The real problem with private equity

by pdxblake

There has been a lot of attacks on Bain Capital and Mitt Romney’s affiliation with it in the campaign, and much of it has been focused on specific cases and whether he was involved in outsourcing jobs.  However, there has been much less focus on what is private equity and why it exists.

Private equity, generally speaking, in practice is the exercise of investors buying companies and taking them private (i.e. removing them from the universe of publicly-traded companies).  The private investors restructure the companies, changing management, selling off unprofitable parts of the business and generally cutting costs (which includes firing workers, squashing unions, and offshoring).

Those parts are well understood and highlighted by the attacks from Obama (which I think are generally on-target).  However, there are many other parts of private equity that operate under-the-hood that are to varying degrees lesser understood, but are important for evaluating whether the private equity industry benefits society as a whole.

First, private equity buys companies by putting a little money down, and then borrowing a lot of money to buy the company.  They then borrow further to pay dividends, pay themselves management fees and invest in high-upside areas of the business (not all the debt is used to loot the company).  The reasons they do that is mostly about making as high returns as they can (private equity companies experience high rates of failure, so the resulting successes have to generate high returns).  It is the old story of leverage that we learned with Lehman Brothers where there is a small equity buffer and a lot of borrowed money.  They make a lot of money when things work out, but can fail spectacularly (most PE companies do not fail spectacularly because the debt is placed on the companies they own, not the PE companies, which is what differentiates PE from investment banks like Lehman).

Apart from the ability of leverage to magnify returns, it is also a very nice strategy for PE firms to use for tax reasons since interest expense can be deducted from income to reduce taxes.  A company that a PE firm buys and adds debt to, can lower its tax bill (and thus leave more money available to pay out to the PE owners) by taking on additional debt.  As long as the businesses remain afloat, it benefits the PE firm as well as the business, since it is able to make higher after-tax profits.

What trips this debt orgy up is when the economy slips.  Many of the Bain Capital firms detailed in the media are in cyclical businesses, where sales and profits swing greatly between boom and bust.  When the PE firm invests, as long as it is in good times, the business booms and there are windfall profits to pay out to the PE firm, and still pay the interest on the debt.  However, when the economy turns, as it inevitably does, the heavy debt load becomes crushing.  If the PE managers are ‘smart’ they have taken out enough profits to make a profit even if the firm ends up in bankruptcy.

These same managers get to walk away with their profits, in part taxed as regular income (their management fee), but mostly taxed as capital gains (at a 15% rate), even though the PE managers’ wealth is not at risk except what they have invested in the funds.  They have gamed the preferential treatment of debt over equity. It would be much more expensive to fund the takeovers using equity, where investors get paid dividend income that comes out of the company’s after-tax income.

This is the real perversity of the tax system and Bain Capital.  They get to benefit from owning companies that get to deduct most of the cost of the acquisition.  If (when) the companies go bust from having too much debt, the PE funds walk away with only small losses in relation to the amount money they are usually able to extract.  And the managers of the fund get to pay lower tax rates on their winnings earnings.

The losers are the employees of course, and the communities where they were located.  But the taxpayers also lose.  During the good times, the PE-owned companies pay less in taxes than they would without the deduction for their interest payments.  The taxpayers have to pay the pensions to the workers of the companies when the PE owners shove the pension liabilities on the Pension Benefit Guarantee Corporation (PBGC).  The economy loses with unnecessary business failures brought upon by leveraging up companies beyond their ability to repay.

In some ways, the financial crisis has helped to stem the tide of PE buyouts, since the debt they rely on is not as freely available.  However, the bigger distortions–the tax deductibility of interest payments and low tax rates on the ‘performance’ fees for fund managers–remain.  The former, tax deductions for interest payments, incentivizes companies to take on a larger than optimal level of debt.  It makes equity financing more costly, which leads to more volatility in the economy as a result of higher debt levels than would exist in the tax credit’s exemption.  The latter, the tax breaks for PE and hedge fund performance fee income, is well documented and a stopgap solution is in place with the Buffett Rule.

If we really want to make the tax system fairer, here are a couple more areas to add to my earlier post on getting rid of the Bush tax cuts for the highest income earners.