The Romney Files: From Bain to Boston to White House Bid

Wall Street Journal writer Brett Arends takes a closer look at the Massachusetts Governor and Bain Capital CEO in his new ebook: The Romney Files: From Bain to Boston to the White House Bid.

Note: This was just published on August 5, 2012.

In addition to his work at WSJ and Smart Money, Arends is also the author of Storm Proof Your Money: Weather Any Economy, Rebuild Your Portfolio, Protect Your Future.

Excerpt follows:

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“If there is one thing everyone seems to agree on, it’s that Bain Capital under Mitt Romney was one of the most amazingly profitable and successful investment companies in history. Romney was “a brilliant businessman,” according to the New York Times’ David Brooks. He was “coolly brilliant,” agreed his biographers, Kranish and Helman.

How brilliant?  Published reports cite fantastic performance figures. Some media reports say the firm earned “50% to 80% a year” for investors over fifteen years. The Real Romney cites reports that put the figure even higher, at an incredible 88% a year. The American Enterprise Institute think-tank in Washington, D.C., went even further than that. In a glowing profile of Mitt Romney published in its magazine, The American, in 2006, it claimed: “During the 14 years Romney headed Bain Capital, the firm’s average annual internal rate of return on realized investments was a staggering 113 percent.” The magazine added: “At that growth rate, a hypothetical $1,000 investment would grow to $39.6 million before fees. Few, if any, VC firms have ever matched Bain Capital’s performance under Mitt Romney.”

These are amazing numbers.

Alas, they are too amazing.

My job involves writing a lot about superstar investment managers. I’ve met many over the years. I view them like chess grandmasters – rare, fascinating geniuses. But I had never heard of a manager, or a firm, producing returns of 88% a year – let alone 113% – over fourteen or fifteen years. Not even in a boom. I decided to do a little digging.

The first thing to know about private equity is that the industry operates behind closed doors. Private equity firms don’t comment on their investment returns in public. Academic researchers have to sign the most stringent anti-disclosure forms in order to get access to data. “Private equity funds,” warns the Harvard Business School overview of its own course on the subject, “jealously guard their privacy.” Brian Cheffins and John Armour, two experts at Cambridge University, say that “privacy has been a hallmark of private equity,” and add that big firms like Bain Capital operate “as secretive partnerships.”

The best overall account of Bain Capital’s performance under Mitt Romney is a prospectus produced in 2000 by Deutsche Bank as it sought to raise money for a new fund. This is  the main source relied on by the Wall Street Journal, the Los Angeles Times, the Boston Globe, and other publications. It’s the one cited by the Romney campaign itself when discussing his record.

It tells a story. And one of the first things I noticed was that a few things didn’t add up. For example, the prospectus showed that Bain Capital’s clients invested about $900 million during Romney’s fifteen year tenure. The firm made investment gains of about $2.4 billion.

Yet if you invested $900 million in steady amounts over fifteen years and earned “80%” a year, by the end you would have about $900 billion. If you earned “113%” a year, you would end up with about $9 trillion – or nearly three quarters of the size of the U.S. economy’s annual output. Such are the miracles of compound interest. Bain Capital is a wealthy company. But if it now owned three quarters of the nation’s annual economic output, I think we might have heard.

Professor Ludovic Phalippou at Oxford University’s business school, a leading expert on private equity, has a simple verdict for some of the sky-high figures being bandied about. They are, he says, “absurd.”

“These returns…are vastly overstated,” he told me. “The ‘star’ returns are overstated, sometimes to absurd magnitudes like in the case of the 80% of Bain.” Such numbers, he said, bear little relation to what investors actually earned.

Why? Put simply, there are lots of ways of calculating annual rates of return for an investment fund. Should you use a geometric average or an arithmetic one? Time-weighted rates of return, or dollar-weighted? Should you calculate your returns based on all the money committed to the funds, or just the money actually invested? Should you use simple returns, or annualized ones? Gross or net? Private equity managers and Wall Street bankers, for obvious reasons, tend to prefer numbers that make them look best.

