The Evil of Private Equity*

The Evil of Private Equity

“A Delicate Balancing Act” in the May 29th TLR discussed a New York Times editorial entitled “Charity Won’t Solve Student Debt,” which took to task Robert Smith, the founder, chairman and CEO of Vista Equity Partners, who had announced during his commencement address at Morehouse College that he would repay all of the student loans burdening the 396 men in the 2019 graduating class. The editorial made the point that “[a] new generation of plutocrats [Mr. Smith being the Times’ plutocrat-of-the-day] has amassed great fortunes, in part because the federal government has minimized the[ir] burden of taxation.” It argued for government control of the charitable giving process to determine how much and to whom such magnanimity should be allocated …, a suggestion that TLR’s commentary found ludicrous undemocratic questionable. But its central point was to argue for repeal of “a provision of federal tax law known as the ÔÇÿcarried interest loophole’” that benefits plutocrats who own private equity firms, like Smith does, and who make their fortunes by making leveraged investments in speculative businesses. According to the Times, “Closing that loophole would be a much better graduation present for the class of 2019 [than Smith’s payment of their student loan debts].” TLR also considered that statement to be ludicrous specious questionable.

Senator Elizabeth Warren doesn’t. She shares the New York Times’ opinion of private equity firms. Consequently, as part of her proposals in the Stop Wall Street Looting Act of 2019, Warren wants to put an end to private equity investing as we know it … and as it has existed for decades. Her goal, as stated in “My Plan to Rein in Wall Street” (MPTRIWS), is “To raise wages, help small businesses, and spur economic growth, [by shutting] down the Wall Street giveaways and rein[ing] in the financial industry so that it stops sucking money out of the rest of the economy.” Few would argue that Wall Street has its unfair share, and maybe even more than its unfair share, of abusers and abuses. Abusers and their abusive practices always and everywhere should be addressed and, to the extent that doing so is carefully targeted, stopped. One danger in Warren’s proposals is that they are not carefully targeted. If enacted, the totality of those proposals, and a brilliant little tweaky one in particular, would “suck money out of the rest of the economy.” Because Warren is running for President, her proposals naturally are designed to be appealing and simple-to-understand. They are. They target demonstrably “bad guys,” filthy rich “bad guys” like fictional corporate raider Gordon Gekko who amass their wealth by stripping companies of their assets and firing their employees. Warren cites a few egregious examples that appear to show precisely that … and uses those examples to attribute bad conduct to the private equity industry as a whole. And then, in order to address the abusive behavior in those examples, Warren proposes to deliver the coup de gras – an end to the possibility of private equity firms doing any such thing which, after close analysis, would lead to an end to the private equity industry itself … and thereby strip private equity companies of their assets and require them to fire their employees. Warren readily admits that the changes she proposes “would shrink the sector,” but insists that this would be a good thing. She states: “Let’s call [private equity investing] what it is: legalized looting ÔÇö looting that makes a handful of Wall Street managers very rich while costing thousands of people their jobs, putting valuable companies out of business, and hurting communities across the country…. [F]ar too often, the private equity firms are like vampires – bleeding the company dry and walking away enriched even as the company succumbs.”

Hmmmm. Let’s see. Should people side with “vampires” and “looters” who “cost thousands of people their jobs” and “put companies out of business…, hurting communities across the country,” whose owners are covered in blood and who walk away enriched? Or should they side with Warren and her Stop Wall Street Looting proposals?

