Capitalism

The 1% are in bad odor at the moment.  That's certainly the conventional wisdom and I think it is largely correct.  Where the disagreement comes about is why.  Mitt Romney seems to think ("seems to think" is as close as you can get given his propensity for routinely changing his thinking based on what is currently advantageous to him) that it is because the rest of us are envious.  I don't think that analysis stands up to serious scrutiny.

I can easily think of three people who are much wealthier than Mitt.  I'm thinking of Bill Gates, Warren Buffett, and Steve Jobs.  Any one of them is vastly more wealthy than Mr. Romney.  Now certainly many of us are envious of them.  We would all like to switch places with them (assuming Mr. Jobs was healthy and still alive).  But what's important is that these three people are very popular with ordinary people.  Mr. Romney is not even well liked within his own party.  People may prefer him to President Obama as a Presidential candidate but the number of people who just like him as a person is quite small.  So what's the difference?

One of the key differences is the number of people who went along with the ride.  Mr. Gates is responsible for creating many millionaires and a number of billionaires.  And these newly wealthy people were not wealthy or powerful people when they started out.  Instead they went to work for Microsoft.  A lesser number of people bought Microsoft stock in the early days and held on to it through its fantastic rise.  The same is true albeit to a lesser extent with Mr. Buffett and Mr. Jobs.

If you bought Berkshire Hathaway (Mr. Buffett's company) stock back when and held it you would now be very wealthy.  You did not need any kind of inside connection.  The stock was sold to the general public.  Now I have to admit that in Mr. Buffett's case you couldn't start from nothing.  You needed to have at least thousands of dollars, perhaps tens of thousands of dollars.  This is out of reach for poor people and many middle class people.  But it could have been done and was done by many middle class people.  I don't know of any billionaires created by Mr. Buffett except his close business associate Charlie Munger, and perhaps some members of his immediate family.  But he has made many millionaires and has improved the financial well being of many others.

Steve Jobs sits somewhere between Mr. Buffett and Mr. Gates in terms of his direct financial influence.  He has made several Apple executives a lot of money.  And Apple stock has run up impressively in the last decade or so.  But another thing Mr. Jobs has done to a much greater extent than Mr. Buffett and even to a greater extent than Mr. Gates is create products that ordinary people can buy and fall in love with.  There are many people who have never worked for Apple nor owned a share of Apple stock who celebrate Mr Jobs' great wealth because they love the products he has created.

So it is possible to make a great deal of money, far more than Mr. Romney has made, and be well liked by the public.  So what's with Mr. Romney?  So far most of what I have said is a divergence.  I am now going to return to the central point.

I think most people's idea of a capitalist is someone who puts money at risk.  The narrowest definition would be that the capitalist puts his own money at risk.  But most people are comfortable with expanding the definition to include people who put other people's money at risk.  Mr. Buffett fits this expanded definition of a capitalist to a tee.  He was able to talk people into giving him money to invest, to put at risk, and he earned substantial returns on that money over a very long time.  So it's not that people hate all capitalists.  In fact, I think people don't hate most capitalists if we stick to my definition of a capitalist.  But Mitt Romney is not a capitalist, not at least during his time at Bain Capital.

I just saw a poll indicating that about half the people polled either did not know the "Bain story" or did not have an opinion on it so let me do a quick review.  Bain & Co. is a long established management consultancy.  They advise businesses on how to do business better.  About 30 years ago Bain & Co. decided their focus was too narrow so they created a new entity called Bain Capital.  Bain Capital would be more active.  They would buy up companies, apply Bain &Co. business methods to their management, and make them much more successful (e.g. profitable) companies.  Mr. Romney was one of the founders of Bain Capital and ran it for its first 15 years of existence.  (It is still in business but Mr. Romney no longer has an active role in it).  During Mr. Romney's tenure Bain Capital did over 100 deals.  Some of them were successes.  Some of them were failures.  Typically, the Bain Capital people would buy a controlling interest in the company, make substantial changes to the management and business practises (e.g. run the company the "Bain" way") and this was supposed to substantially improve the company.  So this looks like typical "capitalist" activity.  But I contend it is not.

