some firms only invest in technology while others only invest in commodity type companies. Like hedge funds these guys invest other people’s money.

Then there are the angel investors who are responsible for providing the seed capital to startup companies in order to get them to the next level of funding with a VC or hedge fund. These are wealthy investors that invest their own money into companies. Angels must be “accredited” investors meaning they have at least $1 million in assets excluding their home and make $300,000 per year.

The Family Office is another type of private equity firm, which consists of a single or group of extremely wealthy families, such as the Rockefeller and Kennedy families. These investors generally consist of old family money, but are no longer in business and the only way they continue to protect and increase their wealth is through investing.

As stated earlier there are a variety of private equity fund types and each has a specific area of expertise, business model and function within the capital funding process. The darling investor adored by almost everyone (except me) is Warren Buffett who heads the private equity fund Berkshire Hathaway and then there is of course Bain Capital.

The difference between the two business models provides an interesting dichotomy. Berkshire is viewed as the good and moral capitalistic private equity fund, while Bain is perceived as the evil morally bankrupt “vulture” capital firm, at least as Newt Gingrich would have you believe.

Analyzing these two business models, coupled with the two men that ran Berkshire and Bain brings about many questions. The first of which is whether or not either business model is more or less moral than the other? Should Warren Buffett to be revered as a savior and portrayed as the model "good" capitalist any more than any other private equity guy? Isn’t Warren Buffett’s business model the same as all the others when it comes down to the final analysis -- he makes money for his investors? And if this is case, then isn't Buffett as evil and greedy as all the others? Or instead, are all the other private equity guys simply good moral capitalists like Buffett?

Two Opposing Private Equity Capitalist Business Models

To begin with Buffett only invests in companies that he understands. His other criteria are that they be well managed and very profitable. Buffett also invests in the big blue chip companies like Coca Cola and his primary industries are insurance and banking. Furthermore, Berkshire does not invest in startup companies, distressed companies (unless the distressed company is a large blue chip company that Buffett has inside information on coupled with a taxpayer funded backstop).

Buffett therefore, does not invest in companies that create jobs he invests in companies that already have created jobs. He makes extremely large profits because the companies he buys are the best companies in the industry with great cash flow, no debt, as well as having abundant assets and cash on the balance sheet. This allows him to strip out cash.

Also Buffett has never invested in a technology company in his history, that was until recently when he invested in IBM. Although IBM is more of a technology services company than a tech company like Cisco, Compaq, Motorola or Intel who actually manufacture tech products.

Therefore, it was companies like Bain that were responsible for all the technology capital investment that generated hundreds of thousands of jobs, built fortunes, created companies that went public which permitted pensions, mutual funds and 401k managers to invest in and build the retirement savings for people to retire. It also produced innovation throughout the world over the past 30 years that enhanced the productivity of existing companies and spawned new industries. However, Berkshire did provide the insurance to insure tech workers, and the banks where the tech employees opened bank accounts and the coke they drank while working all night writing code and creating new products.