To take one example: In 1996 Bain Capital bought Experian for about $80 million and then sold it for about $250 million. To you or me this would count as a 200% gain: Bain Capital trebled its money. But according to the 2000 prospectus issued by Deutsche Bank, this deal is described as having an “implied annualized internal rate of return” of “6,636%.” The reason? The deal went through in seven weeks. On an annualized basis, it’s amazing. But that’s only relevant to investors if Bain Capital were able to come up with a string of identical deals for a full year.

Consider another illustration of the perils of percentages. Imagine you hire your brother-in-law for a year to manage some of your money, much as people hire Bain Capital. Let’s say you give him $100.

On the first day he spends $1 of that money buying a bag of muffins and takes it to his office, where he sells the muffins to coworkers for $2. He then does nothing for the rest of the year.

When you meet to settle accounts, your brother-in-law hands you back your original $100 investment, plus your $1 profit. You would hardly be impressed at his investment success. But he could tell you, quite truthfully, that he had produced an “average internal rate of return” on his “realized investments” of 100%. He had one realized investment. The return was 100%.

If you think that’s crazy, try this. Imagine the same scenario, but in this case he buys two bags of muffins, each for $1.  On the first day he sells the muffins from one bag to coworkers for $2. On the second day the company starts offering free muffins in the cafeteria. No one wants your  brother-in-law’s muffins any more. He puts the second bag in the freezer, where it sits for the rest of the year, unsold and uneaten.

In this case when you meet up he hands you back your original $100 plus a bag of frozen muffins. No loss, no gain. The $1 profit made on the first bag of muffins is offset by the $1 wasted on the second bag. Yet he can still boast of an “average internal rate of return on realized investments” of 100%. He made two investments. The first was “realized” when he sold the muffins. On that investment he made a 100% return. The second investment – the second bag of muffins – never got sold. He is still carrying it on the books at its historical cost, $1. So far, there has been no loss.

Private equity firms have been known to do things like this. Funds often cash in on the best investments early to boost the internal rate of return. They delay selling the bad investments as long as possible. Ideally, they never sell them at all. Their performance numbers can be even crazier than the ones here. That bag of muffins sold on the first day? In the private equity marketing materials, the rate of return would be annualized. A return of 100% achieved in one day, compounded for a full year, is an astronomical number with about 90 zeros on the end. Let’s call it all the money in the world, and then some.

So how did Bain Capital really do? One way to measure that is to look at how much investors made in actual dollars earned.

From 1984 through the end of 1998, as mentioned above, Bain Capital’s investors put in about $900 million, and the firm’s investments produced gains of about $2.4 billion. This understates the final total a little, as some investments hadn’t fully matured. Nonetheless it’s the best figure we have, and the one most widely relied upon by both sides.

In other words, Bain Capital under Romney made a dollar-over-dollar gain of about 170%. Not annualized: In total.

How good was that?

Hmmm.

I asked Vanguard, the low-cost mutual fund company, how much investors would have made if they had just dollar-cost averaged $900 million into a basic U.S. stock index fund over the same period, 1984 to 1998. The company’s response? The investor would have made more than $3.5 billion in gains. No kidding.

It’s not an apples-to-apples comparison. There are several other factors that we need to include. But it’s context. The most far-fetched estimates of Mitt Romney’s investment performance should be tossed aside. They’re nonsense.

Let’s run some numbers. Over the course of those fifteen years, clients’ money was often coming in, to be invested, or going back out, as investments were sold.

The typical private equity dollar is invested for about four years, industry experts say. If you invest your money for four years and earn 170% gains, you’ve made about 38% a year. Sources with direct knowledge of Bain Capital’s operations under Mitt Romney say the firm typically tied up its clients’ money for longer than that. The average dollar, they said, was invested for “about five to seven years.” If we use that figure, it means Bain Capital’s dollar-over-dollar returns would have averaged somewhere between 20% and 30% a year.

How does that stack up?

Consider this: Mitt Romney got the call from Bill Bain to set up Bain Capital in 1983. At the time Romney was a young 36-year-old partner at Bain & Co., the strategy consultancy. Setting up a private equity company was not his idea. It was Bain’s. According to several accounts, Romney took a lot of persuading to make the jump. He thought the new venture sounded too risky. In the end, after lots of assurances, he agreed to take it on. He ran Bain Capital until the start of 1999. Then he left to take over the troubled Salt Lake City Olympics.

