Private Equity Companies: How They Work & Make Money

Not many people seem to know exactly how private equity firms work. And judging by the media coverage and the comments by the average American, there is some misperception and confusion about private equity firms and their function. In fact there is so much confusion that the media claims a private equity firm such as Berkshire Hathaway, operated by Warren Buffet, is a “good” capitalist private equity firm, but a firm like Bain Capital is considered a bad evil capitalist firm.

The media would have you believe there is such a thing as a good and bad private equity company. That is unadulterated nonsense. A private equity firm is responsible for making money for shareholders and protecting their capital by investing in sound investments. And it is precisely why investors invest in Berkshire -- they make money. In fact that is the quality that makes Berkshire good or desireable. And all the other stuff about Bain destroying jobs or preying on vulnerable companies is media hype motivated by pure politics. In fact the argument against the private equity industry is a complete fraud.

Of course there are a number of different methodologies and models that private equity firms follow. It is based on the type and structure of the private equity company. However, in the following example we will analyze the differences in a private equity firm like Bain Capital, which is essentially a restructuring firm specializing in “distressed” (companies facing imminent bankruptcy) companies, relative to a Berkshire Hathaway company.

To begin with, distress companies are organizations that are heavily in debt and can no longer service their debt obligations to their creditors, which include their banks. Without an infusion of capital distressed companies go out of business. This results in laying off all employees and liquidating (selling) all corporate assets. All the money raised from the sale of assets goes to paying off creditors who usually are receiving pennies on the dollar.

Let’s say for instance a company called Obamanista Corp which is in trouble and facing imminent bankruptcy. They have 2,000 employees and need $100 million. One of the problems the company is facing is that they are in the steel industry and have high union paid jobs with high medical and pension benefits to deal with. These extra costs increase the cost of their steel relative to lower cost steel produced in “right-to-work” states and international competitors such as China and Brazil. In order to continue operations and keep people working the company lowers its price to compete. This strategy keeps people working, but results in the company losing money. Over time the company cannot sustain the losses and must file for bankruptcy protection because the banks are attempting to force management to liquidate assets.

Bain Capital, a private equity group that has amassed billions of dollars from investors around the world who pay Bain to manage their money, will risk their capital to save a company similar to the Obamanista Corp. Bain’s business model is buying distressed companies that have a good business model that can be restructured (made profitable by changing operations). These companies will most likely be heavily indebted, have low cash flow, poor operations and management, inadequate cash reserves, highly leveraged assets (assets/property that is used as collateral against a bank loan) and other issues.

Berkshire Hathaway on the other hand only buys out companies that are extremely profitable, well organized, excellent management and great operations personnel. Buffets model is predicated on acquiring the best in best class with great management and cash flow, a superior market presence, excellent revenue and profit margins and dominance in their sector. The only time Buffet will invest in a struggling company is if the company is backed by taxpayer money, like GM or Bank of America or the company has an inside connection to the government such as Goldman Sachs.

Therefore, the only savior or white knight that a company like the Obamanista Corp has is a private equity firm that has experience, the capital, and expertise in turning distressed poorly managed companies around.

Obamanista Corp may hire a company like Goldman Sachs to advise them on how to restructure as well as assist with the financing. Goldman contacts Bain Capital because Bain is noted for buying out and restructuring companies that are facing bankruptcy. Management with the Obamanista Corp want a loan. Bain says no to the loan, but will buy the company provided they have command and control over the entire decision making process.

Obamanista Corp management and Bain agree to the terms and Goldman advised Obamanista management on deal. Goldman receives an advisory fee and may put up some capital with Bain being the major investor. This results in initially saving 2,000 jobs and prevents a bankruptcy. Bain gets control of the company and the company receives $100 million.

However, Bain management finds upon conducting further due diligence that upper management at Obamanista Corp has been mismanaging the company and has twice as many employees as needed for the amount of revenue they are generating. In addition the company is paying their workers one third more than that of their competitors and the union medical and pension benefits in the future will eventually destroy the company regardless of what Bain does.

Bain management completes a top to bottom analysis of the company and determines that what Obamanista Corp management has done is fail to implement cost efficient technology, botched negotiating sensible employment contracts with the union and mismanaged capital allocations and investments.

Bain management fires all Obamanista top management and replaces them with new proven successful management. The company then looks at midlevel management and finds there are twice as many white collar employees as needed essentially duplicating work. Bain fires half the unnecessary mid level white collar workers.

Bain then assesses the company’s production efficiencies and goes on to retool by adding new equipment and technology which reduces the work force by half because of adding the new equipment. The production efficiencies obtained allow the company to increase production and product quality. However, the remaining union employees are asked to restructure the contract so that they can get in line with the competition. Bain warns the union that the union contracts are either restructured or the company is moving operations.

The union challenges Bain by going on strike in order to demand not smaller cuts, but an increase in pay and benefits -- to which Bain responds by shutting down the company and moving operations to another state. The result is that the remaining 1,000 employees lose their jobs and the community loses another business.

However, another 1,000 employees in another state get new jobs and another community benefits from the arrival of another business. In addition the new cost savings allows Obamanista Corp to lower prices, thereby gaining a competitive advantage and increasing market share. Increased market share results in higher product demand to which the company adds more employees and another shift.

Because the Obamanista Corp moved to a right to work state the employees wages are less than what the union contract was, however the lower cost of living in the right to work state, the no state income tax, lower housing prices, reduced property taxes and the improved working conditions from automation and a restructured benefits package made up for the difference.

At the end of the day, Bain’s job is to turn the company around and then sell their stock for a profit. This may involve selling the company to another company or by completing an initial public offering (IPO). Regardless of how they structure the sale Bain’s work makes US companies more competitive, creates and keeps jobs in the United States, improves product quality and efficiencies, enhances the state and local community tax base, modernizes plant and equipment and creates a strong company that takes jobs, sales and revenue from international competitors and brings them to the United States.

Essentially, when you look at the differences between Berkshire and Bain the stark reality is that Bain is the private equity company that takes risks, rebuilds companies, creates jobs, invests in plant, equipment and human capital, rebuilds communities, adds to the local, state and federal tax base, improves working conditions, retains jobs and manufacturing businesses in the United States and in general creates a strong vibrant company so that someone like Warren Buffet can then come in and reap the rewards.