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May 26, 2012

Private Equity in Salvage Business


Making something busted luster again. That's the basic premise of an innovative television show called American Restoration featured on the History Channel. On the show, people bring their worn, rusted, creaky old stuff from America's past – stuff like an old Dodge pickup truck, an old Chicago police phone box, or an old slot machine, to Rick Dale and his crew to restore the old item to like-new quality. One of the best episodes is when Rick restores a very special item of Americana – a 1960s NASA helmet.

Private equity firms such as Bain Capital, which was once run by Republican presidential candidate Mitt Romney, are very much in the news again, and they're a source of great confusion on the part of commentators and the public alike. But all you really need to know to understand what private equity firms do is watch American Restoration.

Private equity firms buy companies. But not just any companies. They don't buy flourishing companies at peak prices. There's no profit there. Private equity firms buy companies that are failing or substantially underperforming for some reason – companies with managements that lack the knowledge or capacity, financial, managerial, or otherwise, to turn the companies around. Private equity firms often have that knowledge and capacity.

Because a company bought by a private equity firm is often struggling, the sale price is often fairly low. After all, no one can get a high price for a company heading for mediocrity or closure. And if the private equity firm can use its own expertise and resources to heal the company, then after a few years the company is sold again for a profit.

Maybe the problem is old production methods and a lack of expertise about state-of-the-art processes. Maybe the product line is cluttered but management can't decide what to keep and what to drop. Maybe the management systems prevent timely decision making. Maybe the company's financial structure is unsound. In some cases, there may be too many employees or, more often, the wrong employees in terms of skills and aptitudes. Whatever the problems, if under the flaws remains something of real value, then with the right tools, that value can be brought to the surface again. Private equity provides those tools.

Another distinguishing feature of private equity firms is that they raise their own capital. They are primarily risking their own money. However, private equity firms are generally not buy-and-hold investors. They buy, fix and sell. And when they get it right, the company is better positioned to grow and create new jobs, and the private equity firms can make a lot of money.

But they don't always make money. Sometimes the company's problems run too deep, so a company destined for closure still winds up closed. This is a risky businesses, and risk means not just that the profits are uncertain but that losses are occasionally inevitable.

Freud once said that sometimes a cigar is just a cigar. Well, sometimes a failing company is just a failing company, and jobs destined to be lost cannot be saved.

American Restoration is about taking things that still have value and would have more value if repaired and restored, performing the work, and creating the value.

What American Restoration does with stuff, private equity firms do with struggling or underperforming companies – turn them into profitable, growing, job-creating companies.

They don't always succeed. But their very existence and the profits they reportedly make testify that they succeed far more often than they fail, and a lot of Americans can thank their continued employment to the prowess of these American restorers.

J.D. Foster is the Norman B. Ture Senior Fellow in the Economics of Fiscal Policy at The Heritage Foundation.

This article first appeared on OCRegister.com.

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