At DealBook, Andrew Ross Sorkin talks to Paul Levy of JLL Partners and a self-confessed small-fry among the big fish of the private-equity world. As you probably know, in recent weeks, private-equity — the practice of buying struggling companies, usually with debt, taking them private, turning them around, and re-selling them — has taken a drubbing, based on the notion that successful PE guys, like GOP presidential candidate Mitt Romney, are Gordon Gekko-esque in their commitment to greed.
Levy thinks this is terrible. How terrible? It's nearing red-scare levels:
...Mr. Levy has been dismayed that the industry’s heavyweights have not sought to publicly defend their industry in recent days. Private equity came under attack when Mitt Romney’s political rivals put his career at Bain Capital in the spotlight as part of the Republican primary.
“There’s a tinge of McCarthyism here,” Mr. Levy said in an interview. “I think it’s a pretty honorable industry, and I don’t know why people aren’t stepping up and defending the careers that define their lives. That’s a sad thing. What do they fear it will cost them?”
Mr. Levy, who voted for President Obama in 2008, is right. Virtually none of the big names in private equity have spoken up to defend the industry. Over the past several weeks, anytime my colleagues or I have sought comment about attacks on the industry, private equity’s kingpins have declined. (The industry’s lobbying group, the Private Equity Growth Capital Council, has been working behind the scenes to shore up support and plans a more public campaign in the coming weeks, but with none of the leading private equity executives playing a significant role.)
McCarthyism, of course, was the effort in the 1950s by Wisconsin Sen. Joseph McCarthy to root out suspected communists in government. McCarthy held hearings, riled up the citizenry, but was eventually revealed to be a paranoid fraud by Edward R. Murrow, among others. Since then, "McCarthyism" has become shorthand for finding guilt where there is none.
Levy's implication is that private-equity is the victim is all this. But this is just another indication that Wall Street is comically out of touch with Main Street. People don't begrudge Mitt his money, nor do they uniformly disdain private-equity as a way of making money. They just don't like the absence of transparency about how private-equity has benefitted from a financial system that they rightly suspect might be rigged.
There are two core problems with PE that Romney's time at Bain Capital has forced into the sunlight. First, private-equity managers pay taxes in two ways: like normal folks on their income; and like serious money guys on "carried interest," or the profits that they make on their investment returns. The latter is taxed at the capital-gains rate, 15 percent.
It now seems apparent that Romney is paying taxes at a pretty low effective rate, and that he paid taxes at a low rate when he was raking it in at Bain.
Second, private-equity firms don't buy distressed companies with money — they buy them with debt. This is a critical distinction. Debt has big advantages over cash or equity, if you don't plan to hold onto a company for a long time. And PE firms rarely do. They often give undervalued companies a fighting chance by removing them from public markets, but their idea isn't to support the recovered firm for decades. The idea is to sell it back to the public or to an investor.
Private-equity, out of necessity, loads up companies with debt in order to take them over. That's why we used to call private equity "leveraged buyout." The "leverage" in LBO is all the debt — and the debt can be huge. But the debt is also tax-deductible, creating a subsidy for private equity to do the deals, as the blog emptywheel explains.
Debt-financing became a standard — and potentially lucrative — way of doing business for private equity in the the 1970s, '80s, and '90s. But it is a way that financiers used the tax code as a way to create value that wasn't necessarily there, in the sense that value comes from running a good company that makes stuff people want to buy and has become unfairly distressed.
Additionally, as former investment banker Steve Rattner points out here, debt begets more debt. A leveraged buyout can morph into a "releveraged" buyout, with a company's new equity turned into debt so that the equity can be extracted, to enrich the private-equity investors and roll-over the old debt. Great when it works out, but a formula for bankruptcy if they company can't keep up the pace.
It isn't McCarthyism at all to find these things out. And if we're talking about someone who's running for president and could play a more-than-major role in how the U.S. goes about collecting revenue, you could argue that the public should have learned more about how private equity works a long time ago.