Those fifteen years would turn out, in hindsight, to be the most spectacular years in history to be in private equity – the equivalent of the recent real estate bubble in Las Vegas. They happened to coincide with the greatest bull market in the history of the U.S. stock market. Someone tapped to buy U.S. stocks with debt during those years hit the jackpot.

As Mitt Romney later admitted, according to The Real Romney, “I was in the investment business during the most robust years in the history of investments.”

Stock prices soared. The Dow Jones Industrial Average rose more than sevenfold. When you include dividends, the market rose twelvefold during that time.

So the clients could have just picked stocks out of the newspaper at this time, gone fishing, and earned about 20% a year. No Harvard MBAs. No Mitt Romney. A dart board, a copy of the stock prices page of the Wall Street Journal, and a fishing rod. Twenty percent a year.

And that’s not all. As anyone in finance knows, what really matters aren’t just your returns, but your returns when adjusted for the risks you took.

Bain Capital didn’t just buy stocks, the way a mutual fund does. It bought stocks with debt – ­lots of it. Leverage, as Mitt Romney said, was absolutely key to the business model. LBO firms like Bain Capital bought stocks the way a high-risk Las Vegas condo-flipper bought condos, with a few dollars down and a huge mortgage.

In some cases the leverage was enormous. Bain Capital made spectacular “internal rates of return” of 1,100% on one of its earliest deals under Mitt Romney, Accuride, which it bought in 1986 and sold a few years later. How do you earn returns that big? According to newspaper reports at the time, Bain Capital put down just 3% of the purchase price. Most of the remaining $200 million it borrowed. The Experian deal, according to reports, involved just 10% down.

Stock prices, as we’ve seen, boomed during the eighties and nineties. Meanwhile the cost of debt – like the cost of mortgages for the real estate speculator – plummeted. Prime lending rates fell from 12% to about 8%, according to the Federal Reserve. The interest rate on corporate bonds halved.

So for fifteen years, it got cheaper and cheaper and cheaper to borrow money to buy stocks that just went up and up and up. There was, in short, never a better moment in human history to borrow money and use it to buy U.S. companies.

Naturally, very few people took out gigantic mortgages in the early 1980s and used the money to buy stocks. For an ordinary person the costs and legal difficulties of doing so would have been prohibitive. And their neck would be on the line if it went the wrong way. Few people want to take a massive gamble in this way with their own money. As every condo-flipper (and most homeowners) now know, debt means risk. If the market goes your way you make a fortune. If the market goes against you, you lose a fortune.

But if you work on Wall Street, including at a private equity company like Bain Capital, you have one big advantage over everyone else. You get to gamble with other people’s money.

The United States has generous “walk away” corporate bankruptcy rules. They were designed, back in the past, so that legitimate businessmen who failed in a business could get back on their feet and try again.

For people in private equity, when an investment goes bad, they just write it off. They never end up on the hook for the bad debts. They are like Bill Murray’s weatherman in Groundhog Day. They can behave as recklessly as they like and it won’t matter. Tomorrow they can start again as if nothing happened.  This lets them take big risks.

There was the case of Dade International, a medical diagnostics business based in Illinois that Bain Capital bought from Baxter International. Bain put down $27 million, alongside some other investors, to buy the company, and pocketed $230 million. Meanwhile, according to published accounts, Dade racked up $1.6 billion in debt. A few years later, in 2002, the company laid off 1,700 workers and had to go through bankruptcy protection.

Or there was GS Steel. This is a steel company that Bain Capital owned which collapsed in 2002. About 750 workers lost their jobs. Romney has faced criticism on this from Republicans and Democrats alike.  He points out in his defense that he had left Bain Capital when GS Steel closed down. And he points out that the company was hit very hard by a worldwide slump in the steel business, which was neither his fault, nor that of Bain Capital.

Both may be fair points. But what really matters is that Bain Capital effectively took out a big “cash-out refi” on GS Steel soon after buying it in the mid-1990s – when Romney was still there. In two years, the company said in public filings, GS Steel borrowed at least $250 million. The company paid out some of that in dividends to Bain Capital. That vastly boosted the company’s returns.

