Monday, January 23, 2012

Private Equity’s Public Subsidy?

Bloomberg columnist William Cohan reports, Private Equity’s Public Subsidy a Tragedy:

The real reason that private equity executives need to be full taxpayers -- paying 35 percent of their income in federal tax as opposed to the 15 percent capital-gains rate they have enjoyed for years -- is not because, generally speaking, they make so much money.

Nor is it because the return they get on what personal capital they risk is dwarfed by the profits they get on their investors’ capital.

Nor is it so they will pay the same tax rates as their secretaries (although this is a good reason, too).

No, the real reason the tax loophole for private equity mavens must be closed once and for all is that American taxpayers subsidize the private-equity industry -- and its outsize paychecks -- and simple fairness demands that they don’t also get an additional break in the form of lower tax rates.

Mitt Romney, the co-founder of Bain Capital LLC and the leading contender for the Republican presidential nomination, got blindingly rich because of this taxpayer subsidy, and it isn’t right that he and his cohort can also pay taxes at a 20- percentage-point discount compared with the rest of us.

Here is how the subsidy works: The Internal Revenue Service allows for the tax-deductibility of interest expense on corporate debt. Since corporate debt is the mother’s milk of a leveraged buyout, there would be no private-equity/LBO industry without this huge tax benefit. Indeed, anyone who has used an Excel spreadsheet to model a leveraged-buyout -- you know who you are! -- knows that the magic of the entire industry depends almost solely on the interest-expense provision in the tax code.

Loading Up Debt

By loading up a company with debt and then deducting the resulting interest expense, tax payments are generally wiped out, allowing the remaining “free cash flow” to be used to pay down the debt taken on to buy the company in the first place. Given that tax revenue is necessary for the government to function, this means the rest of us provide a subsidy that allows the private-equity firms to thrive.

If the company a private-equity firm invests in does well, the original borrowed money is paid down, interest expense is reduced and profits slowly but surely rise, creating equity value for the private-equity investor. Over time, if the company is performing well enough to pay off its debt load and show net income, it will either be sold outright, taken public through an initial public offering or re-leveraged to allow the private- equity firm to take out a hefty dividend and begin the process of financial alchemy all over again.

This is the moment when the private-equity practitioners really ring the cash register (not to minimize the importance of the annual fees also paid to them by investors, generally amounting to 2 percent of the money under management and which can add up to hundreds of millions of dollars per year, spread among a relatively few people). In most cases, the private- equity firms take 20 percent of the increase in equity value between when they bought the company and when it is sold. (In Bain’s case, it can be 30 percent because for a while investors were clamoring to be in its funds.)

Fine enough: This seems to be the industry’s convention, savvy investors have agreed to the arrangement time and time again, and undoubtedly many companies that might have failed have been turned around (while many others haven’t).

The problem is that, having used the tax code to create the financial magic in the first place, the people working at these firms and sharing in the equity payoff then get the additional benefit of paying tax on their profits -- which are called “carried interest” -- at a 15 percent rate rather than 35 percent.

Fighting the Inevitable

This nifty tax treatment can add up to considerable wealth. Come to think of it, I can’t name a single partner of a major private equity firm I know who doesn’t live in the most lavish way. Many -- Steve Schwarzman of Blackstone Group LP, Henry Kravis and George Roberts of KKR & Co., David Rubenstein of the Carlyle Group LP (CG) and David Bonderman of TPG Capital LP -- are among the wealthiest people in the country. This isn’t meant as criticism -- what they have been doing is not illegal or unethical, it’s actually quite brilliant. Rather, I think it’s a statement that the industry must stop fighting the inevitable.

The tax rate on carried interest must be raised to 35 percent on the profits that come to private-equity partners from their investors’ capital. The gravy train for private-equity partners has gone on for three decades. It has been a great party, but -- as the Bloomberg View editors have also made clear -- it’s time to take the punch bowl away. The private-equity moguls know it. The American people know it. Even Mitt Romney knows it, despite sheepishly admitting that why, yes, his federal tax rate has been around 15 percent lately, come to think of it.