Warren’s MPTRIWS lists a number of reasons why “the financial sector hurts the economy,” relying on analyses that raise both good points and … not-so-good ones. Without getting into the weeds of the analyses she relies on, Warren’s proposals attempt to fine-tune existing legislation and mandate regulatory changes that would limit the fees that private equity firms are permitted to receive from the companies they acquire, limit private equity investments in sectors considered by Warren to be over-invested (which she indicates include construction and property development), incentivize investment in manufacturing companies (which she indicates should include those reliant on research and development), and provide disincentives for talented people to gravitate to finance(!) rather than more productive pursuits. She would (1) hold private equity firms responsible for pension obligations of acquired companies, (2) eliminate the ability of private equity firms to pay themselves huge fees (by imposing a 100{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} tax on fees paid from companies to the private equity firms that buy them) or distribute huge dividends (by prohibiting dividends and other distributions for two years after an acquisition), (3) revise the tax rates on debt-financed interest, (4) modify bankruptcy rules to claw-back for employees compensation paid to private equity firms, (5) limit the amount of debt privately-owned companies can incur, (6) “close the carried interest loophole” (a subject addressed in the May 29th TLR), and (7) “[put] private equity firms on the hook for the debts of companies they buy, making them responsible for the downside of their investments so that they only make money if the companies they control flourish.”

Although several of these provisions contain good ideas that could add a level of balance to what today is not always a balanced financial playing field, enacting a majority of these “anti-looting” provisions would emasculate the private equity industry …, and enacting the last one would kill it.

This is the text of the last item (#7 above) (Section 101 of the Stop Wall Street Looting Act of 2019): “(a) IN GENERAL.–Notwithstanding any other provision of law, or the terms of any contract or agreement, a private fund shall be jointly and severally liable for all liabilities of each target firm with respect to the private fund, and any affiliate of such a target firm, includingÔÇö(1) any debt incurred by the target firm or an affiliate of the target firm, including as part of the acquisition of the target firm by the private fund….”

Section 101 therefore would repeal limited liability for the assets and liabilities of companies acquired by private equity firms. PE firms accordingly no longer would be treated as shareholders of acquired companies. They instead would be treated as having merged the acquired companies into themselves, aggregating the assets and liabilities of the acquired company with those of all other acquired companies, thereby changing the entire economic, governance and legal analysis of acquisition and operation, as well as the quality and quantity of companies that warrant acquisition.

This small tweaky change to limited liability is radical …, and would have radical consequences.

Perhaps the greatest invention of modern capitalism was limited liability. British and American industries and economies flourished as a result. Limited liability promotes investment. It encourages entrepreneurial risk-taking. And it enhances capital formation. Eliminating it in the private equity world would have far-reaching consequences and create an economic environment wholly different from the capitalist environment of the last 200 years.

Despite the examples of private equity excess that Warren and others point to, analysis after analysis has shown that private equity firms on the whole – albeit with exceptions – improve the operational efficiency of the companies they acquire, increase productivity and improve management practices. That’s their job! Otherwise, their predatory practices over time wouldn’t be profitable. Yet, even were that not so, laissez-faire capitalism wouldn’t be laissez-faire without limited liability. Capitalism of necessity includes high-risk investing that sometimes strips companies of assets and results in wholesale employee firings. That what distinguishes it from centralized, static and protectionist State planning. And disruption is precisely what private equity seeks.

Warren is correct, however, that private equity firms often overdo debt, to the detriment of the target company and its employees … and the private equity firm. If government intervention is the answer, then such intervention needs to be through rifle-shot legislation, not the shotgun legislative and regulatory approach that Warren proposes that includes changes to the tax, bankruptcy and corporate laws … and to a foundational tool of capitalism.

Warren’s Stop Wall Street Looting Act of 2019 seeks to address any number of Wall Street abuses. Although questions can and should be raised concerning its breadth and assumptions, in a healthy political environment the fact that it is being proposed would lead to a meaningful, bipartisan discussion about reconciling private equity with the long list of laws that impact on Wall Street and American business as a whole. Unfortunately, we live at a time when thoughtful, bipartisan discussions exist only in skit parodies on Saturday Night Live. What we are left with is a set of highly complex, impossible-to-enact proposals that are useful only as a means of motivating a candidate’s political base. The most dangerous part of those proposals, and the one to fear, is the brilliantly small tweak that just might find traction at some point in the future … and change the world of capitalism.

Finally (from a good friend)

*┬® Copyright 2019 by William Natbony. All rights reserved.

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