Is private equity crony capitalism with tax breaks instead of kickbacks?

I’m tempted to put David Waldman’s post on yesterday’s Daily Kos up for the Onion Award for headlines that say it all:

“Mitt Romney is a ‘businessman’ like the Hamburglar is a rancher.”

Another line in the piece is almost as good: “[F]orget running government like a business. Romney doesn’t even really know how to run a business like a business.”

But reducing the post to the quips would be a shame. For one thing, it contains some good analysis (as well as some language whose absence would have made the post stronger). For another, it contains a link to this neat little video by Robert Reich:

This video seems particularly compelling because of what it doesn’t assume: that the companies bought by private-equity firms always go bust. Some survive and some even prosper: we know that. But the point is that the whole enterprise is only profitable, on average, because the investors are gaming the tax code (deducting interest payments for debts unrelated to investment, counting what’s effectively ordinary income, not based on profits from an equity stake, as capital gains) and socializing costs through the unemployment system—and, Reich might have added, the pension insurance system, and soon the health-care subsidies built into the Affordable Care Act.  (Without the ACA, laid-off workers would either become poor enough to qualify for Medicaid, or have no insurance at all. That’s a cost too.)

I can’t think of a good rebuttal. Any takers? Or has private equity been a form of crony capitalism all along, without anybody having the guts to come out and say so?

Comments

  1. Tommy says

    I can’t help but think that these deals are similar to what the mob calls a “bust out”.

  2. Dennis says

    One thing Waldman (and Reich, for that matter) makes clear is that the vampire capitalist business model is viable if and only if the privateers can take control of the company. Waldman points out that Rmoney’s successes in building real businesses with a genuine product (Staples) came when Bain Capital couldn’t afford a controlling stake — they had to take a minority position and were thus forced to work for the success of the business.

    To use a biological analogy, they were symbiotes rather than parasites. And perhaps the key to controlling the likes of Bain Capital is to prevent them from hold a controlling stake in a business other than their own.

  3. Allen K. says

    The second article (mis)linked to, http://www.browardpalmbeach.com/2012-04-19/news/mitt-romney-and-bain-capital-represent-everything-you-hate-about-capitalism/ is pretty amazing. Or at least, it should be.

    “When Bain purchased the mill, Sanderson says, change was immediate. Equipment upgrades stopped. Maintenance became an afterthought. Managers were replaced by people who knew nothing of steel. The union’s profit-sharing plan was sliced twice in the first year — then whacked altogether… ‘It was like they were taking money from us and putting it somewhere else.’ … Bain’s first move [at another company] was to fire all 258 workers, then invite them to reapply for their jobs at lower wages and a 50 percent cut in health-care benefits.”

  4. MikeM says

    Some forty-odd years ago I counted my kids’ toes with, “This little piggy went to Harvard, This little piggy went to Yale, This little piggy played the market, This little piggy went to jail.” [The fifth little piggy I left alone.]
    I’m changing the third and fourth piggies for my grandkids: “This little piggy bought a business, This little piggy made it fail.”

  5. MikeM says

    Some forty-odd years ago I counted my kids’ toes with, “This little piggy went to Harvard, This little piggy went to Yale, This little piggy played the market, This little piggy went to jail.” [The fifth little piggy I left alone.]
    I’m changing the third and fourth piggies for my grandkids: “This little piggy bought a business, This little piggy made it fail.”

  6. sd says

    This is complete nonsense. Back in the days before a former private equity investor was running for President on the Republican ticket liberals barely made a peep about the PE world. Indeed, given the fact the the majority of PE capital comes from the endowment funds of universities and other non-profit organizations, one would think that the oh-so-morally sensitive critics of PE among the tenured professoriate would be happy to return to the general public that portion of their salary paid for by the returns on the PE funds held by their employers, but hey – let’s not get crazy here!

