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This column is about the excesses of the private equity investment industry. It delves into the minutiae of the tax code, corporate structure and certain abstruse practices of financial engineering. There will be jargon: carried interest, leveraged buyout, joint liability. I am aware that none of this is anyone's favorite thing to be discussing on a summer's day.
But private equity is counting on your lack of interest; the seeming impenetrability of its practices has been called one of its "superpowers," among the reasons the trillion-dollar industry keeps getting away with it.
With what? An accelerating, behind-the-scenes desiccation of the American economy. Democrats in the Senate had been poised to pass a rule that might slightly clip the industry's wings — a change to the tax code that would force partners in private equity firms, hedge fund managers and venture capitalists to pay a fairer share of taxes on the money they make.
But private equity has wrangled out of proposed regulation before, and it's done so again. Sen. Kyrsten Sinema, the Arizona Democrat who has often frustrated her party's agenda, agreed last week to support the Inflation Reduction Act only after tax provisions in the plan were scaled back.
I can't fathom what her reluctance might be. One of private equity's main plays is the leveraged buyout, which involves borrowing huge sums of money to gobble up companies in the hopes of restructuring them and one day selling them for a gain.
But the acquired companies — which range across just about every economic sector, from retailing to food to health care and housing — are often overloaded with debt to the point of unsustainability. They frequently slash jobs and benefits for employees, cut services and hike prices for consumers, and sometimes even endanger lives and undermine the social fabric.
It is a dismal record: Private equity firms presided over many of the largest retailer bankruptcies in the last decade — among them Toys "R" Us, Sears, RadioShack and Payless ShoeSource — resulting in nearly 600,000 lost jobs, according to a 2019 study by several left-leaning economic policy advocates.
Other investigations have shown that when private equity firms buy houses and apartments, rents and evictions soar. When they buy hospitals and doctors' practices, the cost of care shoots up. When they buy nursing homes, patient mortality rises. When they buy newspapers, reporting on local governments dries up and participation in local elections declines.
It is unclear even if private equity pays off for the investors — like university endowments, public pension funds and wealthy individuals — who put money into the industry in the hopes of outsize returns. Since at least 2006, according to a study by the economist Ludovic Phalippou, the performance of the largest private equity funds has essentially matched returns of comparable publicly traded companies.
Still, the industry has been growing quickly, and it had a record year in 2021. According to McKinsey, private equity's total assets under management reached almost $6.3 trillion last year. The American Investment Council, a trade group representing the industry, says that companies backed by private equity firms employ nearly 12 million Americans.
With the help of lax regulation and indefensible tax loopholes, private equity's apparent destructiveness can be enormously profitable for its partners. Private equity firms make money by extracting hefty fees from their investors and from the companies they purchase, meaning they can succeed even if their investments go kaput. Phalippou found that between 2005 and 2020, the industry produced 19 multibillionaires.
Private equity partners also get a pretty good deal from the government on what they earn. The funds generally charge their investors two different fees: a management fee of 2% of invested assets per year (funds are held for an average of about six years), and a "carried interest" fee that is 20% of any investment gains realized in the fund.
In most other industries, the Internal Revenue Service would categorize a fee like carried interest as ordinary income (like how your salary is taxed) rather than a capital gain (like how your stock market winnings are taxed). After all, the partners are receiving the fee as compensation for performing a service (managing investors' money), not collecting a gain on their own invested capital.
But that's not how it works for partnerships like private equity, hedge funds and venture capital firms. Under IRS guidelines, carried interest is taxed as a capital gain, which has a top rate of 20%, rather than as income, which has a top rate of nearly 40%. The upshot: Millionaire and billionaire partners in private equity firms pay a far lower tax rate on much of their income than many of the rest of us.
The private equity industry defends its preferential rate by citing "sweat equity" — even if partners don't put much of their own capital at stake, they are being rewarded for investing their "ideas and energy," as Steve Klinsky, a former chair of the American Investment Council, put it in a recent article.
Barack Obama called for the loophole to be eliminated. Donald Trump pledged to do so. So did Joe Biden. Even several financial tycoons have called for its repeal — Jamie Dimon, Bill Ackman and Warren Buffett among them.
Despite widespread opposition, though, the tax break has somehow endured.
Eileen Appelbaum, an expert on the private equity industry who is a co-director of the Center for Economic and Policy Research, a liberal think tank, told me she favored many of the ideas in the Stop Wall Street Looting Act, a bill introduced last year by Sen. Elizabeth Warren and several other liberal Democrats. The act would impose lots of new rules on the industry, including limiting tax deductions on excessive debt and adding worker protections for when debt binges lead to bankruptcy.
One of the most important ideas, Appelbaum said, is known as joint liability, which would hold private equity firms responsible for the debt incurred by portfolio companies if the companies go belly up.
"It doesn't tell you how much debt you can put on it," Appelbaum said. "It just says, 'whatever debt you put on it, you're going to be jointly responsible.'"
That struck me as an elegant and sensible idea. If private equity firms claim they should get credit for their "sweat equity," why shouldn't they be held responsible when the sweat turns to tears?
