Doug Schmidt Blog & Writings

Fellow Republicans (and soon enough Democrats) are delivering broadsides at Mitt Romney for his fortune and how he amassed it at Bain Capital. His career in finance is lumped in with corporate raiders, vulture capitalists, robber barons, and Barbary Pirates. No one is shocked that political rivals will sift through and distort a presidential candidate’s past to gain an advantage. In the process, necessity requires that Romney’s adversaries ignore history and accuracy. But if you were interested in understanding why Romney became so rich, you might wonder what those times were like when he laid the groundwork for his fortune. What was it about Bain Capital that allowed it to succeed when most of its competitors failed?

Romney’s detractors might wish to throw back the curtain and find a merciless arch-capitalist in his past. But they have looked hard and found little dirt in Romney’s years as a financier. As with most of Romney’s life and career, his time at Bain Capital was far more clinical and waveless. Make no mistake—under Romney’s leadership, Bain Capital grew from a start-up operation to a leader in the business of leveraged buyouts (LBOs). But Bain Capital had an unusual advantage—an advantage that made Bain Capital a forerunner of many of the current generation of private equity funds. Romney’s leadership may never have been the stuff of Wall Street books and movies; but Bain Capital had a secret ingredient that made it uncommonly successful.

Imagine the time period of the late 1980s when Bain Capital began its rise to prominence. It was an era when mergers and acquisitions (M&A), the buying and selling of companies, dominated daily life on Wall Street. Each morning, the financial press covered breaking stories on the latest big name deals like RJR Nabisco and Lear Siegler. Law firms, accounting firms, printers, and consultants all serviced the M&A Juggernaut. The hottest jobs for college, law, and business school graduates were on or near Wall Street. Initial Public Offerings (IPOs), the product that would dominate the next decade, were a sporadic sideshow. The LBO period was an era dramatized in the movie “Wall Street,” full of financial cowboys and characters and charlatans. One thing was certain for those of us who experienced it—you woke up in the morning and you left the office late at night working on a “deal.”

In that era, I worked in the M&A group of Drexel Burnham Lambert, one of the most feared (and occasionally respected) investment banks on Wall Street. I was a little cog on a big wheel of a huge machine, working the smaller deals that were the staple diet of the era. I remember making a telephone call one day to a CEO, a typical call that I made hundreds of times a year. This CEO was a potential buyer of one of our client companies that we were offering for sale. I described the company and its selling points to the CEO. He asked me about the expected pricing of the deal. After I told him a price range for the company, he reflected for a moment and replied, “Hell, at that level, I’m not a buyer. I’m a seller.” He wasn’t joking. “Should we be buying or should we be selling?”—that thinking dominated every executive suite and every board room across America.

At any given time, Drexel, like other major Wall Street firms, represented dozens of companies for sale. The primary target market of buyers was, as it is today, strategic buyers -companies in approximately the same business as the seller that would pay a premium price for a complementary acquisition. Although LBOs stole the headlines and in many ways drove the overall M&A market, strategic buyers always represented the largest share of the activity. In that heady M&A period, the whole market was underpinned by a massive amount of money available to the many leveraged buyout funds. Think of it as a solid floor under the market. When you represented a company for sale, you went first to the strategic buyers. But you always had a group of financial buyers (leveraged buyout funds) waiting in the wings, and they would be quick to step in. The M&A beast never rested because there were always buyers.

Romney and his partners launched Bain Capital in 1984 with a modest $37 million fund focused on early stage, venture capital type investments. By the late 1980s, Bain Capital had altered its strategy, raised over $150 million, and established itself as a top tier LBO firm for smaller, “middle market” sized companies. Top tier meant that Bain Capital had money in the bank and was actively buying companies on a regular basis. Bain Capital had also developed its reputation as a tough, no nonsense, get-it-done buyer. If Bain Capital took an interest in your company, your transaction would get completed. The giant signature deals of the decade were getting done by the KKR’s and the Forstmann Little’s, but for the increasing number of smaller and middle market deals, Bain Capital made every investment banker’s short list.