When the industry slump hit later, there was no way to get that money back.

Bain Capital made an annualized return of more than 400% on its small GS Steel investment, Wall Street documents show. Banks and bondholders lost money. (And so did the government. News service Reuters reported in January, 2012 that the federal government’s pension guarantee fund had to pay $44 million to bail out the company’s pension fund.) None of the millions Bain Capital had taken out of the company earlier was ever clawed back. There was no way to do so.

“I’m a guy who has lived in the world of business,” Mitt Romney boasted during a Republican debate in Arizona in February, 2012, as he sought to put down Rick Santorum’s lack of experience. “If you don’t balance your budget in business,” Romney added, “you go out of business.” Except it was the creditors, and others, who went out of business. Not Bain Capital.

According to the Wall Street Journal analysis in January, 2012, about 22% of the companies Bain Capital bought – more than one in five – either ended up in Chapter 11, or closed their doors, in the eight-year period after Bain Capital bought them. (Bain Capital challenged the point.)

Bain Capital’s use of leverage was perfectly legitimate. It was a gamble that paid off. But it matters a lot when it comes to measuring the investment returns.  As everyone now knows from the housing market, leverage massively increases your returns when things go your way – and massively increases your risks when they don’t. An investor wants to know their returns when adjusted for risk.

Bain Capital, as we’ve seen, produced real dollar-on-dollar investment returns that were, at best guess, somewhere between 20% and 40% a year. If we figure the money was typically tied up for five to seven years, it was below 30%.

From 1984 through the end of 1998, the stock market overall produced gains of nearly 20% a year. If you had leveraged each dollar with $2 in debt at corporate interest rates, your returns would have ballooned to nearly 30% a year. If you’d been able to borrow $3 at corporate interest rates, you’d be up towards 35% a year. That’s how much money you could have made by issuing company bonds and then spending the money picking stocks out of the paper at random.

If they look pretty similar to the returns Bain Capital earned under Mitt Romney, maybe that’s not a complete coincidence.

Bottom line?

Mitt Romney’s investment returns were nowhere near as high as some of the most fantastic numbers you’ve read. And the lion’s share had nothing to do with him at all. They did not come from “vulture capitalism” or from genius. They were not the result of finding the underperforming companies and making their operations better, nor of ruthlessly stripping assets and laying people off. They came from gambling on U.S. stocks with borrowed money.

Good for him. But let’s call it what it is.

And there’s one more thing.

All these investment figures are gross – before fees. I have to confess that when I first looked at this issue, I assumed the numbers were net. After all, all mutual funds quote their figures net. So does every hedge fund I know.

But after my discussions with Romney’s team, though, I went back to the prospectus for another look. That’s when I saw the tiny little footnote: The returns were “Before expenses, fees and General Partner carried interest [i.e., Bain Capital’s share].” So my thanks to the Romney campaign: Without them I might have missed this.

Fees are the big story on Wall Street. Indeed they are the subject of the oldest joke there. A visitor from out of town (goes the joke) is being shown around the harbor by a friend at a big Wall Street bank. The friend shows him all the yachts owned by the brokers, money managers and so on. At the end, the visitor innocently asks: “And where are the customers’ yachts?”

I’ve long argued that Wall Street is one of the least capitalist places in the world. Nowhere else do the owners of capital ­– the investors – hand over so much of their money to the workers. Karl Marx wouldn’t believe his eyes.

The fees charged by private equity companies are somewhere between heroic and astronomical. Bain Capital charged investors between 1.5% to 2% of their money each year just for managing it. They took another 20% of any profits. Simple math will tell you that over the course of fifteen years, based on the information we have about the size of the investment funds, Bain Capital must have pocketed at least $500 million in fees, and quite possibly a lot more. (Oxford’s Phalippou says the industry norm works out at about 7% of assets a year, including a lot of obscure fees the clients usually overlook).

Once you deduct these fees, you realize that during a fifteen year period Mitt Romney’s investors put in about $900 million and probably got back about $2.7 billion. If their average dollar was invested for five to seven years, it means that Romney’s investors earned, net, between 17% and 25% a year.

On a risk adjusted basis, how far did these returns, net of fees, even beat the market?”