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Private Equity Analysis: Do We Need More Mitt Romneys?

Democrats have attacked Mitt Romney’s past as a private equity executive. Republicans have held it up as an example of hard work, intelligence and management skills.

Opponents of Romney and Bain Capital’s private equity strategy claim that it sends jobs overseas and shutters businesses. Proponents argue that this makes the economy run more efficiently.

These competing views have been argued ad nauseam and studied in-depth. Yet, it’s still not clear which side has a stronger case.

No – I won’t settle that argument today. Instead, I’d like to explore two questions that haven’t received as much attention.

Does private equity make money for investors?

And do private equity investments foster innovation?

In other words, are investors and consumers better off with more (or fewer) Mitt Romneys?

Let’s take a look…

The Investor Side

To get an idea of whether or not it pays to invest in a private equity firm, we first need to look at Bain Capital in particular.

And there’s no better place to start than with the claim circling the internet that Bain returned 113% per year.

Don’t believe it – 113% is an impossible number. (If you do the math, it would mean Romney should be a trillionaire by now.)

The Wall Street Journal recently did an investigation of 77 of the companies in which that Bain Capital invested. Many went bust. A few became big successes. You should expect skewed returns like that in this type of investing.

In truth, the best estimates for Bain’s return to investors is somewhere in the 20% to 30% range.

That still sounds impressive. But keep in mind that it’s all due to leverage. If an individual investor could borrow massive sums like a private equity firm and invest them in regular stocks, they’d do just as well.

As Brett Arends, author of the biography, The Romney Files, explains: “From 1984 through the end of 1998, the stock market overall produced gains of nearly 20% a year. If you had leveraged each dollar with $2 in debt at corporate interest rates, your returns would have ballooned to nearly 30% a year. If you’d been able to borrow $3 at corporate interest rates, you’d be up towards 35% a year. That’s how much money you could have made by issuing company bonds and then spending the money picking stocks out of the paper at random.”

Indeed, what makes a private equity firm successful isn’t the ability to invest, but it’s the ability to raise large sums of money and justify the high fees they pay themselves to investors.

So the answer to the first question – Does private equity make money for investors? – is no.

The investing world certainly doesn’t need any more Mitt Romneys to take our money and charge more fees for standard returns.

The Consumer Side

Investors might be better off with less private equity. But the same might not be said about consumers.

A new working paper from the National Bureau of Economic Research has found proof that private equity investments foster and accelerate innovation.

Now, these innovative companies are usually small and private, so gauging returns is no simple matter. But the researchers on the paper got their hands on a unique data set.

By tracking the activities of nearly 500 small companies that were part of the Small Business Innovation Research Program, the progress of innovation could be measured separately from stock returns.

The study measures four different signs of innovation: Has the company licensed the technology it’s developed? Has it sold the technology rights? Has it entered a joint venture agreement to develop the technology? And has it entered a collaborative research and development effort with others?

All these are signs that these small businesses have made progress towards real innovation.

And they discovered that when you throw a private equity investment into the mix, that innovation surges. More specifically, the probability that a company follows at least one of those innovation paths leaps by 40%.

It could be that the money from private equity allows these firms to flourish. Or maybe the pressure for results from investors leads to quicker progress. It could also just be that private equity firms hunt out the most likely innovators.

Either way, from a consumer perspective, it’s clear that more private equity would be better, since consumers benefit when innovation thrives.

Of course, in an ideal world, we’d have investment professionals who foster innovation and create economic efficiency, while not charging exorbitant fees and taking on excessive leverage.

But face it, that’s less likely to happen than a truly honest man making his way into the Oval Office.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk