(Bloomberg Opinion) -- Private equity — a form of investing that typically involves assuming control of companies — has long been among the most controversial and poorly understood areas of finance. Even as it attracts ever more money from institutional investors, including pension funds acting on behalf of teachers and firefighters, its practitioners face increasing criticism for taking undue advantage the businesses they target.
Now, with a new bill in Congress, presidential candidate Elizabeth Warren has sparked a debate about how to curb private equity’s more predatory aspects. Despite the political posturing, her plan includes a couple of good ideas.
The most popular private-equity strategy stems from a tenet of finance theory — that an actively involved owner can do a better job of running a company than a diffuse group of passive shareholders. To put this into practice, firms such as Blackstone, TPG, Apollo and KKR raise money from investors, which they use to take significant or controlling stakes in companies. Ideally, they then improve the businesses, with the goal of selling at a profit within several years.
When they adhere to this model, private-equity firms can play a useful role in the economy. The process isn’t always great for everyone involved. It can entail layoffs, cost-cutting and even dismantling. (Sometimes the best option for a mature business is to shrink along with a diminishing market.) But if assets are put to their best use, the country as a whole gains.
The trouble is that private-equity executives’ incentives aren’t always aligned with the greater good.
Consider compensation. Private-equity funds are typically set up as partnerships, with the firms serving as general partners and investors as limited partners. The latter pay management and performance fees to the former, which choose the target companies. Yet the general partners also extract fees directly from the companies — purportedly for management services and advice on mergers and acquisitions, although the fee agreements often don’t require them to do anything at all. Thanks to such “monitoring and transaction” payments, which amount to hundreds of millions of dollars a year in the U.S., private-equity executives can come out ahead even if the companies go bankrupt and investors lose out.
One might reasonably ask why investors accept such terms. The answer, in part, is that they suffer from the same oversight problems that private equity is supposed to solve: They’re diffuse, have limited powers and are usually managing other people’s money.
Granted, in recent years investors have pushed private-equity firms to rebate a portion of monitoring and transaction payments. This can make investment managers at pension funds and endowments look better by offsetting the management fees that their bosses and clients track. These rebates do not, however, lessen the drain on the companies concerned or necessarily erase the firms’ perverse incentives.
Private-equity firms also have strong incentives to load up companies with too much debt. For one, they can use the borrowed money to pay themselves special dividends — a way of cashing out their investments quickly. And the government subsidizes debt: The tax code treats most interest payments as a deductible expense, unlike payments to shareholders. This makes borrowing artificially cheap, allowing firms to reap added returns merely by levering up. As of late 2018, the typical ratio of debt to operating income at private-equity-owned companies was about four times that of the average company in the S&P 500 index. Such extreme leverage has a big downside. It makes the target companies — and the people they employ — more vulnerable in slumps, as interest payments overwhelm their declining income.
How can lawmakers discourage the bad kind of private equity without killing off the good? Warren has a plan. Together with several Democratic co-sponsors, she has introduced a 103-page bill that she says will stop “legalized looting.” It contains provisions dealing with everything from the basics of corporate structure to the minutiae of bankruptcy proceedings. Moderate it is not.
One provision takes aim at a foundation of modern capitalism: limited liability, the idea that shareholders should not be on the hook for a company’s debts. It makes an exception for general partners in private-equity firms, holding them responsible for the obligations of target companies. This means that a single failed investment could lead to personal bankruptcy.
No doubt, the prospect of financial ruin would make private-equity executives more cautious about borrowing. But it would also make them less willing to participate in an inherently risky endeavor — most likely killing private equity as an investment strategy. It’s hard to see how this would be a net gain for the economy.
Setting aside that sledgehammer, the bill has some constructive proposals. For example, it would halt the fees that private-equity firms extract directly from target companies. That’s wise, because the firms have no good reason to pay themselves for running companies they own, particularly when they are already receiving fees from investors. If the market can’t impose this discipline, legislators are right to step in.
The bill also prohibits special dividends in the first two years after an acquisition. The period is somewhat arbitrary, but this could lead private equity firms to focus more on improving businesses than on extracting cash, at least initially. Experience suggests it wouldn’t be too onerous: Europe imposed a similar ban several years ago with no ill effect.
When it comes to the government subsidy, the legislation is strangely timid. It limits the deductibility of interest only for highly leveraged companies. Why not remove the subsidy completely, by taxing payments to creditors and shareholders equally? This would have beneficial effects far beyond private equity, eliminating an incentive to lever up that renders the whole economy more fragile.
Lastly, Warren would shut down the well-known “carried interest” loophole, which allows performance fees to be taxed at low capital-gains rates rather than as ordinary income. That’s a good idea. It’s a pity the bill doesn’t also explicitly preclude other dodges, such as slipping private-equity stakes into individual retirement accounts — a strategy made famous by former presidential candidate Mitt Romney.
In sum, policy makers do need to take a look at how private equity is taxed and regulated. Warren’s plan includes some good ideas but fails to take up others — and can’t seem to decide whether it wants to shut the business down or just nudge it in a better direction. It’s a plan, all right, but one that needs more work.
—Editors: Mark Whitehouse, Timothy Lavin.
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