Private Equity Has a 'Social Responsibility': Carlyle Founder

NEW YORK ( TheStreet) -- Gordon Gekko? Try Mother Teresa.

The private equity firms that sometimes reap billions in gains on buyout investments also have a social responsibility, says one private equity titan.

Such an acknowledgement would add to the expectation that firms can find the highest investment returns in the financial world and could solve the industry's negative image, as outrage bubbles underneath the Presidential candidacy of the former Massachusetts governor and Bain Capital head Mitt Romney.

"If you own a lot of companies on behalf of your investors, you have a social responsibility," says The Carlyle Group's co-founder David Rubenstein. He adds that the social responsibility gets bigger with a private equity firm's size and investments. That responsibility includes making investments that creat jobs and help the economy grow -- not just those to fill investor and partner wallets.

Rubenstein co-founded The Carlyle Group with Bill Conway and Daniel D'Aniello in 1987. In January, the company announed an initial public offering and on Friday it dropped a clause in the filing that would have barred the prospective shareholders from filing class-action lawsuit against the company, succumbing to a negative investor reaction.

Rubenstein spoke at a Columbia University Business school panel alongside Joseph Rice of Clayton, Dubilier & Rice, who both took the stage in front of MBA students and industry peers.

Par for the course at such conferences these days is soul searching and a vigorous defense of the industry in light of accusations made in political debates and the press that buyout investments are a jobs killer, which benefit from tax subsidies.

"Ultimately, I want to have people who give back to society," added Rubenstein about the types of people hired by the buyout firm. Rubenstein's recently proved the point, donating millions to causes like education, the restoration of the Washington Monument and even the maintenance of the Panda bear population. Presidential candidate Mitt Romney has repeatedly referenced a public service calling as a key to his departure from the private equity firm he founded, Bain Capital, to run for governor of Massachusetts and the Presidancy.

For more on private equity, see Blackstone's big retail contrarian bet.

Those maxims would contrast sharply with Wall Street's less ethically laden ethos of profit, shareholder and market maximization.

Still, private equity practitioners are widely perceived in a similar light as Wall Street bankers whose large pre-crisis bonuses were surpassed in size by taxpayer funded bailouts after the overleveraged industry imperiled the global economy. Now private equity financiers are out to change their image as an industry don bids to be Commander-In-Chief.

An interesting visual divergence between private equity's wanted image and that of Wall Street came up in January when a photo of Romney during his Bain Capital days showed him posing as Gordon Gekko, the ruthless fictional corporate raider in the 1987 classic Wall Street. That photo inspired flocks of rage and even a website called Romneygekko.com.

Gekko coined the term "greed is good," a motto that's since permeated Wall Street trading floors for decades. "Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures, the essence of the evolutionary spirit," said Michael Douglas, who won an Oscar Award for his portrayal of Gekko.

While the private equity industry has long championed its important role in corporate evolution by investing in promising assets and cutting failing ones, a new narrative may be emerging. If large private equity firms were to have a social responsibility to create jobs and economic growth on top of their goal of high investment returns, it could be a watershed moment for the industry and the U.S. economy.

"The policy debate that we are having about private equity is a microcosm of the economy," said Columbia Business School Dean Glenn Hubbard when introducing Rubenstein and Rice to the university's Friday panel. That's because the financiers accelerate innovation within the economy, while bringing the latest in financial theory to companies for their benefit, argued Hubbard.

The twenty largest private equity firms employ nearly 6 million workers in the companies they control, over 5% of present day private sector employment, according to data compiled by the Service Employees International Union in 2007.

Would an openly socially responsible private equity industry be helpful in imparting the job growth that the U.S. economy needs to recover the 8 million-plus jobs lost in the recession and push the unemployment rate down?

Meanwhile, private equity's social responsibility would be at odds with a perception that the industry is representative of Wall Street.

For instance, Goldman Sachs ( GS) Chief Executive Lloyd Blankfein appeared to echo a Gekko-like mentality in a 2010 Senate hearing where he defended the firm's practice of hedging risky investments that the company sold to its customers. Blankfein noted that the firm's responsibility was to provide "liquidity" and make markets, not to act as an advisor to its trading customers.

Liquidity and market making have clear benefits to society, as do other Wall Street services like lending, capital raising and even storing savings as deposits, but a social responsibility beyond conducting operations in a profit-maximizing fashion and that grows with a firm's size is an ethical Rubicon that Wall Street investment banks have been reluctant to cross.

In fact, Wall Street reforms aimed at the nation's largest banks also are filled with "too big to fail" and "living will" clauses, which reflect the belief that as banks get larger their social costs may actually grow.

"It's an entirely different mindset," said Rice of Clayton, Dubilier & Rice about the private equity industry's role in being a principal for company investments in contrast to Wall Street's agent role of arranging transactions. As an owner of companies, firms have an interest in growing jobs and the economy said Rice, who is working to compile unbiased data that would prove private equity investments are both high returning and good for the economy.