It is simply illogical, and unfair, for the IRS to give private equity two major benefits, one for their businesses and one for their wallets, while the rest of us pay much higher federal tax rates with nary any comparable subsidies at all.

There is no question about it, private equity firms have profited handsomely from the tax-deductibility of interest expense on corporate debt.

But the real public subsidy which Cohan doesn't discuss in his article is the trillions of dollars that US and global public pension funds have allocated and continue to allocate to private equity funds and funds of funds.

And just like hedge funds, most private equity funds are terrible. Academic studies have shown there is clear evidence of performance persistence in private equity, but buyer beware, studies have also found current fund performance is not correlated with the second and third follow-on funds. "Therefore, performance persistence is short lived, and, interestingly, performance converges across funds over time."

Investors should also keep in mind that post-2008, credit remains tight. Private equity's changing landscape means the old model of levering up debt is pretty much finished. The new kings of private equity won't be financial engineers but guys and gals with actual operational experience, people who know how to roll up their sleeves and restructure a company from the bottom-up.

Investors looking for more in-depth insight into private equity should read Coller Capital's Global Private Equity Barometer Winter 2011-12. Some of the key highlights below:

  • Europe’s sovereign debt crisis will deter one in five PE investors
  • Half of LPs have ‘zombie’ funds in their portfolios – and see no solutions for them in most cases
  • Investors regard the re-financing of existing buyout debt as a major challenge for the industry
  • 93% of LPs will refuse re-ups in the next 18 months – and reductions in commitments will be common

Private equity investors (LPs) see major challenges for the industry in the next few years, according to Coller Capital’s latest Global Private Equity Barometer – but despite these worries they think 2012 will be a good vintage year and they expect strong medium-term returns from their private equity portfolios.

Fallout from the bubble years is very visible to private equity investors. Half of LPs believe they have ‘zombie’ funds in their portfolios – that is, situations in which private equity managers (GPs) with no prospect of earning carried interest are motivated to keep funds going for their management fees. Neither are investors optimistic about their ability to remedy these ‘zombie’ fund situations: 72% of LPs think they will find solutions in only a minority of cases; a further 22% of LPs expect none of these situations to be susceptible of remedy.

With the fragile state of today’s credit markets, the majority of investors also think re-financing the ‘wall’ of buyout debt due to mature in 2013-15 represents a major risk to the industry.

Despite these worries, investors generally believe 2012 will be a good or excellent vintage year – over two thirds of North American LPs share this view – and their 3-5 year return expectations for private equity have almost returned to pre-crisis (Winter 2007-08) levels: one third of LPs expect returns of 16%+ from their private equity portfolios; half of LPs expect returns of 11-15%.

I think a lot of LPs expecting returns of 16%+ in private equity are in for a shocker. These investors are deluding themselves and their plan beneficiaries if they think private equity will continue to deliver outsized returns of the last 20 years.

Importantly, conditions in credit markets and public equities will continue to challenge private equity. It's ludicrous to allocate more into private equity to "escape the volatility of public equities." That only buys you some time, it doesn't solve the fundamental issue, which is that private and public equities are highly correlated (with a lag).

Another Bloomberg editorial states that The Trouble With Private Equity Is Privilege Not Profits:
Mitt Romney, the favorite to win the Republican presidential nomination, has brought the rights and wrongs of private equity to the front of U.S. politics. He once ran a private-equity firm, and he has been attacked for it even by fellow conservatives.

This is a new version of an old complaint, and the quality of the discussion is not improving with age. The question to ask about private equity -- which involves taking over companies, restructuring them and selling them at a profit -- is not whether it creates jobs. It is whether taxpayers should be subsidizing its practitioners’ paychecks.

Many politicians say private equity is rapacious. Not long ago, the same charge was laid against leveraged buyouts, and before that against hostile takeovers. The issue is essentially the same. When control of a company changes hands, are the new owners so intent on short-term profits that they act against the interests of other stakeholders -- not just shareholders, but also employees, customers and the wider community?

The current debate has revolved around jobs. Defenders of private equity say the new owners tend to boost employment, and critics say the opposite.