Bain Capital had one unique characteristic that distinguished the firm from its competitors—a competitive advantage that belies the current charge that Bain Capital was a common corporate raider pilfering its prey and tossing aside employees. Bain Capital was created from Bain & Company, a respected strategic consulting firm of that era, smaller but on an intellectual par with McKinsey and Boston Consulting Group. These premier consulting firms were sought after by American companies to solve internal problems and create strategic plans. There was a mystique about them, a belief that if you could afford the fees, these consultants could concoct a magic elixir to cure all your corporate ills. Bain Capital was populated with former industry consultants from Bain & Company, including Mitt Romney, the man tapped to found Bain Capital. Romney had been a star consultant for Bain & Company as well as Boston Consulting Group before that. This was after he had completed the highly selective joint Harvard Law and Harvard Business School program. By any measure, Romney was ambitious and a proven achiever.

Romney and his top lieutenants who started Bain Capital were all ardent strategists at heart, immersed in the details of how to build businesses. These consultants were some of the best and brightest that the U.S. university system had to offer. The Bain Capital people I met were as terrifyingly intelligent as they were stultifyingly dull. That is hyperbole, of course, but there is an element of truth to a characterization of the average Bain Capital professional that Romney wrestles with to this day on the campaign trail. His training is to be brutally frank and analytic, and he is forced to fight those impulses every day as candidate Romney.

In those early days, Bain Capital’s message to the financial community and to the companies that Bain Capital acquired was, ‘We analyze your market; we improve your operation; we help you create a growth strategy; we build companies; we create value.’ This mantra was like a breath of fresh air to sellers of businesses. They compared Bain Capital to the majority of financial buyers who walked in the door and who could only speak the language of numbers. Bain Capital understood your business, and if you did not want the firm to buy your business, you certainly wanted to impress it.

In 1989, I waited at a small town airport in Pennsylvania for two Bain Capital professionals who were arriving for a “buyer visit” with my manufacturing client. Ducking as he deplaned was Geoffrey Rehnert, an uncommonly tall, thin young man of about 30 years of age. With him was an even younger, junior colleague. All the Bain Capital people were young-and smart. When he was just in his 20’s, Rehnert was one of the original employees of Bain Capital. In the infamous and hammy “money photo” that has been used to torment candidate Romney, Rehnert is the happy young man in the back row with a bill in his teeth. To this day, more than a decade removed from Bain Capital, Rehnert remains an active and vocal supporter of his former leader.

I was more than a little nervous hosting Bain Capital people for a plant visit. First of all, it was rare to get Bain Capital to the point of actually taking a day for a due diligence visit. Although every LBO firm declined to pursue most of the companies we introduced to them, it was well-known that Bain Capital was far more picky than average. The Bain Capital people also made me nervous because with their consulting backgrounds, they were notorious for doing their homework on your company and its industry. Just walking off the plane, these two were likely to know more about my client and its prospects than I did as a financial jockey. Although Drexel bankers feared no one, we were not above being intimidated. As I soon discovered, there was good reason to be concerned.

On a walk on the factory floor, Rehnert and his partner were tenacious observers, asking a barrage of questions of the host company’s executives. Rehnert pointed out to me something I would never have known to assess. “Do you see all those parts piled up against the wall?” In a later conversation, he explained how those piles of metal represented manufacturing process problems as well as excess money tied up in work-in-progress inventory. In other words, the plant was sloppily run.

In a classic moment, Rehnert sat in the main conference room grilling the senior vice president of sales. Rehnert had the detailed numbers in front of him and knew where he was going. After numerous questions, he finally looked up at the hapless man who was twice his age and said, “It appears to us that there is a cap to what the salesmen in Texas or Michigan or anywhere can earn. Are we getting this right?” The executive finally had a point that he could drive home. “That’s right,” said my client. “You wouldn’t want the guys in the field making more money than the head of sales, would you?”

Bain Capital never made that investment.

