America celebrates its innovators. When Steve Jobs passed away, millions held vigil and thousands wept. Jack Dorsey and Drew Houston sell out MIT.  A picture of President Obama chatting with Mark Zuckerberg goes viral. In short, Americans love people that make things that change the way we live our everyday lives.

Financial innovators, on the other hand, do not enjoy the same love and respect. At best, innovators in finance make a lot of money and have tons of fun but don’t become household names.  Arthur Rock, for example, should be as well known as Gates, Jobs and Zuckerberg. After all, he created venture capital – the tool that enabled Microsoft, Apple and Facebook.

At worst, financial innovators are reviled as fat-cat villains. Look no further than the topic du jour: Mitt Romney and his private equity background.

It’s easy to demonise people that “don’t build anything” and “make money on the transaction.” But the bad rap on private equity is misguided. Private equity was an important financial innovation and a key factor in the productivity gains and technology boom that began in the 1990s.

Before going any further, this blog is NOT an endorsement for Mitt Romney. It’s simply a look at the overall private equity market, and not a judgment of any specific deals done by Bain or any other firm.

This Machine Kills Conglomerates
Following World War II, American companies enjoyed nearly three decades of growth. At home, Americans consumed American-made goods. There were no German or Japanese or Chinese imports. These nations were decimated during the war and were rebuilding. And guess which economy provided the equipment, materials and services for the rebuilding? America. In short, America was #winning.

This period saw the rise of the conglomerate. According to The New Financial Capitalists by George Baker and George David Smith, three factors led to conglomerations. First, companies became bloated and staid in light of no competition. Second, ERISA (passed in 1974) limited the amount of money pension fund managers could invest into a single company. As a result, pension funds held a small number of shares in a large number of companies.  Such a structure fosters passive – not active – shareholders. Lastly, antitrust rules made it difficult for two companies operating in the same industry to merge.

To put it all together, managers who face no threats from the outside (competitors) or the inside (shareholders), and who do not want to ruffle the feathers of anti-trust authorities, have only one option with excess cash: buy businesses in completely unrelated industries. It was this formula that led oil industry giant Mobil to acquire Montgomery Ward, a retail chain.

Private equity and the leveraged buyout were the change agents that dismantled conglomerates and realigned management with ownership. In its simplest form, a buyout works like this. An acquirer like Bain buys a target company using cash from its fund and debt from either a bank loan or a bond issuance. The target company’s assets serve as collateral for the debt. So a company worth $10 would be purchased using $1 of cash and $9 of debt.

Debt is the secret sauce. When a company has an obligation to meet, it must trim the fat and only make sound investments. That means no more corporate jets, lavish headquarters or underperforming divisions bought for the purpose of Empire Building. It means investing in projects with expected rates of return above the companies cost of capital. I equate LBOs to a mortgage. A person who takes on a mortgage will watch his or her money more closely and make financially sound investments -- one hopes, at least.

Private equity affected all enterprises in the economy. In order to avoid a takeover, management proactively levered up. (A company that already has debt cannot take on more debt to do a leveraged buyout.) In the end, American companies got leaner and more focused. By the 1990s, the LBO dividend began to pay-off. Companies invested soundly into R&D and process improvements, which in turn improved productivity and helped fuel the information technology revolution.

In conclusion, private equity isn’t perfect and it isn’t always pretty. The anger over compensation and taxes is understandable; private equity managers charge a 20% fee on profits earned, which is taxed as long-term capital gains (15%) as opposed to income or a bonus (35%). Partners in private equity firms also use debt to extract dividend payments for themselves; in some cases, these payments are too burdensome and good companies are forced into bankruptcy. Overall, however, private equity is a tool - though sometimes blunt - that moves the economy forward.