Small Effect

The most comprehensive study to date -- by Steven Davis of the University of Chicago and four other economists, one of whom has been a paid adviser to the private-equity industry -- found that private equity has only a small overall effect on employment. The researchers looked at 3,200 target companies and roughly 150,000 operating units (factories, offices, retail outlets and so on). They found that the acquired companies lost jobs at existing units but added jobs at new ones. Altogether, employment at companies bought by private-equity investors fell in the first two years by less than 1 percent relative to employment at similar companies.

More revealing than the net effect on jobs was gross employment turnover -- jobs created plus jobs eliminated. This total was 13 percent higher for private-equity targets than the control group. In other words, companies bought by private equity both fired more people and hired more people. The study concluded that “private equity buy-outs catalyze the creative destruction process.”

Exactly. In a market economy, some companies or industries are shrinking, while others are growing. You can’t have one without the other, and the spur for both kinds of adjustment is profit. Market forces raise living standards not by increasing wages and employment enterprise by enterprise, but by applying capital and labor to the best uses. Private equity, leveraged buyouts and hostile takeovers all serve this purpose. To keep managers on their toes, capitalism requires a functioning market for corporate control.

Now let’s suppose, contrary to the findings just quoted, that private-equity owners always reduce jobs. Suppose they always drive wages down, too, as some critics say. Would this prove that private equity is bad? Before you answer, remember that -- again at the level of the company, not for the whole economy -- labor-saving innovation also tends to have those effects. So does competition from new entrants. Such is capitalism.

If private-equity owners cut costs and improve efficiency, they are doing what incumbent managers should have done already. If the new owners manage incompetently, they will lose money. As for investors’ selfish motives, Adam Smith gave the wisest advice 250 years ago: “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.”

Valid Concerns

While politicians focus on misguided complaints about private equity, valid concerns are all but ignored. Two are pressing and closely related: debt and political influence.

The private-equity business relies on borrowing. If government policy were neutral on the matter, leverage and the risk that goes with it would be for managers old or new to decide. But policy is far from neutral. The U.S. tax code discriminates strongly in favor of leverage, for example, by giving companies a tax break on interest payments. Without this bias -- which should be reduced as part of a larger tax reform - - the private-equity business would be conducted differently, if it existed at all.

Private-equity and other high-paying financial firms also receive a tailored preference in the form of special tax rates on “carried interest.” This allows income to be taxed as if it were capital gains, hence at 15 percent instead of 35 percent, even if the person concerned has put no capital at risk. Romney said Tuesday that his effective federal tax rate is “probably closer to the 15 percent rate.” Efforts to close this loophole - - a move Bloomberg View supports -- have come to nothing, demonstrating how private equity has made an art of political connections and influence.

If private equity can succeed without preferences, that’s fine: The more competitive the market for corporate control, the better. Its current mode of operation, though, is largely a symptom of a flawed tax code. The industry’s borrowing is subsidized and so are the generous incomes it pays its staff. These privileges are a problem. The issues its critics choose to emphasize aren’t.

I want to be careful not to demonize private equity firms, just like I do not want to demonize hedge funds. There are many excellent private equity firms in the world and they do serve an important part in restructuring companies and making them more competitive. The current political discourse attacking PE firms on employment is terribly flawed.

But there is no question that private equity firms also enjoy privileges that come from an advantageous tax code which they lobbied hard to change. And we all know that some of the richest private equity funds have huge political connections with many former presidents and prime ministers sitting on their board of directors.

Private equity is on the defensive. Bloomberg's Cristina Alesci and Deirdre Bolton report on Stephen Schwarzman, the chief executive of Blackstone Group LP who said four months ago he pays an effective personal income tax rate of 53 percent, is taking steps to avoid releasing his personal financial information (also watch on YouTube).

And David Rubenstein, co-founder of Carlyle Group, was on Fareed Zakaria GPS on Sunday defending private equity's track record on job creation. Carlyle has been the target of many critics in the past, but it was a good interview where Mr. Rubenstein talked about alignment of interests, his humble background, how he gives away most of his profits, has pledged to give away his fortune, and how he thinks Americans need to learn more about their history. Watch a clip of that interview below (wish CNN posted the entire interview).

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