I find it amusing that the increasingly desperate Romney-chasers among the remaining US Republican presidential candidates are working overtime to attack the front-runner for his leadership of Bain Capital in the 1980s and 1990s. While not a blind supporter of the private equity industry, I actually find Mitt's business experience one of his more attractive attributes.

There is a serious debate to be had about the social utility of the private equity business, and the tax incentives which encourage riskier PE capital structures, in particular. However, the attacks unleashed by Newt Gingrich, Rick Perry and others have eschewed such policy-based criticism in favor of a more populist, anti-free market attack. This is ironic given the Hayek-style belief in free market capitalism that has dominated Republican politics since the Reagan revolution of the 1980s. The core of the Gingrich/Perry attack is that private equity is all about firing American workers to line the pockets of "vulture capitalist" financiers like Mitt. While the job destruction, or at least job export, criticism merits critical analysis (not likely in this election cycle), the data I have seen suggest that for every job eliminated, PE-backed companies create at least as many new jobs — and not menial ones. This is "creative destruction" as envisioned by Joseph Schumpeter in its most concentrated form.

What private equity firms (and for that matter, all good investors) do pursue is the competitiveness and efficiency of their portfolio companies. This often includes reducing labor costs as a percentage of total revenues, but as growth is achieved new jobs are also created. Indeed the central fallacy of the politicization of the PE debate is the insinuation that respectable firms like Bain somehow seek to ruin and bankrupt companies for the sheer pleasure and greed of the sport. This has not been my experience. What these firms are organized to deliver for their pension fund and other institutional investors as well as for their operating partners is the maximum return on investment achievable at an acceptable level of risk (more on this below). This core free market goal results in an efficient allocation of capital and labor – often more efficient than the internal allocation mechanisms that operate within large corporations. Thus a private equity buyout or significant equity participation often acts as a catalyst or concentrating force, enhancing the economic performance of the enterprise.

Now, all is not perfect in the PE universe. There are potential negative externalities – in particular the allocation of risks and rewards (abetted by US tax policy) that tends to favor greater risk taking and provide less margin for error in down markets. In brief, private equity professionals typically have more to gain than lose financially from increasing the variability of returns from a given investment. Let's see why. First, as with most corporations, PE-backed companies benefit from the deductibility of interest payments on indebtedness — this encourages more leveraged structures by lowering the cost of debt versus equity financing. Second, income earned by PE sponsors in the form of a "carried interest" on the overall gains of their funds (typically 20% of total gains) is currently taxed at favorable capital gains not at ordinary income rates. While there has been a raging debate as to why US tax policy should favor this form of employment income over wages, my goal here is limited to noting that this favorable tax treatment tends to amplify the incentive already created by the asymmetrical carried interest reward mechanism to seek the highest return on equity – typically, but not exclusively, by taking on the maximum debt lenders are prepared to commit. When a portfolio company goes bust, the PE sponsors lose their often substantial personal invested capital in the deal alongside their limited partner investors, and they earn no carry on that investment; however, they do not pay a 20% "negative" carry to their investors. At most they risk having to give back the positive carry earned on prior winning investments and they potentially incur a repetitional hit which can hinder future fundraising. However, when portfolio companies succeed and the overall fund achieves positive returns, the sponsors earn their substantial carried interest (even taxed at a favorable rate as we have seen above). This asymmetrical reward structure resembles a call option on the upside of the investment portfolio, and classical options pricing model tells us that the holder of an option benefits from increasing the variability of the returns on the underlying investment (I.e., the value of an equity call option increases as the beta of the underlying common stock rises).

I delve into this somewhat esoteric detail only to point out that there is a reasoned economic criticism that can be leveled against private equity. Namely, that it tends to increase the riskiness of the economy by encouraging the substitution of debt for equity as a result of the asymmetric reward structure and tax advantages afforded this form of ownership. However, the analysis must not stop there, as private equity also enhances the efficiency of its portfolio companies and often provides badly needed growth capital when other more risk averse investors are unwilling to fund.

In withdrawing today from the race for the Republican nomination Jon Huntsman declared that the party must return to being the "party of ideas." All I can add is that this would be a welcome change.