    The most inane portion of the post is the section that begins:

    “But the point is that the whole enterprise is only profitable, on average, because the investors are gaming the tax code”

    To which the following is added as support:

    1) “deducting interest payments for debts unrelated to investment”

    Interest payments on debt are “tax deductible” for every single business operating in the economy and have been more or less forever. And that’s because they are a frickin’ business expense. Here’s a news flash for you: Compensation payments to employees are “tax deductible.” Invoice payments to suppliers are “tax deductible.” In fact (with the occasional quirky exception) every payment from a firm to the non-equity owners of the firm is tax deductible.

    You might as well say that it only makes sense to hire employees because employers are “gaming the tax code.” Because that’s exactly as meaningful a statement as the one you made.

    Accounting 101 folks – its offered at every community college in this great land!

    2) “counting what’s effectively ordinary income, not based on profits from an equity stake, as capital gains”

    Now, reasonable people can indeed argue that the income PE general partners make from carried interest should be taxed at the rates for ordinary income rather than the lower rates for capital games (I myself have sympathy with this position, though I would favor a hybrid treatment that, IMHO, more accurately replicates the true economics of the general partners in a legal partnership).

    But carried interest is only granted to the GPs if the fund in question earns a profit (indeed most partnership agreements stipulate that the fund has to earn a profit above a pre-determined hurdle rate for there to be a carry). So to say that the whole enterprise is only profitable because of favorable tax treatment is just flat wrong. The GPs take home more money under the current tax treatment then they would under an alternate tax treatment in which their carry was taxed as ordinary income, but there has to be a profit (and for funds with a hurdle rate – a significant profit) for their to be a carry to tax in the first place.

    Again – Accounting 101. Its probably offered nights and weekends in case you’re busy during the day.

    3) “and socializing costs through the unemployment system”

    I suppose one can make this statement as a definitional assertion. But if this is true, then no business can earn a profit apart from “gaming the tax code.” Because (and I know that this may sound shocking) when someone applies for unemployment compensation its granted regardless of whether their former employer was or was not a PE-owned business. We have a social safety net. In the absence of a social safety net I doubt that many businesses (whether owned by eeeeeevil money-obsessed hooligans like Mitt Romney or sainted virtue-obsessed philanthropists like Warren Buffet **cough cough**) would pay their former employees for extended periods of time. If they had the money to do that, they’d might as well have kept them on as employees.

    Now, if indeed PE owned businesses were net contributors to the unemployed population (vs. a properly matched control group of non-PE owned businesses in similar industries, at similar points in their life cycles and with similar ex ante financial positions) then you might sort of kind of have a point. Fortunately the research has indeed been done, and it turns out – not so much.

    • says

      Accounting 101 folks – its offered at every community college in this great land!

      At the University of Minnesota, where I got my masters in accounting, it’s actually Accounting 250 where you start. However, you may notice, if you look at the course catalog, that there are many more accounting courses than just Introduction to Financial Reporting. That’s because things aren’t nearly as simple as your first class would indicate. (Conservatives have similar problems with not understanding that there are Econ courses beyond the introductory microeconomics class.)

      As you learn more about you accounting, one thing you pick up is that many interest payments have fundamental differences from ordinary business expenses like wages. The fundamental difference is that wages are considered an operating expense. The accumulation of debt is considered a financing transaction. Shifting the cost of a financing operation (i.e. paying interest) out of financing and into operations is really kind of an odd thing to do.

      One consequence of this is that you end up with debt financing being privileged over equity financing. That has some rather toxic consequences, including overleveraging companies. One problem with a lot of private equity deals as that the purchasers deliberately overleverage the company. In their prospectus, they usually describe it as forcing the company to run lean. In practice, it often allows them to use bankruptcy as an escape hatch. Along the way it allows them to suck money out of the company. This isn’t what happens in all deals and probably not even in most deals. But it happens enough that it is a real problem.

      So, yes, you are correct that all interest is tax deductible whether it is related to a private equity transaction or not. THAT’S THE PROBLEM. The private equity deals discussed are simply the reductio ad absurdem of the fact that interest is a deductible expense. The proper response is to treat it like what it is: a non-deductible financing expense rather than a deductible operating expense. There are some debt transactions that actually are operations related rather than financing and you could find a way to treat them as such. But privileging debt over equity is just a bad idea.

