Private Equity’s Public Subsidy Is a Tragedy: William D. Cohan

Jan. 23 (Bloomberg) -- The real reason that private equity executives need to be full taxpayers -- paying 35 percent of their income in federal tax as opposed to the 15 percent capital-gains rate they have enjoyed for years -- is not because, generally speaking, they make so much money.

Nor is it because the return they get on what personal capital they risk is dwarfed by the profits they get on their investors’ capital.

Nor is it so they will pay the same tax rates as their secretaries (although this is a good reason, too).

No, the real reason the tax loophole for private equity mavens must be closed once and for all is that American taxpayers subsidize the private-equity industry -- and its outsize paychecks -- and simple fairness demands that they don’t also get an additional break in the form of lower tax rates.

Mitt Romney, the co-founder of Bain Capital LLC and the leading contender for the Republican presidential nomination, got blindingly rich because of this taxpayer subsidy, and it isn’t right that he and his cohort can also pay taxes at a 20-percentage-point discount compared with the rest of us.

Here is how the subsidy works: The Internal Revenue Service allows for the tax-deductibility of interest expense on corporate debt. Since corporate debt is the mother’s milk of a leveraged buyout, there would be no private-equity/LBO industry without this huge tax benefit. Indeed, anyone who has used an Excel spreadsheet to model a leveraged-buyout -- you know who you are! -- knows that the magic of the entire industry depends almost solely on the interest-expense provision in the tax code.

Loading Up Debt

By loading up a company with debt and then deducting the resulting interest expense, tax payments are generally wiped out, allowing the remaining “free cash flow” to be used to pay down the debt taken on to buy the company in the first place. Given that tax revenue is necessary for the government to function, this means the rest of us provide a subsidy that allows the private-equity firms to thrive.

If the company a private-equity firm invests in does well, the original borrowed money is paid down, interest expense is reduced and profits slowly but surely rise, creating equity value for the private-equity investor. Over time, if the company is performing well enough to pay off its debt load and show net income, it will either be sold outright, taken public through an initial public offering or re-leveraged to allow the private-equity firm to take out a hefty dividend and begin the process of financial alchemy all over again.

This is the moment when the private-equity practitioners really ring the cash register (not to minimize the importance of the annual fees also paid to them by investors, generally amounting to 2 percent of the money under management and which can add up to hundreds of millions of dollars per year, spread among a relatively few people). In most cases, the private-equity firms take 20 percent of the increase in equity value between when they bought the company and when it is sold. (In Bain’s case, it can be 30 percent because for a while investors were clamoring to be in its funds.)

Fine enough: This seems to be the industry’s convention, savvy investors have agreed to the arrangement time and time again, and undoubtedly many companies that might have failed have been turned around (while many others haven’t).

The problem is that, having used the tax code to create the financial magic in the first place, the people working at these firms and sharing in the equity payoff then get the additional benefit of paying tax on their profits -- which are called “carried interest” -- at a 15 percent rate rather than 35 percent.

Fighting the Inevitable

This nifty tax treatment can add up to considerable wealth. Come to think of it, I can’t name a single partner of a major private equity firm I know who doesn’t live in the most lavish way. Many -- Steve Schwarzman of Blackstone Group LP, Henry Kravis and George Roberts of KKR & Co., David Rubenstein of the Carlyle Group LP and David Bonderman of TPG Capital LP -- are among the wealthiest people in the country. This isn’t meant as criticism -- what they have been doing is not illegal or unethical, it’s actually quite brilliant. Rather, I think it’s a statement that the industry must stop fighting the inevitable.

The tax rate on carried interest must be raised to 35 percent on the profits that come to private-equity partners from their investors’ capital. The gravy train for private-equity partners has gone on for three decades. It has been a great party, but -- as the Bloomberg View editors have also made clear -- it’s time to take the punch bowl away. The private-equity moguls know it. The American people know it. Even Mitt Romney knows it, despite sheepishly admitting that why, yes, his federal tax rate has been around 15 percent lately, come to think of it.

It is simply illogical, and unfair, for the IRS to give private equity two major benefits, one for their businesses and one for their wallets, while the rest of us pay much higher federal tax rates with nary any comparable subsidies at all.

(William D. Cohan, a former investment banker and the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. The opinions expressed are his own.)

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