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Monday, September 26, 2016

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?

  • ObozoMustGo

    All you leftist nutjobs always talk about “excesses” as if you have a friggin clue. What makes you qualified to say what is excessive and what is NOT? It’s none of your damned business you bunch of busy-body know-it-alls.

    But I get your view. Any moron that believes economic resources first belong to government/the people, will automatically believe he has a right to define what is and what is not excessive. It’s also why you idiots on the left (you included Madrick) call business accounting practices of subtracting standard costs of operations from revenues “tax breaks”.

    You know damned well, Madrick, that different businesses have different revenue and cost structures. But you also know that if you call them “tax breaks”, you’re gonna rile up the base of useful idiots that are too damned stupid and lazy to actually figure out what the hell you mean. That would be 95% of the morons that read your drivel in this leftist sea of insanity called The Memo, Jeff.

    Have a nice day!