      • sd says

        “As you learn more about you accounting, one thing you pick up is that many interest payments have fundamental differences from ordinary business expenses like wages. The fundamental difference is that wages are considered an operating expense. The accumulation of debt is considered a financing transaction. Shifting the cost of a financing operation (i.e. paying interest) out of financing and into operations is really kind of an odd thing to do.”

        Interest payments also have fundamental differences from payments to the providers of equity capital. Namely, lenders have no governance role in the company, have a legal right to be paid interest and cease to have a claim on the cash flows of the business when the debt principal is repaid. Providers of equity capital on the other hand do generally have a governance role in the company, have absolutely zero right to be paid dividends but retain a claim on the cash flows of the business in perpetuam (unless of course the sell their equity to others).

        Interest payments on debt are tax-deductible because the firm cannot choose to not pay interest in a lean year when operating profits are lower than the firm would like. The alternative would be to treat interest payments as a post-tax expense, but this of course would lead to widespread business failure among firms that generate an operating profit that is enough to cover interest obligations but not enough to cover interest obligations after taxes are paid. Given that statutory corporate taxes rates are 35%, and average effective corporate tax rates are approximately 25%, a VERY large number of businesses would fall into this category. A helluva lot more workers would lose jobs under such a policy framework than do so now in the wake of PE transactions.

        “One problem with a lot of private equity deals as that the purchasers deliberately overleverage the company.”

        One problem with public equity ownership is that managers deliberately underleverage the company. In other words, they pass up the opportunity to take advantage of relatively cheap debt capital (the use of which provides financial leverage that increases the value of the firm to the equity holders) and instead finance the business with relatively expensive equity capital. And they do so precisely because the legal rights of lenders impose operating and cost discipline on the business that most managers would prefer not to be bothered with. But the situation is economically inefficient.

        “In their prospectus, they usually describe it as forcing the company to run lean. In practice, it often allows them to use bankruptcy as an escape hatch.”

        This makes absolutely no frickin’ sense whatsoever. Under bankruptcy the equity holders in a business are effectively liquidated. The incentive to not over-lever a company is precisely that the entirety of invested capital can be lost in a bankruptcy.

        During the period that a PE fund owns a company, it faces a real risk of losing its investment if it forces the company to take on too much debt. Not to mention the fact that the debt itself grows more and more expensive the greater the ratio of debt to equity in the capital structure. After the company is taken public again, the new owners of the business have every freedom to de-lever the business by selling more equity to pay down debt.

  7. says

    Interest payments on debt are tax-deductible because the firm cannot choose to not pay interest in a lean year when operating profits are lower than the firm would like

    Well, yes. That’s one of the reasons I think that we’d be better off if there were more equity financing than we currently have.

    One problem with public equity ownership is that managers deliberately underleverage the company.

    Congratulations. You’ve just indicted the entire basis of Anglo-American capitalism. Maybe we should spend some time on the corporate governance issues that have grossly overpowered managers relative to equity holders.

    Under bankruptcy the equity holders in a business are effectively liquidated.

    Yes, but that’s all that happens to them. Their losses are capped to the amount of equity they have invested. However, their gains are not capped. This distorts risk tolerance. If you are a private equity firm that engages in numerous such transactions, the incentive is to overleverage. You make out like a bandit when it works and don’t lose that much when it doesn’t.

    The idea that bankruptcy procedures provide an adequate penalty to risky behavior depends upon the investors getting wiped out. That happens when those involved have everything sunk into one entity. If you aren’t so limited and can have enough entities that the mean of the expected return starts to matter more than the variance, it does no such thing. For a private equity firm, bankruptcy is just the cost of doing business, not a catastrophic event.

    And that’s before you get into the ways that the PE firms collect fees along the way. There are a number of cases where a deal made money for the PE firm despite ending up in bankruptcy because of these extractions.