New Yorker, FT: the real problem with private equity

Following our blog about US presidential candidate Mitt Romney, an excellent short article in The New Yorker explaining that the principal problem with private equity firms is not their effect on stripping jobs:

The real reason that we should be concerned about private equity’s expanding power lies in the way these firms have become increasingly adept at using financial gimmicks to line their pockets

And it goes on to explain concisely what the problem is. In essence, it's debt, as we've explained before. Buy a firm, load it with debt, and that leverage increases your returns.

"The rewards can be extraordinary: when Romney was at Bain, it supposedly earned eighty-eight per cent a year for its investors. But piles of debt also increase the risk that companies will go bust."

And it gets worse.

"In the past decade, though, that calculus changed. Having already piled companies high with debt in order to buy them, many private-equity funds had their companies borrow even more, and then used that money to pay themselves huge “special dividends.”

And from 2003 to 2007 private equity funds took over $70bn out of their companies. The New Yorker adds:

These dividends created no economic value—they just redistributed money from the company to the private-equity investors.

Indeed. And it goes on to explain how private equity firms can increasingly profit even if the companies they run go under—an outcome made much likelier by all that extra borrowing. It gives the example of a U.S. company that was bought and eventually went bankrupt, dumping its debts on society and wiping out its workers' pensions obligations - while making a 23 percent profit for the private equity firm (more examples of this, in an in-depth article in the New York Times here). A letter in the Financial Times from Professor Louis Brennan of Trinity College Dublin has more on this:

Private equity “works” not because of accountability but because of the ease with which implicit and explicit contracts may be broken – pension commitments, employee contracts, supplier contracts, and intellectual property stripped out and repackaged.

Private equity “works” not because of greater accountability but because of a reduced accountability that enables a minority to benefit at the expense of a majority. It is not even a zero-sum game but a game that involves both value shifting and value destruction.

(And see some Harvard research on this here.) here we get into an often overlooked aspect of tax havens. Tax havens create laws deliberately to help investors do this, under a veil of secrecy. No wonder Mitt Romney and his former company Bain Capital chose the Cayman Islands to locate their activities.

And all this is destabilising. Take a look, now, at Marty Sullivan's article on Romney, Bain, private equity and taxes, in the highbrow U.S. publication Taxanalysts.

"Bain profited from a dangerous flaw in our corporate tax that subsidizes destabilizing financial structures.
. . .
the tax incentive for leverage goes to the heart of the deal and can cause serious economic damage.
. . .
higher levels of debt threaten macroeconomic stability by leaving the economy more vulnerable to small contractions in business activity."

Now back to the New Yorker:

"That’s not exactly how capitalism is supposed to work."

You don't say. This is a classic example of the corruption of capitalism - which we believe is right at the core of what the Occupy protesters are angry about. Oh, and then there's the very closely related question of tax justice, and another example of this corruption:

"As if this weren’t galling enough, taxpayers are left on the hook. Interest payments on all that debt are tax-deductible; when pensions are dumped, a federal agency called the Pension Benefit Guaranty Corporation picks up the tab; and the money that the dealmakers earn is taxed at a much lower rate than normal income would be, thanks to the so-called “carried interest” loophole."

Ugh, ugh, and thrice ugh. And, to round the New Yorker article off:

"If private-equity firms are as good at remaking companies as they claim, they don’t need tax loopholes to make money."

Absolutely spot on. All you really need know about the private equity industry, in a single page.