01.13.12

The Truth About Private Equity: Politicians Need It, Taxpayers Fund It

Ignore the ‘vulture capital’ talk. Romney, Obama, and both parties rely on their support—money that comes from government-backed, taxpayer-supported pension funds.

GOP presidential hopeful Mitt Romney inspired a slew of commentary about the private-equity industry, following his boasts of creating 100,000 jobs during his reign at Bain Capital. Some columns claimed private equity is an important part of capitalism, so stop picking on it. Some pointed out the sector infiltrates firms, cuts jobs and expenses, and makes buckets of money in the process. Which it does. But simply examining whether private equity is inherently good or evil, and by extension whether Romney is, misses key points fundamentally related to our nation’s economic health.

First, the tax structure for private equity—and hedge-fund and venture-capital firms—gives it an unfair advantage, while encouraging excessive fee and profit extraction from flailing companies. Second, private-equity funding disproportionally comes from public pension funds. In other words, from government-backed, taxpayer-supported money.

On the tax matter: the leaders of these firms pay at the most 15 percent on their income, rather than the 35 percent rate that normal people pay. The GOP won’t touch adjusting this discrepancy, and though President Obama has been talking about it since his last presidential campaign, there’s been little activity in Congress to indicate it will be happening any time soon. Two political parties, different use of words, same result.

Then, there’s the issue of where private-equity firms get their capital. On average, public pension funds allocated 6 percent of their assets to them, with the larger ones, such as Calpers (California Public Employees’ Retirement System), having raised their allocation in 2008 to 14 percent from 10 percent, and California State Teachers’ Retirement System (CalSTRS) in 2009 to 11 percent from 9 percent.

Thus, private-equity funds receive one third to one half of their new capital per year, $150 billion to $300 billion, from the $5 trillion public pension system—that means from taxpayers hoping to retire with their nest eggs intact. In addition, pension funds forked over $1.7 billion in fees during the 2000s, according to a New York Times study.

As pension funds come under increasing pressure to meet their liabilities, or payments, private-equity funds are sharpening their claws to get at even more from these public funds to accommodate them. For pension funds, accepting high fees and more risk is like doing a dance with the devil. Only, the devil won’t pay pensioners if the bets don’t pan out.

Besides all that, Romney isn’t the only politician attached to a private-equity fund (there are far more politicians that are than aren’t), although having run one is a distinguishing factor.

The argument that private-equity companies create jobs, predicated on high “success rates” or turning otherwise terminal companies around, is a hard one to make. The only way to truly determine this is to examine the nature of those jobs before and after private-equity involvement. If two companies were merged, one company might appear as if it added those extra jobs; but the overall figure for the two is lower, because the second company lost them. Likewise, if the company was already in pre-bankruptcy mode, it probably fired workers beforehand.

Private-equity firms are basically glorified loan sharks that take a hands-on management role in restructuring companies in return for a big cut. Sometimes it works. Sometimes it doesn’t. The biggest profits come from arriving on the scene when a target is weakest, and turning it around, but taxpayers can wind up paying for that in other ways, too.

In the case of IndyMac, the fifth-largest U.S. bank bankruptcy, a consortium of private-equity firms coalesced in a holding company, IMB HoldCo, set up by Dune Capital Management L.P., a private-equity fund founded by former Goldman Sachs executive Steve Mnuchin. The group included J. C. Flowers, an investment fund of George Soros, and Paulson & Co.—the hedge fund that made a boatload of money betting against the housing market.

The deal went like this: IMB HoldCo bought $32 billion of IndyMac assets for the bargain price of $13.9 billion in January 2009. It injected an additional $1.3 billion of capital into its prize and assumed the first 20 percent of losses. The FDIC picked up the tab for most of the rest. The entire episode cost the FDIC between $8.5 billion and $9.4 billion. The upshot is the consortium made money, and taxpayers subsidized their risk.

It’s beyond ironic that Texas Gov. Rick Perry threw the term “vulture capitalist” at Romney, as if Perry didn’t catapult his key donors to adviser positions at the $110 billion Texas Teachers Retirement System pension fund, which then steered it toward increasing private-equity allocations. Newt Gingrich’s video release was even more ludicrous in its attempt to paint Bain as somehow different from every other private-equity firm.

In the end, former New York mayor Rudolph Giuliani characterized the problem best, without meaning to: “You get rid of venture capital and private equity, you get rid of risk-taking, which is what it’s about, risk-taking, Romney was a risk-taker.”

Private-equity firms are basically glorified loan sharks that take a hands-on management role in restructuring companies in return for a big cut.

And that risk-taking, in the wake of entering this fourth year of economic recession, post multi-trillion-dollar bank bailouts and subsidies, should be constrained, not glorified.

Romney retaliated against his rivals, understandably perplexed that they were attacking the free-market system they are supposed to promote. Free markets are one thing, but subsidized tax-advantaged risk-taking entities bestowing CEOs with multi-billion-dollar wealth, via government-backed pension funds, is corporate welfare. There are less risky ways to create jobs.

Of course, no one in Washington is going to make a big deal out of that. Why? The top 10 private-equity companies in the world include Goldman Sachs, the Carlyle Group, Kohlberg Kravis Roberts (KKR), the Blackstone Group, and Bain Capital. During the past five years, these firms raised $339.4 billion in capital, banking $6.7 billion in management fees. That gives them plenty of money with which to be big political donors.

The private-equity sector has given $10.3 million to this forthcoming presidential election to both parties, with top donors encompassing Goldman Sachs, Bain, KKR, and the Blackstone Group.

As in the case of his last campaign, it is the financial industry as a whole that has bundled (collected from high-net-worth individuals) the most money for Obama’s 2012 campaign, $17.6 million so far. Those bundlers include quite a few private-equity firms or firm divisions, such as Centerview Partners, Barclays Capital, MF Global (financed by PE firm J. C. Flowers—who lost $47.8 million on the venture), UBS, and Greenstreet.

The financial sector has also given the most money to Mitt Romney’s campaign. His top 20 donors included Goldman Sachs, Bain (of course), Barclays, Credit Suisse, Morgan Stanley, JPMorgan Chase, Bank of America, UBS, and Blackstone.

Private-equity firms aren’t in business to create jobs, but to make money, and use it to maximize their profits and political opportunity. Bain Capital touts its ability to deliver returns for its investors, not jobs for the economy. The others are no different. For Romney to paint things otherwise is disingenuous. And for the rest of his GOP competitors to claim that of all the private-equity firms out there, only Bain left behind a trail of pain, is at best clueless, and worst, an outright lie. For the Democrats, to remain silent is spineless. No party is discussing public stability over private risk-taking. Again.