A lot of the flack Mitt Romney has taken over the years related to his time at the helm of Bain Capital concerns the ethics of making money by laying people off. And I suppose that’s worth debating – though I’d be curious how such critics propose generalizing the implicit principle here.

But some of the more trenchant criticism of the “Bain way” revolves around the assertion that their deals were structured so that Bain was unlikely to lose money, even if the company ultimately went bankrupt. The logic of the leveraged buyout is that it’s a check on what amounts to self-dealing by incumbent management. Running at a low degree of leverage, the business can continue to operate while generating a sub-par return on equity. That shouldn’t be tolerable to equity investors, but they have limited ability to change company performance directly. Their ultimate leverage is to sell out to a private equity firm that will completely change management – increasing leverage substantially, raising the risk of the business and forcing changes (particularly cutting overhead and eliminating unprofitable lines of business) to increase free cashflow and profitability. If all goes well, the business becomes more successful and sustainable. If all goes south, well, the company goes bust but the private equity fund also loses its investment. The assumption, in other words, is that the investor’s incentives are properly aligned: Bain makes money if the business succeeds, loses it if the business fails.

This logic goes out the window if the private equity investor makes money whether the company succeeds or fails. But the question is: how can deals be structured to achieve that?

There are a variety of ways to do it. For one, Bain could hire itself for what amounts to consulting. Bain invested $5 million of its own money in Ampad, for instance – one of the more notorious deals – but paid itself a $2 million annual fee for managing the company, plus millions more for arranging a series of acquisitions and, in 1997, the IPO of the company. If you knew you could get paid millions per year in fees for making a $5 million investment, you might be willing to make that investment even if your expectation was that you would lose it – provided you believed you would earn enough in fees to more than offset that expected loss. If you could keep the company limping along for 3-4 years, you might come out ahead. That, in turn, would increase your tolerance for leverage, which in turn would increase the chances that the company would, in fact, go bust.

If the company does succeed – either by increasing sales or by reducing costs or by acquiring additional assets – the equity investor can pay himself rather than leaving the money in the business. The equity investor might even borrow to increase the leverage of the company, and pay himself dividends with borrowed money rather than out of free cash flow. Bain did something of this sort, it’s alleged, at Ampad in 1995, borrowing to finance an acquisition and then paying itself a large special dividend out of a portion of the borrowed funds. Again, there’s an asymmetry: the returns from the original turnaround accrue to the investor who bet on the possibility of that turnaround, while the company has to repeat the original turnaround success merely to remain solvent.

These are troubling practices. But the logical check on these practices should be the debt markets that finance LBO activity. After all, the debt-holder is on the other end of these asymmetries. If the equity investor has an incentive to suck all the value out of a transaction, then the lender to that investor should be aware of that incentive, and respond to it either with restrictive covenants (typical in bank loans) or extremely high yields (typical in the subordinated “junk” bond market) to compensate for the obvious risks. These responses should prevent a situation where LBO firms have an incentive to do “bad” deals – deals that would be expected to destroy the value of corporate assets but that would nonetheless earn returns for the LBO firm.

If LBO’s routinely generate excess returns for equity investors, that could be due to one of two possibilities. One possibility is that corporate assets of various assets are routinely underpriced, and LBO practitioners are skilled at identifying undervalued assets and unlocking their value. In that case, one could argue that LBO firms – buy increasing the value of corporate assets – are providing a real service, even if one can still debate the distributional consequences of their mode of business. And the question would be why more money doesn’t flow into private equity to end this market inefficiency.

The other possibility, though, is that the debt side of the market is inefficient – that, on average, investors who lend to LBO firms earn sub-par risk-adjusted returns on their money. If that is the case, then there is indeed an incentive to do “bad” deals. If an LBO firm knew that it could dump risk on debt-holders – by, for example, borrowing to pay itself special dividends – then the incentive to preserve the value of corporate assets would be subordinate to the incentive to extract value by means of financial engineering. But the question would remain why such a mispricing of risk in the debt market would persist.

I would be curious to learn how the Ampad transaction, to pick one example, was financed: how much was done with loans versus bonds, how the debt was syndicated, what kinds of covenants were in place, how those covenants (if any) were negotiated, etc.

The Bain “issue,” it seems to me, isn’t whether Romney learned how to “create jobs” as head of Bain Capital but whether he learned how to create value. And even this isn’t really the issue. If Bain could figure out how to do “heads I win / tails you lose” deals, I’d expect them to do them – they’re in business to make money. And, on the other hand, being a good investor has very little to do with being a good President. Financial engineering is simply a tool. If savvy market participants face incentives to use that tool to destroy value rather than creating it, that’s what they will do. Recognizing when such incentives exist, and acting to counter them, is a big part of the job of our regulatory infrastructure (and regulations can create those perverse incentives as well as counter them, of course). And in the wake of the financial crisis, it’s incumbent on any candidate for high office to articulate a vision for how that job will be carried out.

Romney, because of his experience at Bain, is in an exceptional position of knowing some of this world from the inside. It would be fascinating to know what he learned that’s actually relevant from the perspective of the public interest. It’s a shame that nobody will ask him.