In the early and mid-1980s, Mike Milken and Drexel developed the high yield bond (“junk bond”) as a financial weapon. It not only fueled larger and larger LBOs, but it also opened up new investment in cash flow industries such as telecom where MCI Communications was an early beneficiary. Only in retrospect do we see how quickly the heyday of the LBO period came to an end. At the time, as with any boom, the participants thought that the good times would roll on and on. But the easy to-do-deals, based on financial leverage and stripping of assets, were completed in a handful of years. As the 1980s wore on, more and more money came into LBO funds hoping to repeat the earlier successes, even as the supply of good transactions was diminishing. This mismatch of supply and demand led to excesses and failures, undercutting the health of the economy.

By 1988, Milken had left the scene, struggling with his legal problems. Wall Street was awash with less experienced dealmakers and high yield traders. The market stretched to breaking with hopelessly weak, over-priced, and over-levered deals like Ohio Mattress Company and Federated Department Stores. By 1990, the party was over. The high yield market collapsed in spectacular fashion. Drexel’s machine ground to a halt, with its capital base eroding into bankruptcy. The economy went into recession only to reset itself in preparation for the next big boom—the dot-com bubble of the 1990s.

It was in this period of the mid-to-late 1980s, with a market that would eventually overheat and decline into chaos, that Bain Capital introduced a new way of investing that I would argue has persisted into today’s era of private equity. Bain Capital may not have been the first firm to recognize that the future of LBOs lay in introducing operational and strategic improvements, but it was the first that I knew of where the investment staff were all professionally trained to assess and introduce those changes. Unlike the financial shops which dominated the LBO market at the time, Bain Capital’s employees had hands-on industry and consulting experience. Bain Capital recognized that for its firm to compete in a crowded market of LBO buyers, it had to have a new model and add value through a new methodology. Analyze a potential investment’s markets thoroughly. Improve operations. And, of course—buy low and sell high.

Did this new model ultimately prove successful? That is not too difficult to measure when you consider the riches that Bain Capital created for its investors and Mitt Romney’s recently disclosed investment income. Bain Capital not only survived the collapse of the LBO market of the 1980s, it developed into one of the best known names in the private equity market for the past two decades.

A more serious charge is whether Romney gained his fortune at the expense of workers, lost jobs, and plant closings. In light of how Bain Capital entered and differentiated itself in the LBO market, the labeling of Bain Capital as a raider or asset stripper disregards the facts and ignores history. The Bain Capital model was designed as a counter to those early LBOs where it was easy to create value through expense cuts and firings. Bain Capital could only succeed if it grew companies instead of dismantling them. Growth was baked into Bain Capital’s strategic model and the professional training of the people who founded the firm. The Bain Capital people honestly believed that they could analyze any company and, if they invested, they could run it better than the current owners. Call it hubris, but Romney’s fortune was built upon a belief that his firm was smarter than the rest of the pack.

Did Bain Capital lay off and fire some people along the way to make its companies competitive? I am sure they did. Did Bain Capital make mistakes and invest in companies that were destined to be losers? You can be sure that they did—but not as many as the vast majority of LBO firms of the era that ultimately closed their doors. Was Bain Capital a major “job creator”? That characterization is probably a stretch and is asking the wrong question. Remember, the companies that LBO firms bought were for sale for a reason. The better question is how many Bain Capital portfolio companies would have disintegrated or failed if Bain Capital had not invested in them and redirected them? “Jobs preserved” may be a better statistic than “jobs created”.

If you look at today’s “private equity” firms (the current euphemistic term that has replaced “leveraged buyout”), you will find that the successful ones almost all have industry specialists and former industry executives picking and guiding the investments. The hours of analysis and research that a modern private equity firm invests before writing a check make many 1980’s deals look as though they were done on the backs of envelopes. Today, there are more LBO deals completed each year than at any time in the 1980s—the result of smaller average deal sizes and hundreds more private equity firms in the market.

Did Mitt Romney and his team bring a new level of discipline to leveraged buyout investing and create the initial successful model for today’s modern private equity firm? When I look back at the players that existed then, there is not one firm that I would put ahead of Bain Capital in seeing the future of the industry and capitalizing on that vision. Romney wasn’t just lucky. He did not make his fortune on the backs of fired workers or gutted companies. He and his colleagues built a better mousetrap—and were rewarded handsomely for their effort.

(Published by Citybizlist in New York, Boston, and Washington, D.C. on February 24, 2012 and in Baltimore on February 27, 2012.)