Peeling away financial reporting issues one layer at a time

“Vulture” Capitalism, Accounting … and Mitt Romney?

Rabid conservative ideologues believe that everything transacted in a free-market, i.e., unfettered by government involvement or regulation, is by definition a good thing. I presume this is why Newt Gingrich acted like he was between a rock and a hard place when going negative on Mitt Romney's wealth, which was gained largely out of the purview of government regulators.

Gingrich has been desperately trying to besmirch Romney's reputation by any means possible (and I do mean any), but either he has been too lazy to collect facts or he has been unwilling to risk offending too many of the politically conservative oligarchs. Gingrich's excuse for vague assertions and conjectures seems to be that Bain Capital's affairs have been impenetrable.

Before going on, I want to be clear about what this post is not: a direct criticism of Mitt Romney's business dealings. Other than reading one Wikipedia article, I do not have a single fact as to what Romney did or did not do while at the investment firm he co-founded, Bain Capital. My objective is to provide a roadmap to the others for acquiring facts (if they exist) for legitimately evaluating Romney's past dealings. The signposts along that road are mostly failures in corporate governance, but as you might expect coming from yours truly, financial reporting has a little something to do with the story.

Corporate Governance and LBOs

It is well-known that Romney became rich in large part through acquisitions of controlling interests in hundreds of companies. Some of those companies were start-ups, but others were mature; they were transformed in one way or another such that Romney, his partners and the investors in their private investment fund reaped large profits from buying them up.

Many of these companies had been publicly traded before Bain's investment; these are the ones I will be focusing on. Typically, firms like Bain Capital obtain their interest in public companies as part of a "leveraged buyout" transaction, or "LBO." Very simply, an LBO is the acquisition of a company financed by a lot of debt. Sometimes, an LBO is referred to as a "bootstrap" transaction, because the acquiree's future cash flows (either from operations or sale of operating assets) are expected to be sufficient to pay down the debt and provide a healthy return to investors. Very often, and critically so, the top management of the acquiree takes an equity interest in the LBO. That can create a conflict of interest between one's personal ambitions and one's duty to shareholders, and the history of LBOs since the 1980s is replete with shareholder fleecings.  Here's my all-time favorite example:*

On Dec. 6, 1983, the senior management of Metromedia, offered shareholders $720 million in exchange for all of the outstanding shares. The offer was accompanied by a prospectus in which it was stated that by taking the company private, management could more effectively pursue a long-term growth strategy. The offer also followed a series of very negative press releases, which were clearly designed to drive down the share price, and consequently, the cost of the LBO.

Upon consummation of the LBO, John Kluge ended up holding 90% of Metromedia's equity, without having invested a single dollar. Within two years, Kluge realized over $4 billion from the outright sale of most of Metromedia's businesses (so much for that long-term growth strategy!).

In 1986, Forbes identified Kluge as the second richest American, behind only Sam Walton of Wal-Mart fame.

Not coincidentally, I believe, the shakedown of Metromedia's shareholders happened around the same time as Mitt Romney was offered the opportunity to become a venture capitalist – for Kluge's coup must certainly have whetted the appetites of many a high roller. LBOs began to lose their luster as a get-rich-quick scheme starting in the late 1980s, but the ethics still remained questionable. In a nutshell, here's why: If a public company could benefit from shouldering more debt, improving operations or selling assets, why should it take an LBO to get the job done?

The LBO Accounting Story

All of this would be a digression from the main theme of my blog – financial reporting – without this additional accounting twist. LBO accounting was controversial until FAS 141R, Business Combinations, became effective in 2009. Up until then, one school of thought was that if management continued to run the same company, and/or the LBO transaction was absorbed by a brand new legal entity and effected outside of the target company (i.e., through the purchase of shares from existing shareholders), the carrying amounts for the assets acquired in the LBO should not change. Under that view, companies that are taken private could do an IPO a few years later with the same basis for their assets; i.e., without the burden of additional depreciation or amortization expense, and with a higher return on assets.

Is window dressing important to LBO investors? Maybe not to all, but to some (perhaps Bain Capital) it must be. EITF 86-16, Carryover of Predecessor Cost in Leveraged Buyout Transactions and its successor, EITF 88-16, didn't just come from nothing. The special accounting for LBOs structured in just the right way must have been pushed by investors who really needed that type of accounting to make their deals work. Paul Kluge would not have been one (although Abe Briloff called him out for questionable accounting a few years earlier – and Metromedia's stock price dipped 25%), but as deals became more difficult (higher buyout prices and lower leverage), maybe Mitt Romney would have been willing to use an accounting trick to sweeten a deal. EITF 88-16 was finally nullified by FAS 141R, but that was not until 2009, ten years after Romney left Bain Capital for good to enter politics. In the meantime, aggressive use of EITF 88-16 clearly must have played a part in LBO transactions somewhere and somehow.

Whom Do You Trust: Mitt the Vulture or the Newt the Dodo Bird?

Maybe Bain Capital's LBO transactions were pure as the driven rain. I don't know, and all I'm doing is providing a line of inquiry for those like Newt who seem to need a roadmap to validly question whether some or all of Romney's considerable wealth was fairly or ill-gotten. At the very least, those looking to put Mitt Romney's business career under a microscope should be asking whether the equivalent of Bain's brains and money could have been had without: booting shareholders out first; or paying such princely sums to Romney and his partners; or by giving preferential accounting treatment for LBOs. Creative destruction may be essential to economic growth, but vulture capitalism is not.

I don't buy Gingrich's excuse for not having facts to support his claims. There are always two sides to every transaction. Surely, if they exist, disgruntled counterparties and abused former employees of LBO targets should be all too willing to "swift boat" Romney. Come to think of it, since no one has yet to come forward, then maybe he's clean.

I won't speculate any further whether there are skeletons in Romney's LBO closet, but keep in mind that LBO transactions are rife with potential for conflicts of interest. For example, management may sell its own shareholders down the river for a quick buck; board members don't want to become too obstructive to their friends in management; investment advisers with a stake in the transaction may offer bogus "fairness opinions"; and auditors may remain silent even with full knowledge that a fleecing is about to take place. All of this could be happening as an LBO investor writes checks to facilitators and gives them encouraging pats on the back.

If Romney is complicit in a Kluge-type scheme to any degree, then a part of his fortune would have been built not from taking a fair share of value added through creative destruction, but through vulture capitalism – shareholder fleecing and economically unjustified upheaval of the lives of employees, their families and other innocent bystanders.

Ultimately, voters have a right to know.


 *Adapted from two articles by Benjamin Stein in Barron's, "Where Are the Shareholders' Yachts: But John Kluge Pockets Billions from Metromedia's LBO" (August, 18, 1986); "Shooting Fish in a Barrel: Why Management Always Makes a Bundle in an LBO" (January 12, 1987).


  1. Reply Phil Wilson February 9, 2012

    Tom, was the pre-SFAS 141R theory, no risk of capital…no step-up?

  2. Reply Tom Selling February 9, 2012

    Phil, I believe there was no single underlying justification. But the theories in support of no step up were these: (1) Since the acquiree was not being combined with another entity, then business combination accounting was not appropriate. In essence, the transaction was a recapitalization (i.e., affects only the right-hand side of the balance sheet). (2) No substantive change of control if enough of the old interests (management and investors) carried over to the new entity.
    I hope this helps.

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