The Case Against Tax Breaks for Private Equity
Private equity disproportionately rewards privatization companies while others are burdened with the risks.
I wanted to wait a few days before commenting on Newark Mayor Cory Booker’s spontaneous criticism of Barack Obama for picking on Mitt Romney's experience at Bain Capital. Booker doesn’t know much of anything about private equity, but many financial services donors have his ear. He took in nearly half a million dollars in campaign donations from the industry over the last nine months, and he frankly sounded like its mouthpiece.
Booker backtracked, but it would be nice if he knew something about the private equity business before he spoke publicly about it. This expectation of knowledge should also apply to widely read columnists like David Brooks, who, as usual, reflexively defended the Wall Street practice without presenting evidence. He issued a piece of public relations diatribe that no doubt soothed the right but contributed nothing to our understanding. The contention is that these buyouts turned fat American companies into lean and productive ones since the 1970s. Other pundits less well known for their conservative reflex responses have also given partial defense of private equity.
So let’s begin with one point: there is a place for private equity. In a privatization or leveraged buyout, a company is bought by an investment partnership with moneys borrowed against the company itself. The new money can be used productively even when levels of debt against the company’s assets and profits soar. A smaller company that cannot raise adequate equity can raise money by being bought by a private equity partnership. A company that is doing poorly can benefit from added capital and new management. Sometimes trimming labor costs in the process makes sense, of course.
But the record of leveraged buyouts and private equity reflects its excesses, and most importantly, the lopsided nature of the financial incentives for doing the deals in the first place. Companies like Romney’s Bain or Steve Schwartz’s Blackstone or Kohlberg Kravis Roberts, the early industry leader when privatizations were called leverage buyouts (LBO), take advantage of a major government-provided benefit. The interest on debt is tax-deductible, and high levels of debt are the source of profits in these transactions. It is just like buying a house with a small down payment; if you can sell as the value goes up, the return on the down payment is high and the interest was deductible all along. In the meantime, the house is collateral for the loan. Similarly, partners are rarely if ever on the line for the debt; the company being privatized is. The one difference is that if the collateral value of the house falls, as it has recently, the homeowner is on the line. This is usually not so with privatizers.
Great deal? You bet. The owners of the privatizing firm put up very little capital; it is their limited partners who put up more. Then they borrow like mad from banks, pension funds, hedge funds and so on. If the new company can be sold or brought to market again at a higher price, they make a bundle compared to their equity down payment. The CEOs of the company, or the new executives brought in, are given huge amounts of stock. They too make a bundle. Are these incentives conducive to good business decisions?
Most likely, the investment decision is based not on how much the company can be improved, but how much can be borrowed against its assets. The second concern is the interest rate on the debt. There is no evidence that privatizers mostly buy struggling companies to resuscitate them.
Moreover, companies with high levels of debt are subject to great risk of bankruptcy. Macy’s did one of the first leveraged buyouts of its size, the CEO made out wonderfully, and soon Macy’s was in bankruptcy. It reorganized and reemerged successfully due to its retailing skills, but these were not enhanced by the LBO partners.
Data shows the newly bought firms create fewer new jobs—or result in more lost jobs—than firms that are not subject to private takeover. But what about the much-lauded productivity gains? On balance, these target firms mostly increase productivity by selling or closing low-productivity units. Arguably, they also make their employees work harder. The fear of lay-offs can enhance productivity. There is no evidence that these firms improve productivity mostly by investing in new technologies, new managerial methods, and so on, which is often their claim.
And of course what productivity gains they have had (overall they are small) did not reinvigorate the American economy. The two main sources of productivity gains in the U.S. were high-tech companies and the retailing behemoths led by WalMart. Many retailing targets of privatizations eventually went bankrupt.
The best recent paper on private equity was written by Eileen Appelbaum of the Center for Economic and Policy Research and Rosemary Batt of Cornell University. The David Brookses of the world will cry that these researchers are of a liberal bent. But read the paper to see how carefully it is done. The exegeses of much of the right in defense of private equity are essentially outright propaganda.
However, the basic point comes back to government and regulation. A major tax advantage gives rise to these buyouts. The privatization partnerships are lightly regulated. After-fee returns to the limited partners seem to be below average. But as for their benefits to society, privatization rewards investors by cutting short-term costs. For a long time, the stock market pushed up the stock prices of companies that kept short-term earnings growing. The influence of such corporate governance has been to keep downward pressure on wages and stoke fear in employees for three decades.
Let’s be clear; some private equity investments were healthy and some of these partnerships do a good job. But all in all, it is clear most are simply exploitations of tax law, market fashions, and their power to borrow money. There is no reason America should reward these investors with a tax break on their huge loans.
Privatizers didn’t rebuild America. They were rarely the people who planted the garden, watered it, or designed it. They were by and large the ones who weeded it, sometimes recklessly, throwing out the gorgeous roses in the process. Gardens do need to be weeded, but should those who do the weeding, often heedlessly, make so much more money than those who do the planting? And with the added help of government tax breaks?
In the end, Romney’s Bain made money even though its takeover target, American Pad & Paper, went out of business. Consult Appelbaum and Batt on how some of these strategies work, involving mortgaging real estate holdings and transfer pricing to reduce taxes. Privatization was mostly, if not entirely, about working the system, not building capitalism. On balance, evidence suggests it hurt more than helped. Any way you read the evidence, it is clear the rewards for private equity firms clearly exceeded the risks. That’s not good for free markets.