Reviews | Private equity doesn’t want you reading this


This column is about the excesses of the private equity industry. It dives into the details of the tax code, corporate structure, and some abstruse financial engineering practices. There will be jargon: interest carried, leveraged buyout, joint responsibility. I’m aware that none of this is anyone’s favorite topic of discussion on a summer day.

But private equity relies on your lack of interest; the apparent inscrutability of its practices has been called one of its “superpowers,” among the reasons the trillion-dollar industry continues to fare.

With what? An accelerated and behind-the-scenes drying up of the American economy. Democrats in the Senate are now poised to pass a rule that could slightly clip the wings of the industry — a change to the tax code that would compel partners of private equity firms, hedge fund managers and investors venture capitalists to pay a fairer share of taxes on the money they make.

I can’t understand what his reluctance could be. One of the big players in private equity is the leveraged buyout, which involves borrowing huge sums of money to gobble up companies in hopes of restructuring them and one day reselling them for a profit.

But the businesses acquired — which span just about every economic sector, from retail to food to health care and housing — are often overburdened with debt to the point of being unsustainable. They frequently cut jobs and employee benefits, cut services and raise prices for consumers, and sometimes even endanger lives and undermine the social fabric.

It’s a dismal record: Private equity firms have presided over many of the biggest retailer bankruptcies over the past decade – including Toys ‘R’ Us, Sears, RadioShack and Payless ShoeSource – resulting in nearly 600 000 jobs lost, according to a 2019 study by several proponents of left-wing economic policy.

Other surveys have shown that when private equity firms buy houses and apartments, rents and evictions skyrocket. When they buy hospitals and medical practices, the cost of care skyrockets. When they buy nursing homes, patient mortality increases. When they buy newspapers, reporting on local governments dries up and turnout in local elections declines.

It’s not even clear whether private equity pays off for investors — like university endowments, public pension funds and wealthy individuals — who invest in the industry in the hope of outsized returns. Since at least 2006, according to a study by economist Ludovic Phalippou, the performance of the largest private equity funds has essentially matched the returns of comparable listed companies.

Still, the industry has grown rapidly and had a banner year in 2021. According to McKinsey, total private equity assets under management reached nearly $6.3 trillion last year. The American Investment Council, a trade group representing the industry, says companies backed by private equity firms employ nearly 12 million Americans.

With the help of lax regulation and indefensible tax loopholes, the apparent destructiveness of private equity can be hugely profitable for its partners. Private equity firms make money by taking hefty commissions from their investors and the companies they buy, which means they can succeed even if their investments fail. Phalippou found that between 2005 and 2020 the industry produced 19 multi-billionaires.

“It’s a win-lose tails model,” said Jim Baker, executive director of a watchdog group called the Private Equity Stakeholder Project.

But it gets worse; not only do the private equity partners make money even if their companies blow up, but they also get a good deal from the government on what they earn. Private equity funds typically charge their investors two different fees: a management fee of 2% of invested assets per year (funds are held for around six years on average) and an “interest bearing” fee of 20 % of any investment gain. made in the fund.

In most other industries, the Internal Revenue Service would classify charges like deferred interest as ordinary income (like how your paycheck is taxed) rather than a capital gain (like how your stock market gains are taxed. ). After all, the partners receive the fees as compensation for performing a service (management of investors’ money), and not for receiving a gain on their own invested capital (because this is the money investors, not theirs).

But that’s not how it works for partnerships like private equity, hedge funds, and venture capital firms. Under IRS guidelines, deferred interest is taxed as a capital gain, which has a maximum rate of 20%, rather than as income, which has a maximum rate of nearly 40%. The result: millionaire and billionaire partners of private equity firms pay a much lower rate of tax on much of their income than most of us.

The private equity industry defends its prime rate, citing ‘sweat equity’ – even if partners don’t put much of their own capital at stake, they are rewarded for investing their ‘ideas and energy’, as Steve Klinsky, a former president of the American Investment Council, said so in a recent article. But it’s hard to find many beyond the industry who will champion the low taxation of carried interest.

Barack Obama has called for this loophole to be closed. Donald Trump has pledged to eliminate him. Joe Biden too. Even several financial moguls have called for its repeal, including Jamie Dimon, Bill Ackman and Warren Buffett.

Despite widespread opposition, however, the tax relief has somehow endured – as Tim Murphy recently wrote in Mother Jones, it has been “the most indestructible bad idea in a city that has no shortage of them, a testimony to the unstoppable combination of money and inertia”. .” (Murphy’s article was part of an excellent multi-part survey of the private equity industry published by the magazine.)

The Democrats’ latest tax proposal only narrows — but doesn’t eliminate — the carried interest loophole. Passing it would be a good start to reforming the private equity industry, and I hope Sinema can fight their way through intense lobbying pressure and buy into it.

Even if it passes, however, much more should be done. Eileen Appelbaum, a private equity industry expert who is co-director of the Center for Economic and Policy Research, a liberal think tank, told me she favors many of the ideas in the Stop Wall Street Looting Act, a bill introduced last year by Senator Elizabeth Warren and several other liberal Democrats. The law would impose many new rules on the industry, including limiting tax deductions on excessive debt and adding protections for workers when excessive debt leads to bankruptcy.

One of the most important ideas, Appelbaum said, is known as joint liability, which would hold private equity firms responsible for debt incurred by portfolio companies if the companies fail.

“It doesn’t tell you how much debt you can put on it,” Appelbaum said. “It just says, ‘whatever debt you put on it, you will be jointly liable for it.'”

It seemed like an elegant and sensible idea to me. If private equity firms claim they should be recognized for their “sweat capital,” why shouldn’t they be held accountable when sweat turns to tears?

Farhad wants chat with readers on the phone. If you would like to speak to a New York Times columnist about anything that concerns you, please fill out this form. Farhad will select a few readers to call.

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