KKR Sale Means End of Private-Equity Stardom: Roger Lowenstein
The public stock offering of KKR & Co. put me in mind of three vexing questions.
First, if KKR is based on the premise that private equity is a better, more efficient form of organization, why did KKR itself go public?
Second, is there evidence that private equity is truly better? Does society benefit? Do investors? Or only the fund managers who pocket those gargantuan fees?
Third, what happened to Congress’s plan to end the tax break that benefits managers of private-equity funds, as well as other investment funds? Will it summon the guts to tax billionaires at the same rate as other wage-earners?
Private equity has its roots in the leveraged-buyout fad of the 1980s. The premise was that public-company chief executives weren’t sufficiently rewarded for success, and thus had let their companies drift. Perhaps a small division of a big public company was overlooked, or starved for capital, and would perform better if it were the sole focus of manager-owners. Or maybe the CEO was so insulated from market pressure, or fattened with guaranteed bonuses, he had no incentive.
Henry Kravis, a KKR founder, and like apostles preached the remedy of going private. Give managers a piece of the action and, surely, their capitalist juices would stir. Since not even the KKRs of the world could replace the public equity, most of the enterprise was financed with debt.
Not that this was cause for alarm. Lots of debt meant lots of interest, which cut the tax man’s take. Better still, leverage magnified gains. Admiring scholars added a beguiling coda: high levels of debt were actually a plus, as the ever- present risk of bankruptcy would keep managerial minds focused.
Celebrated Essay
In a celebrated 1989 essay, Harvard’s Michael Jensen predicted the “Eclipse of the Public Corporation.” Jensen’s enthusiasm proved to be the peak. As early deals begat high profits, capital rushed in, pushing up buyout prices. Deals such as KKR’s acquisition of RJR Nabisco didn’t make sense, not that that cooled the dealmakers’ ardor.
In a trend that troubled even Jensen, buyout kings -- supposed paragons of capitalist virtue -- were pocketing princely fees upfront (rather like the slothful, public CEOs they were replacing) and irrespective of eventual results. In 1990, the buyout market crashed. LBOs with too much “L” experienced the dubious charm of bankruptcy.
Then, after a mild recession, buyouts returned. This second wave was distinguished by two subtle changes.
Sloths Disappear
First, public-company CEOs, under pressure to raise their stock prices, were no longer so slothful, if ever they had been so. They were cutting costs, spinning off divisions that didn’t fit -- the very tricks employed in LBOs. This left fewer companies susceptible to formulaic, easy improvement.
But the buyout artists were emboldened by the second change. Miraculously, they were “LBO” firms no more; they had been reborn as “private equity.” The new name conjured up an image of baronial elegance, as if merely to invest with a Stephen Schwarzman was to enter a satiny world of quiet money and managerial brilliance.
Ultimately, Schwarzman bolted for the grubbier, but more bountiful, world of public markets. Blackstone Group Inc., the private-equity firm he co-founded, got a jump on KKR, going public in 2007. Evidently, buyout kingpins are anxious for an exit strategy, which public shares enable.
The industry has never escaped its boom-to-bust pattern. Strong returns in the early 1990s attracted competition, leading to lower returns later in the decade. The cycle was repeated in the 2000s, as deals struck in the easy-credit environment of 2006-2007 collapsed.
Index Funds
How does the record look overall? Steven Kaplan, a University of Chicago Business School professor, has been studying private equity since the late 1980s. Kaplan’s findings: some firms solidly beat the pack, though the industry as a whole bests the stock market by only a modest amount. And after fees, outside investors would do as well or better with their money in an index fund that tracks the Standard & Poor’s 500.
There is no doubt, Kaplan adds, that private-equity firms add operational improvements. But the gains are given back at the outset, in the premiums paid to acquire targets. And as public-company managements have improved, the gap between private and public efficiency has probably narrowed.
In sum, private equity adds modest and probably only temporary efficiencies. As a social good, this isn’t exactly curing cancer.
Which brings us to the issue of taxes. Whereas the feds tax ordinary income at up to 35 percent, capital gains on investments held for more than one year are taxed at only 15 percent, a rate designed to attract investment in capital markets.
Undeserved Break
Managers of private-equity funds, and of other investment partnerships, enjoy an undeserved exception. The performance fee they charge investors, typically 20 percent of profits, is treated as a capital gain and taxed at the lower rate. This makes no economic sense; an outside investor has the same incentive to participate regardless of the tax paid by the manager. It makes sense only if you are Henry Kravis and prefer to pay less.
The House of Representatives has voted three times to end this unwarranted privilege. After the financial crisis, the Senate seemed likely to concur. Then, industry lobbyists stormed Congress. The matter now rests with the Senate Finance Committee. Since nothing is more arbitrary than the proper rate at which to tax, the only sure principle is consistency: what one party pays, so should the other.
No great industry is at stake -- private equity is hardly the engine of job creation its flag-waving lobby maintains, and the industry will survive at any rate. The only principle at stake is fairness: billionaires should pay as much as everyone else.
Roger Lowenstein, author of “The End of Wall Street,” is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Roger Lowenstein at elrogl@hotmail.com
To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net
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