There is a serious debate to be had about the social utility of the private equity business and the tax incentives which encourage riskier PE capital structures in particular. However the attacks unleashed by Newt Gingrich Rick Perry and others have eschewed such policy-based criticism in favor of a more populist anti-free market attack. This is ironic given the Hayek-style belief in free market capitalism that has dominated Republican politics since the Reagan revolution of the 1980s. The core of the Gingrich/Perry attack is that private equity is all about firing American workers to line the pockets of "vulture capitalist" financiers like Mitt. While the job destruction or at least job export criticism merits critical analysis (not likely in this election cycle) the data I have seen suggest that for every job eliminated PE-backed companies create at least as many new jobs — and not menial ones. This is "creative destruction" as envisioned by Joseph Schumpeter in its most concentrated form.
What private equity firms (and for that matter all good investors) do pursue is the competitiveness and efficiency of their portfolio companies. This often includes reducing labor costs as a percentage of total revenues but as growth is achieved new jobs are also created. Indeed the central fallacy of the politicization of the PE debate is the insinuation that respectable firms like Bain somehow seek to ruin and bankrupt companies for the sheer pleasure and greed of the sport. This has not been my experience. What these firms are organized to deliver for their pension fund and other institutional investors as well as for their operating partners is the maximum return on investment achievable at an acceptable level of risk (more on this below). This core free market goal results in an efficient allocation of capital and labor – often more efficient than the internal allocation mechanisms that operate within large corporations. Thus a private equity buyout or significant equity participation often acts as a catalyst or concentrating force enhancing the economic performance of the enterprise.
Now all is not perfect in the PE universe. There are potential negative externalities – in particular the allocation of risks and rewards (abetted by US tax policy) that tends to favor greater risk taking and provide less margin for error in down markets. In brief private equity professionals typically have more to gain than lose financially from increasing the variability of returns from a given investment. Let’s see why. First as with most corporations PE-backed companies benefit from the deductibility of interest payments on indebtedness — this encourages more leveraged structures by lowering the cost of debt versus equity financing. Second income earned by PE sponsors in the form of a "carried interest" on the overall gains of their funds (typically 20% of total gains) is currently taxed at favorable capital gains not at ordinary income rates. While there has been a raging debate as to why US tax policy should favor this form of employment income over wages my goal here is limited to noting that this favorable tax treatment tends to amplify the incentive already created by the asymmetrical carried interest reward mechanism to seek the highest return on equity – typically but not exclusively by taking on the maximum debt lenders are prepared to commit. When a portfolio company goes bust the PE sponsors lose their often substantial personal invested capital in the deal alongside their limited partner investors and they earn no carry on that investment; however they do not pay a 20% "negative" carry to their investors. At most they risk having to give back the positive carry earned on prior winning investments and they potentially incur a repetitional hit which can hinder future fundraising. However when portfolio companies succeed and the overall fund achieves positive returns the sponsors earn their substantial carried interest (even taxed at a favorable rate as we have seen above). This asymmetrical reward structure resembles a call option on the upside of the investment portfolio and classical options pricing model tells us that the holder of an option benefits from increasing the variability of the returns on the underlying investment (I.e. the value of an equity call option increases as the beta of the underlying common stock rises).
I delve into this somewhat esoteric detail only to point out that there is a reasoned economic criticism that can be leveled against private equity. Namely that it tends to increase the riskiness of the economy by encouraging the substitution of debt for equity as a result of the asymmetric reward structure and tax advantages afforded this form of ownership. However the analysis must not stop there as private equity also enhances the efficiency of its portfolio companies and often provides badly needed growth capital when other more risk averse investors are unwilling to fund.
In withdrawing today from the race for the Republican nomination Jon Huntsman declared that the party must return to being the "party of ideas." All I can add is that this would be a welcome change.
What would you do if elected President?
Hi The problem as in many things but especially the financial industry is excess. In the UK it would be from EMI to Yell of piling on the debt with little real consideration of removing the sort of protections that would likely be placed by non-PE companies of greater/stronger balance sheets as the consequence horizon only stretches until the company can be sold onto someone else or listed. The penultimate paragraph sums it up almost perfectly. Yes PE can also make staid businesses more efficient and focused even provide additional new investment-capital that publicly-traded companies might not otherwise be able to gain access to but how often and likely. Private-Equity nee: leveraged-buyouts can have their virtues but the last decade of it also reminds me of the housing bubble over the same time where anyone could buy a house and think they were genius property-developers because no matter how abysmally they managed their portfolios and developed their properties because of the irrationally rising market based on cheap money they made more money than those who never jumped into what was essentially financial-engineering. As for the tax policies effecting the private-equity industry and Mitt Romney there was a great piece on the 24th January 2012 edition of the Daily Show (first 5 minutes but the rest is good as well) where even the Republicans were going to change the carried-interest law but it got lobbied out. Yours kindly Shakir Razak
…the data I have seen suggest that for every job eliminated PE-backed companies create at least as many new jobs–and not menial ones. I think that sounds really interesting. Do you have time to share some links to that data? Thanks Amy
good
thanks article.
Thanks for the share