The Truth About Private Equity

Political expediency too often overrules common sense economics. That has been the case recently when it comes to private equity.

Private equity has become a favorite political target of President Obama, certain members of Congress and other assorted politicians who are pushing a class warfare agenda. For example, in a February 14 Bloomberg report, it was asserted, "Private equity managers' preferential tax treatment, less than half the rate paid by ordinary wage earners, is ‘indefensible,' the investment chief of the California Public Employees' Retirement System said." On the presidential campaign trail, some Republican candidates have even taken potshots at fellow candidate Mitt Romney for his work in private equity.

The standard line against private equity firms seems to go something like the following: private equity groups gut companies and eliminate jobs just so partners can enrich themselves. It's all about greed.

The President has called longstanding law on taxing carried interest at the capital gains tax rate "inappropriate." The Obama budget calls for boosting the tax on carried interest from the current 15 percent capital gains tax rate to a top personal income tax rate of 39.6 percent, or as much as 43.4 percent when the Medicare income tax is included. That's a near tripling of the tax rate on carried interest.

Following the lead of elected officials, no doubt, the Securities and Exchange Commission has begun an examination of the private equity industry.

Do any of these and other attacks on private equity make sense? Specifically, what's the real role of private equity in our economy?

Well, quite simply, private equity provides capital and expertise needed to grow and increase the value of businesses. By the way, that's a good thing.

Specifically, private equity partnerships set up funds that raise capital from various sophisticated investors, including pension funds and foundations. In fact, according to a 2011 Preqin report, 63 percent of capital invested in private equity funds in 2010 came from public and private pension funds, endowments and foundations. They like the higher returns that come with private equity. These investors are limited partners, with the private equity firms serving as the general partners, who also invest their own capital and run the fund. The general point of private equity funds is to buy companies, with the objective of increasing the value of the enterprise and eventually selling the business for a profit.

A key positive of the private equity model is the alignment of incentives. With publicly traded companies, it's often a significant challenge to line up the interests of management with those of the owners (i.e., shareholders). Private equity funds get directly involved in owning and operating companies, including laying out goals and strategies, and selecting the management team, who usually have to invest in the firms as well. The interests and incentives then are uniform, with the focus being to enhance the firm's value.

As for carried interest, that simply is the share of profits earned by the general partners. Carried interest is not the same as a wage or salary, as it is completely tied to the investment in and performance of the firm. Carried interest is all about firm profitability - no profits mean no carried interest - and it is not only typical in private equity, but also in real estate and venture capital. For good measure, clawback provisions mean that limited partners in the fund must first be paid a certain profit, and if other investments fail to meet profit criteria, then general partners have to return their carried interest to the fund. Of course, that is never the case with wages or salaries.

It makes sense then that carried interest not be taxed the same as wages and salaries, but instead be treated as capital gains given the reality that this is a return on risk taking, i.e., on entrepreneurship and investment. And in fact, carried interest has been taxed as capital gains for decades. The only reason this has come up is due to economic ignorance and/or political calculation.

As for what private equity achieves, it's obviously not about gutting companies and randomly firing employees, since the objective is to increase a firm's value in order to eventually sell it at a profit. Instead, the point is to work to improve and build an enterprise, and when successful, that's good news for customers, employees, and owners.

On the issue of jobs, which has been central to the political assault on private equity, the Private Equity Growth Capital Council points out: "According to a 2008 World Economic Forum report that studied 5,000 transactions over 25 years, prior to their acquisition, private equity companies were, on average, losing jobs at existing facilities at a rate one to three percent faster than their competitors. The WEF study also concluded that in the first two years of investment, private equity firms increased the rate of job growth at U.S. facilities by their portfolio companies to six percent above the peer industry average."

Steve Judge, president and CEO of the council, recently offered the bottom line on private equity in our economy: "Private equity is a vital source of capital, having invested nearly $150 billion in over 1,200 companies in 2010 alone."

In a piece summarizing their findings in The Atlantic, economists Kevin Hassett and Steven J. Davis explained, "Private equity firms operate in just about every sector. Some of them focus on leveraged buyouts (LBO), in which a firm uses debt, i.e.: leverage, to buy out a controlling stake in a company. Others specialize in providing capital to new ventures, offering growth capital to promising existing ventures, or turning around distressed companies."

They concluded: "Summing up, the academic literature supports three conclusions about private equity firms. First, they provide attractive returns for their investors. Second, the effect of private equity buyouts on employment in target firms is, on average, quite small. The venture capital side of private equity almost certainly has a positive effect on employment. Third, private equity buyouts accelerate the process of creative destruction: old jobs disappear more rapidly, new jobs get created more rapidly, and productivity growth increases as a result. In this respect, private equity looks like a potent form of capitalism."

Of course, that's exactly what our economy needs, i.e., investment to build up and improve U.S. businesses, enhance productivity and therefore boosting output and incomes, and innovation to drive our economy forward.

Consider private equity's role in the energy sector, where it has been a source of capital for new and expanding enterprises. The February 13 Wall Street Journal noted: "Private equity occupies a crucial slot in the sector's food chain, fortifying small, cash-hungry explorers until they are ready to be consumed by large producers or go public. Firms typically team up with management groups with energy experience to lessen risk." Indeed, private equity's role is a considerable one: "Deal makers are excited because advances in drilling techniques such as horizontal drilling and hydraulic fracturing, or fracking, have made it easier to extract oil and natural gas from shale and other rock formations, creating an opening for private-equity firms to place big bets in a capital-hungry business. Some early investors already have extracted billions of dollars of profits. Private-equity firms completed $24.8 billion of energy deals last year, nearly triple the $8.5 billion in 2010, while the value of all deals last year rose just 17%, according to data-tracker Preqin."

In a related February 13 story on private equity's involvement with energy start-ups, the Journal added: "Private-equity firms don't often start companies from scratch, but in oil and gas they often pair with management groups in exploration start-ups."

Clearly, all of this is good news for energy entrepreneurs in need of capital, for workers in the energy sector, and ultimately, for energy consumers.

Despite the obvious economic value in private equity, attacks continue. Tamara Mellon is the co-founder of Jimmy Choo. She experienced big success running the firm under private equity ownership, and got quite wealthy as a result. But according to a February 10 Wall Street Journal report, Mellon has been taking potshots at private equity via Twitter, and is promising some kind of expose. This, of course, sounds like another political agenda being vented, and/or perhaps some revenge for a work relationship gone awry. But one of her tweets is worth noting here: "Remember - Its (sic) entrepreneurs that create jobs, not Private Equity or Investment bankers."

But what Mellon, along with President Obama and assorted others in the political class, fail to grasp is that entrepreneurs need capital to grow, expand, achieve success, and sometimes to reclaim success. Private equity plays a crucial role in the process of allocating capital, and therefore, the job of private equity is worthy of praise, rather than being set up as a punching bag for political purposes. As we've seen time and time again, sacrificing common-sense economics at the altar of politics never turns out well for entrepreneurship, investment, economic growth and job creation.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. His new book is "Chuck" vs. the Business World: Business Tips on TV.