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Private Equity: Heads We Win, Tails We Win

David Callahan

Among the biggest complaints about the financial industry is that it always seems to do well, even when disaster strikes for everyone else. Investments bankers, venture capitalists, and even stock analysts (like Henry Blodget) made millions during the dotcom boom, getting rich and then getting out before that bubble crashed. Wall Street did even better during the real estate bubble, bundling subprime mortgages, with many key villains in this story walking away with hundreds of millions of dollars before everything fell apart.

Now, as we learn more about private equity, we are discovering that this corner of finance is especially adept at always profiting, no matter what happens. The key to this success is extracting wealth after takeover deals in the form of fees.

As the New York Times reported over the weekend, Bain Capital consistently made money in nearly all its deals under Mitt Romney's leadership even as some of the companies it took over went bankrupt: "Bain structured deals so that it was difficult for the firm and its executives to ever really lose, even if practically everyone else involved with the company that Bain owned did, including its employees, creditors and even, at times, investors in Bain’s funds."

And how did it accomplish this feat of magic? Fees.

The numerous fees collected by private equity firms have been a frequent lightning rod for the industry. First, the firms charge their investors a percentage of the fund as a management fee, meant to cover its overhead. During Mr. Romney’s tenure, this was initially 2.5 percent and then dropped to 2 percent. Private equity firms also collect transaction or deal fees, ostensibly for advisory work, from companies they buy. These fees are generally collected for major transactions, like the purchase of another company, a public stock offering or even the initial acquisition of the company. A third fee stream comes from annual monitoring or advisory fees that portfolio companies typically pay to their owners, the buyout firms.

These fees can be substantial. In the case of Dade International, a medical supply company in which Bain acquired a stake in 1994, Bain and other investment firms piled up nearly $90 million in fees over seven years. The company filed for bankruptcy in 2003 but not before it had borrowed heavily to pay $420 million to Bain and other investors several years earlier.

In 1998 alone, Mr. Romney’s final full year at Bain, The Times was able to identify roughly $90 million in fees collected by the firm across its various funds, a figure that is probably low because most companies in Bain’s portfolio did not have to file financial disclosures.

In some cases, as the Times details, Bain collected fees right up to the point that the companies it controlled declared bankruptcy.

Heads we win, Tails we win. What's not to like about this business strategy? Unless, say, you happen to work in one of the firms that goes under even as a bunch of financiers get rich.