The problem is with the "at risk" part.  Bain (I will always mean Bain Capital unless I specifically indicate otherwise) did put in money up front to buy the company.  And in some cases capital was added to the company so it looks like there was capital at risk.  But this was an illusion.  As far as I can tell Bain always did the deal in such a way that Bain was guaranteed to get all its money back. 

It turns out that there are a number of ways to shake large amounts of money out of a company.  One way is to rob the pension fund.  Companies will put aside money to pay future benefits for their employees.  There are ways to get at this money.  Doing so means that frequently the pension fund will run out of money in the future but that's in the future.  Another common tactic is to sell land and buildings to a bank and lease them back.  This increases the cost of doing business in the long run but it frees up a large amount of money in the short run.  A third tactic is to lay off a lot of workers.  The business will continue to maintain its traditional level of sales in the short run.  But the reduced quality of service or the lack of new and improved product (because you gutted the R&D operation) takes some time to materially effect the company.  So you get money in the short run at the expense of the long term viability of the company.

So there are a number of techniques, I haven't listed them all, to free up large quantities of money in the short run while putting the long term viability of the company at serious risk.  As far as I can tell, Bain only did deals where they could employ these or similar tactics to shake loose enough money to repay Bain for all its out of pocket costs (e.g. purchase cost plus and capital they put in).  So there was never a risk that Bain would lose money on a deal.  The record I have seen of Bain under Mr. Romney is some wins (companies that did well in the long run) and some losses (companies that went out of business).  It is easy to see how Bain could make money on the successful businesses.  After all, what companies like Bain say they do is to buy badly run companies, fix them, and sell them at a profit.  If the do that then they have earned their profit.  But as far as I can tell, Bain also made money, frequently a lot of money (hundreds of millions of dollars in several cases) on deals where the company failed completely within a few years of Bain coming in.  I know of no cases (please correct me if you know otherwise) where Bain lost substantial amounts of money on any of these deals.  So Bain was not operating as a capitalist operation because it was not putting any money at risk while Mitt was running things.

But then there's Mitt's personal situation.  He was very reluctant to take the job of running Bain Capital.  Eventually Bain & Co. put together a special deal.  Bain & Co. would run a paper exercise where they pretended that Mitt continued on as a regular employee of Bain &Co. and continued to be successful.  They would award (on paper) the usual raises, bonuses, and promotions.  Then if Bain Capital failed they would take him back as a Bain & Co. employee.  They would give him the job title the paper Mitt now had.  They would give him the salary that paper Mitt had.  They would look at his compensation at Bain Capital and compare it to the compensation paper Mitt had earned and award him a bonus sufficient to make up the difference.  In short Mitt took no risk.  If things worked out at Bain Capital then all well and good.  If they did not then he would end up back at Bain & Co.  and be "made whole" for any losses.

Bain Capital turned out to make a lot of money for Mitt and for its investors.  The process of pulling money out of some companies definitely turned what could have been a going concern had it been run for the long term and had it not lost all the money paid to Bain as fees and dividends.  So the employees and others who lost out when these companies were effectively driven out of business were definite losers.  Whether the totality of all the Bain deals is a plus or a minus, I don't know.  But Mitt Romney made a lot of money and there was no personal risk to Mr. Romney nor to the investors that backed Bain.  So the whole thing was NOT a capitalist operation.

I think the reason so many people resent Mr. Romney is because he made a lot of money out of a risk free enterprise that benefited a very small number of people.  I now want to expend my view to encompass two other groups that share these characteristics.  Namely, we have a situation where a small number of people make fantastic amounts of money without engaging in any risks.

