The kerfuffle over Mitt Romney's tenure at Bain Capital reveals a troubling ignorance of basic economics. The surprise is the ignorance found a home with two Republican presidential candidates; Newt Gingrich and Rick Perry say Romney is a "vulture capitalist." Of course, it could be simple political opportunism on Newt and Rick's part.
Why do private equity firms, corporate raiders, takeover firms or "vulture capitalists" exist? Can or should we do without them? The creative genius of capitalism is that resources are directed to their most efficient use automatically by the pursuit of individual self-interest. This is economist Adam Smith's "invisible hand" at work; it is also the "self-organization principle" in science (evolution is an example of self-organization, as is the origin of the universe).
Most people understand how raw materials and labor get reallocated to different jobs by the willingness of employers to pay higher prices and wages. But, how do factories, machinery/equipment, trucks or trains get moved automatically from one application to another? The answer: This is what private equity firms, corporate raiders, takeover firms and "vulture capitalists" do; they are engineers of "creative destruction."
A corporation creates wealth when the whole is more valuable than the sum of its parts; if the firm's market value (equity and debt) exceeds the sum of all of its assets sold separately, it creates wealth. The asset market value is what others would pay for the use of those assets. When the firm creates wealth, no one has a use for those assets that is superior to their current use.
Alternatively, a firm reduces aggregate wealth when it is worth more dead than alive; when the assets' market value is more than the market value of its debt and equity, the firm creates negative wealth (the whole is worth less than the sum of its parts). It also means the assets held by this firm could be used more productively elsewhere.
The trick is to figure out what the market value of the assets might be, particularly since those in the best position to know the value are the incumbent management. If that management is negligent or corrupt, they have a strong incentive to hide the true market value of the assets in order to protect their jobs. This prevents the assets from being used by those who have a higher end use for the assets and it reduces national wealth. Take note if you are upset by managerial abuse.
The venture capitalist's purpose is to find firms with negative wealth or firms that are about to go bankrupt, but might be saved by major restructuring. In either case, it is a risky business; they may misjudge the market value of the assets or they may be wrong about the firm's survival prospects.
There are no guarantees where these people play. If they guess right about the value of the assets, they can acquire control, sell all the assets, pay off all the debt, and have a tidy profit at the end.
Why should the general public care about this? What's in it for us? The most important reason is the process reallocates capital assets to applications that are more productive than their current applications. When successful, the firms can hire more people and pay them better wages. The process may fail when economic trends work against the firm and it goes bankrupt anyway. These firms stay in business by being right more often than they are wrong. Since private equity firms are in business to look for these opportunities, the process is constant and automatic.
There is a second reason we should approve of these activities: they are the first best defense against corporate corruption and crony capitalism. The private equity firms are at work every day looking for mismanaged firms and the corrupt or negligent managers know they are looking. They are more efficient than regulators because they are more knowledgeable and they have a financial incentive to pay close attention. If you think corporate incompetence is a problem, how could you reject the role played by private equity firms?
The next time you hear the CEO of a takeover target complaining about evil corporate raiders ask yourself why the raiders think the firm is an attractive target. Is the CEO in that position because he mismanaged the firm?