A Financier in Chief - NYTimes.com Mitt Romney stakes his claim to being a better "job creator" than President Obama largely on his success and experience in the private sector. After the first two presidential debates, voters say that they trust him more than the president on the economy and jobs, but it isn't because Romney has talked much about what Bain Capital actually does. Romney has chosen not to try to put the private equity business in a particularly sympathetic light nor to explain it in a way that would enable voters to see the connection between his financial activity and his ability to create jobs. I understand his dilemma. As one who spent close to 25 years as a partner in two private equity firms, I can't imagine that I would ever want to try to explain the business during an American political campaign. So far, the media has focused on Romney's wealth, which he earned from founding one of the leading firms in the business, a firm that maintains an impeccable reputation. This focus has led to interest in Romney's tax returns, which undoubtedly reflect the sound professional advice of experts in tax and estate planning. Other than identifying practices outside the experience of less fortunate Americans, the attention has not identified anything other than compliance with the intricacies of our tax code. One might feel that Romney should have released more of his tax returns or should not have been able to exploit an over-complicated tax code, but those issues are a red herring, in a way. Let's move past them for the moment and instead try to understand exactly how private equity works and how Romney's experience would inform his presidency. The key point, which has been at once over-discussed and misunderstood, is that the best word for the job Romney did at Bain is financier. He identified attractive investment opportunities and then deployed capital (largely provided by others) to generate positive returns on those investments. For example, imagine that you wish to buy a piece of real estate and that you are able to get a mortgage for 99% of the purchase price (this may stretch your imagination - where can I get a mortgage like this? - but the world of private equity has different rules). You would have very little money at risk, but an opportunity, with inflation or appreciation in real estate values, to pay off your mortgage lender and keep 100% of the gain for yourself. In addition to the skill of ferreting out an attractive investment opportunity, Romney has demonstrated the ability to recruit and motivate managers who actually create value by improving a business, as well as the ability to attract the necessary capital from banks and institutional investors. In short, Romney was an intermediary or broker between capital and business opportunity. It is essential to recognize that there is only one significant benchmark of performance for a financier: internal rate of return (I.R.R.), which is basically the rate at which a particular investment grows. An investor who invests in a private equity transaction only wants to know how the investment did. When it comes to the means employed, ignorance is bliss. Unlike in the more public corporate world, where boards, shareholders, customers and sometimes public activists scrutinize the social implications of what a business does, a financier's performance is measured by one question: what was the I.R.R.? In pursuit of single-mindedly maximizing the return on an investment, a financier must focus on how to increase a company's cash flow in order to create value, and herein lies Romney's greatest political difficulty. A businessman seeking to optimize profitability will look to lower labor costs by reducing head-count, whether through technology, out-sourcing, or rationalization. This is right out of the basic playbook. It is not the mission of the financier to create jobs. In fact, his mission is often to do just the opposite. It is also right out of the playbook to maximize cash flow by paying as little in corporate taxes as possible. This is accomplished by managing the level of taxable income, most commonly by using deductions like interest expenses that result from a maximal level of debt. It is the job of the financier to engage in sophisticated tax-planning, and most business people understand and sympathize with this. Most American voters faced with a job recession and a federal budget crisis do not. Exactly how do financiers like Romney make their money in the institutional private equity business? When large institutions give investment discretion over their funds to a financier, they need to assure themselves that the financier will act as if the money were his own and generally require the financier to make a significant co-investment with his own funds. This basic philosophy of aligning the interests of the financier with those of his investors also gave rise to the compensation structure which has come to be known as carried interest which, in essence, is a sharing of the profits earned on the investors' capital. The carried interest is performance-based because it is earned only if there has been real benefit to the institutional investor. Unless the financier makes money for his investors, he doesn't make money for himself. In this context, Romney can point to his financial success as directly attributable to his performance as an investment manager. But a third way Romney made his fortune was through his participation in a highly lucrative fee structure that includes any management, monitoring, transaction, financing and other fees generated and taken by Bain for its services. Unlike performance-based compensation, these fees create an adverse interest between the financier and his institutional investors. They solely benefit the financier and, to the extent they diminish the value of private equity investment, they are detrimental to the institutional investors. Over the course of the last decade, the scale of the private equity business has exploded in response to the search by institutional investors for ever-higher returns. As a result, private equity increasingly became an asset management business, virtually risk-free to the financiers, rather than a shared-risk business as it was originally conceived. The management and other fees that bring in millions of dollars regardless of investment performance have overshadowed the performance-based compensation for many firms and have created unimaginable wealth for private equity firms, little of which has been shared by the people providing the money. As a Bain founder, Romney has undoubtedly benefited from the immense growth in the value of Bain's franchise, even though he has not been actively engaged in the business during this recent period. Perhaps the most uncomfortable aspect of private equity for Romney to explain is the role of capital from the public sector in driving its growth. In recent years, state and local public employee pension funds have had greater and greater trouble keeping pace with projected obligations to their beneficiaries. The causes of these potential shortfalls vary: unreasonable actuarial assumptions in calculating future benefits, substandard investment performance, inadequate government support, and the unwillingness of politicians to constrain benefit levels. Whatever the reason, the managers who run these pension funds have responded to the anticipated funding gap by seeking investments that offer ever-higher rates of return. In other words, the management of the nest eggs of teachers, police, firefighters, prison guards and other public employees has increasingly been handed over to the captains of private equity. Although Romney is unlikely to admit it on the campaign trail, his much-vaunted private sector success was based in significant part on the savings of public sector workers. Romney constantly derides big government, but government is made up of individuals, whose pension funds helped make him and Bain unimaginably rich. There is no doubt that these pension funds sought the higher returns offered by private equity investing. But as the private equity business grew, the public pension funds and other capital providers have gotten the short end of the stick. They have not completely shared in the value of the franchise that is created in part by their investment in the industry. It seems odd to hear Romney criticize big government without any acknowledgment that he has made much of his fortune managing the retirement funds of many public employees. Mitt Romney argues that his time at Bain has real significance in terms of his qualifications for the presidency. Many on Wall Street and in the business community argue that he developed a keen sense, absent in today's White House, of the concerns of the private sector. But voters need to consider whether the time he spent in single-minded pursuit of profit as a financial intermediary has prepared him to tackle the complex problems facing America, which can't be reduced to a financial model. Romney's financial success is admirable and enviable, but it came by following the mantra of increasing cash flow, cutting jobs and minimizing taxable income. Though the Obama campaign has tried to exploit this with millions of dollars in anti-Bain ads, the real issue is how Romney's experience relates to a president's need to balance budgetary responsibility with the heavy lifting required to address our collective concerns, our common obligations. We have heard a lot about pragmatism and practicality, but I can assure you that compassion and broader social concerns rarely make it into an investment memo. If Romney really wants to push his Bain experience, Americans will have to decide whether the answers to the problems facing them are best provided by a financier president. Peter Joseph is a private investor, with more than twenty-five years in the private equity business. He co-founded two private equity firms and invested on behalf of many leading institutional investors.