The first group I want to focus on is Hedge Fund managers.  Hedge Funds can serve a beneficial purpose.  A Hedge Fund may make an investment that others shy away from because it appears to be too risky.  But sometimes these investments can pay off in a very big way.  And it may turn out that the investment creates something (typically a company) that may be very beneficial to society as a whole.  So the problem is not with the idea of Hedge Funds.  It's with how Hedge Fund managers are paid.  Typically Hedge Fund managers are paid a salary.  This salary is small by current Wall Street standards (hundreds of thousands of dollars, perhaps a few millions of dollars) but it is large when compared to the salary of the average person (the median U.S. salary is a little over 40 thousand dollars).  That's not the problem.  The salary is in line with the skill level necessary to successfully run a Hedge Fund.  The problem is with the bonus system.

Typically Hedge Fund managers are paid 20% of the profits of the Hedge Fund as a bonus.  This has resulted in multi-billion dollar payouts in some cases.  This makes some sense in the case of a successful Hedge Fund.  You can certainly argue that 20% is too much but in principle some percentage of the profits seems a reasonable way to go.  The problem is with what happens if the Hedge Fund loses money.  In this case nothing happens.  The Hedge Fund manager never has to pay anything back.  So if the Hedge Fund does badly then the Hedge Fund manager does OK.  If the Hedge Fund does well then the Hedge Fund manager does well, sometimes very well.  So here again we have a situation where a small group of people can and usually do do very well while undertaking no risk.  Again, the Hedge Fund managers are not capitalists.

Let me move on to my final group, senior executives at large corporations.  Here the situation in detail is much more complicated than in the case of Hedge Fund managers.  Just exactly how much a senior executive is paid in a given year may take a team of accountants weeks to figure out.  But the general idea is the same.  The executive receives a base compensation package.  This is money he gets regardless of how well the company does.  Then there are the "performance" components.  Theoretically these depend on how the company does.  But some of them are rigged to be easy to hit.  And what happens if the company does badly?  The worst thing that happens is that nothing happens.  The executive is never required to give anything back.  And frequently the board of the company will have pity on the executive and award him a bonus even if the company does badly.  So again these executives are not capitalists because for them personally there is nothing at risk.

Many people have observed that these "high potential upside benefit - non-existent downside cost" situations lead to risky behavior.  If nothing bad is going to happen to me personally why not take a flier on some risky deal that might pay off big?  These situations encourage excess risky behavior.    And there is a problem that commentators do not mention.  If nothing is going to happen to me if bad things happen they why should I do "due diligence" to make sure nothing bad actually happens?  The answer is that in this situation "due diligence" is a waste of my time.

One of many contributors to the Wall Street meltdown was a lack of due diligence on the part of many highly paid people.  Highly paid executives and traders were expected to deliver results.  The theory was that if the "trades" many firms engaged in went bad then there were ways to keep the losses small.  No one increased their bonus by questioning this assumption.  Nor did anyone increase his bonus by questioning whether the "safe" ratings of the underlying securities were accurate.  Further, they were in positions where if something did go wrong they would not personally lose any money.  There were other contributing factors to the Wall Street meltdown but the people with the most power were also the people who were encouraged by their compensation system to look the other way (and encourage others like ratings agencies and regulators to look the other way too) and knew they could safely do so.

Some people call the activities of Bain Capital "Vulture Capitalism".  To the extent that Bain did not purchase a company because they thought they could turn it into a going concern rather than make a quick buck before the company went under then they deserve the term.  And you can look at the activities of the takeover company.  Do they do things like slashing R&D that harm the company's ability to be successful in the long term?  Do they pull out so much money in the form of fees and dividends that it leaves the company without sufficient working capital.  Do they raid the pension fund?  Do they do "short term gain at long term cost" things like sale and leaseback deals?  If they do then it is likely that are more interested in making a quick buck then in actually helping the company.

It is clear that a number of deals done by Bain Capital under the leadership of Mr. Romney fell into the Vulture category.  As such the general dislike and distrust of him by a large segemnt of the public is completely justified.  As is also the general dislike and distrust of Hedge Fund managers and many senior executives of large companies.  It is hard to make money.  It is very hard to make a lot of money.  But people like or dislike people who have made a lot of money not based on how much money they have made but on how they went about making that money.  There are few people more generally beloved by the general public than Warren Buffett.  And he is worth tens of billions of dollars.  And he was beloved well before he announced he was going to give almost all of it away.