Josh Kosman

A case study in profits and job losses

By Josh Kosman
November 26, 2009

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STEPHEN PAGLIUCA’S run for the Senate seat left vacant by the death of Senator Edward M. Kennedy has stirred up memories of the bitter 1994 challenge for the seat by Mitt Romney. When polls showed Romney edging ahead on the basis of his business experience, Kennedy’s media consultant, Tad Devine, went to film angry workers at Ampad, one of the companies that had been fleeced bare by Bain Capital, a private equity firm that Romney owned. Was Kennedy just playing rough and tumble politics as Pagliuca has alleged, or did he have a valid point to make about Romney’s type of business experience? And does that point apply to Pagliuca as well?

Private equity firms buy companies under an unusual arrangement - they force the companies to take on huge debt obligations to finance, in essence, their own purchases. The buyout kings then pay themselves huge fees for running these companies, well before it is determined whether they ran them well or into the ground. A Davos study shows that once in control, private equity firms cut more jobs than competitors. And according to a University of Chicago study for the years 1980 to 2001, investors in private equity firms also lose, receiving returns that fell short of the broad market averages.

Consider the private equity buyout that took place under the direction of Bain Capital and Stephen Pagliuca - that of Dade Behring, an Illinois lab equipment manufacturing firm that was bought by Bain and was ultimately left with about $450 million in debt. What happened after its purchase?

While lab-equipment manufacturers typically allocate 10-to-15 percent of sales to research and development, under Bain, Dade spent nearly half, 6 to 7 percent - $61.7 million in 1997 and $88.2 million in 1998. The anemic R&D spending fit the pattern of recent private-equity excesses - first because Dade Behring needed money to pay off the debt Bain had loaded it down with, and second, because Bain lacked the proper incentives to build a company it planned to exit within five years.

Like clockwork, nearly five years after its initial investment, Bain was practicing its exit dance, changing the employee benefits package for many workers from a defined-benefit pension plan, in which employees were entitled to about 75 percent of the average of their combined salary in their last three working years, to a cash-balance plan, saving the company perhaps $10 million to $40 million from the conversion. The same month Dade used the projections of that very savings as part of the basis to borrow $421 million, $365 million of which it turned around and used to buy back some of Bain and co-investor Goldman Sachs Capital Partners’ shares.

The Standard & Poor’s rating agency believed the company with the added debt would be unable to pay its interest if it faced adverse business conditions.

With added debt, new areas had to be cut. Dade’s Miami office, which had 850 employees in 1999, consolidated operations with a similar division in Germany. Pagliuca told the Globe that job cuts were necessary to improve Dade’s performance. But by then it didn’t matter how many divisions were consolidated or workers fired. Nothing could save the company from its crushing debt load. Finally, the decline in the value of the euro, which Dade was too cash-strapped to hedge against, caused the company to collapse. It filed for bankruptcy in August 2002.

Dade’s creditors took over the business, and Bain lost all its shares. But, Bain and Goldman - after putting down only $85 million to buy Dade and receiving the $365 million distribution, made out like bandits - a $280 million profit. Later, the Globe reported, creditors alleging these gains were “illegal dividends’’ got the private equity firms and other entities to pay them back $68 million of the $365 million.

Did this company have to be treated this way? Was it making a bad product? Was it at the end of its productivity? After the bankruptcy, creditors agreed to cut the company’s debt by more than half in exchange for company shares. They saw that if Dade focused on growth and not on juggling its debt load, it had the potential to be a strong business. Dade began pumping money into R&D - more than 8 percent of revenue in 2003, 2004, and 2005. By 2006, Dade’s sales had risen 40 percent. The next year, Siemens bought the company for $6.7 billion, five times more than its value at the time of the bankruptcy.

Pagliuca said recently that the Kennedy ads showing the bitterness of laid-off workers were unfair because they distorted the entirety of Romney’s body of work. An examination of Bain’s record, and Pagliuca has been a key member of Bain since its early days, shows that Bain made big profits out of six formerly healthy companies it helped drive into bankruptcy (Stage Stores, Ampad, GS Technologies, Details, KB Toys, and Dade). During the credit boom from 2005 to 2007, Bain bought 22 businesses. Moody’s Credit Rating Service in November said 10 of those companies, including Clear Channel Communications and Guitar Center, are either distressed or in default, 45 percent of the total.

I am not a resident of Massachusetts and take no side in this campaign. But I agree with Pagliuca that the entirety of a man’s work be available to voters before they throw the lever.

Josh Kosman is author of “The Buyout of America: How Private Equity Will Cause the Next Credit Crisis.’’