"Good rates of return aren't good enough," added Rubenstein of the industry's image problem. While the industry need to prove to politicians and the press that its incentives are aligned with job creation and growth, "we have not succeeded in getting the message across," added Rubenstein.

Rice is currently funding private equity deals database that will quantify the industry's impact on growth, jobs and corporate earnings, in an effort led by Harvard Business School professor Josh Lerner called Private Capital Research Institute. "Until we have that database, it's going to be a difficult sell," said Rice of the industry's ability to prove its economic value to politicians, the press and many in the public.

Prior to the financial crisis, a detailed study by Lerner and other economists featured at the World Economic Forum showed that employment at private-equity owned companies falls 10% on average relative to non-PE controlled firms five years after a buyout. Nevertheless, the study found that targets were job losers prior to a takeover and more likely to do hiring after a buyout -a not so catastrophic finding for the financiers congregating at the mountain resort. However, those findings desperately need a sweeping update to account for the financial crisis.

In the converse, if Rice's Institute proves that private equity investments impart jobs and growth losses even if they enrich investors and general partners, it might catalyze a complete rethink of the industry's practices.

Outside of becoming more socially responsible by making growth boosting investments and grooming idealistic financiers like Romney with the skills to potentially help the U.S. government balance the budget and cut the national debt, what else can private equity firms do to mend their image?

One possibility would be to market their services as similar to venture capitalists, who are seen in a much more positive light after giving the early stage investment to some of the great U.S. companies like Facebook, Apple ( AAPL) and Google ( GOOG). The difference is that venture capital firms give early stage cash to companies, while private equity firms oftentimes make takeover investments with debt financing that can give companies little margin for error and can initiate investment and job cuts.

The difference is embodied in the conflicting accounts of Mitt Romney's record at Bain Capital. Romney oftentimes touts his investment in Staples ( SPLS), a company that grew many times over and created thousands of jobs after Bain's early equity investment. Competing candidates would rather highlight Romney's buyout of Dade International and the debt subsequently plied on the medical equipment company, in part to enrich partners, which eventually put it into bankruptcy.

Already, the private equity industry is headed in a more venture capital-like direction, albeit it unintentionally. Rubenstein noted that when he founded Carlyle, buyout firms only put up 5% of their cash to make acquisitions. The rest of deals were financed using debt in a process then known as "bootstrapping." That equity component has grown to 40%, estimated Rubenstein. Meanwhile, debt-fueled leveraged buyout deals have dropped off significantly since a pre-crisis boom.

Using more equity instead of debt for investments would also physically cut private equity ties to Wall Street. In the pre-crisis days, debt financing for leveraged takeover acquisitions by private equity firms generated billions in fees for Wall Street investment banks, but those numbers are down significantly. Even after a 33% 2011 gain, buyout loan fees of $5 billion paid to investment banks were roughly half of pre-crisis highs, according to Dealogic.

Private equity firms have been accused of receiving an outsized benefit from that leverage because of it's tax-deductability, profiting from a government subsidy.

Meanwhile, the industry can focus on how its investments provide higher returns than most offered on Wall Street, after all private equity returns have outperformed most other asset classes through the crisis, even as hedge funds and banks and even money market funds went belly up. "It's one of the best things you can do with your money , legally," said Rubenstein about the top quartile of private equity returns, which he estimates can beat public market returns by as much as nine times.

Pension funds that serve the retirement accounts of millions of U.S. workers, for instance, look to high returning private equity investments as a way to manage those future liabilities.

In 2011 earnings released on Thursday, the Blackstone Group ( BX) reported continued inflows of private equity fund assets, in large part by investors like state pension funds and endowments seeking outsized returns not available on Wall Street. Private equity "is not only an important contributor to a healthy economy, it is a vital one," said Blackstone President Tony James on a media call after earnings were released.

Blackstone reported a 12% fall in fourth quarter profits on Thursday as fees and income on investments declined in the quarter. Private equity competitors KKR ( KKR) and Apollo Global Management ( APO) report earnings next week.

Proving a positive impact on job growth, acknowledging their social responsibility and cutting leverage may be the way for private equity to win over the public.

-- Written by Antoine Gara in New York

If you liked this article you might like

Quick Tips: Now What Should Investors Do?

Quick Tips: Now What Should Investors Do?

Blackstone Group's Byron Wien: Investors Need Complacency Beaten Out of Them

Blackstone Group's Byron Wien: Investors Need Complacency Beaten Out of Them

Is the Market's Explosive Rally Off the Lows Fake?

Is the Market's Explosive Rally Off the Lows Fake?

9 Banking Bets, From Main Street to Wall Street

9 Banking Bets, From Main Street to Wall Street

Dow Tumbles 362 Points; S&P 500 and Nasdaq Also Finish Lower

Dow Tumbles 362 Points; S&P 500 and Nasdaq Also Finish Lower