Commentary

Raise the Tax on Private Equity


Three years after KKR (KFN) announced it was going public, its shares are finally trading on the New York Stock Exchange. Once, the parent of Kohlberg Kravis Roberts stood for a peculiar Wall Street mythology, the notion that "value" could be created by the simple act of taking a public corporation private. In its wake came a flood of imitators—the entire private equity industry—as well as institutional investors willing to ante up the necessary capital.

Now the quintessential private equity firm is a public company, an oxymoron that raises vexing questions. First, if KKR is synonymous with the idea that private equity is a better, more efficient form of corporate organization, why did KKR decide to go public?

Second, is there any evidence that private equity is better? Does society benefit when public companies go private? Do investors? Or does the process only serve the interests of the fund managers who pocket those gargantuan fees?

Third, whatever happened to Congress's plan to end the tax break that benefits managers of private equity firms, hedge funds, and the like? The plan has been kicking around for years. Will Washington ever summon the courage to tax these billionaires at the same rate as other wage earners?

Private equity has its roots in the leveraged buyout fad of the 1980s. Its premise was that chief executive officers of public companies were not sufficiently "incented" for success, thus let their organizations drift. Perhaps a small division of a big public corporation was being overlooked or starved for capital and would perform better if it were spun off and became the sole focus of a new set of manager-owners. Or maybe the CEO's compensation was so insulated from company performance, or so fattened with guaranteed bonuses, that he had no reason to make his corporation perform.

So-called barbarians like Henry Kravis, a KKR founder, had a remedy for that: the leveraged buyout, or LBO. Kravis and other apostles of private equity preached the advantages of going dark. Give managers a piece of the action, they said, and surely their capitalist juices would stir. Since not even the KKRs of the world, with their dutiful tribes of institutional investors, had sufficient capital to replace the public's equity, most of the enterprise would be financed with debt.

Not that this was cause for alarm. Plenty of debt meant plenty of deductible 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, since the ever-present risk of bankruptcy would keep managerial minds focused. In his celebrated 1989 essay, Harvard's Michael Jensen went so far as to predict the "Eclipse of the Public Corporation."

Jensen's enthusiasm proved to be the peak. As early deals begat high profits, capital rushed in, pushing buyout prices higher. LBO deals such as KKR's $31 billion acquisition of RJR Nabisco, also in 1989, did not make basic financial sense—they carried too much debt—though of course that didn't cool the dealmakers' ardor. In a trend that troubled even Jensen, buyout kings, supposed paragons of capitalist virtue, were pocketing princely fees up front (rather like some of the slothful public CEOs they were replacing) and irrespective of their eventual results.

In 1990 the buyout market crashed. LBOs with too much "L" experienced the dubious charms of bankruptcy. Then, after a mild recession, buyouts returned. This second wave was distinguished by two subtle changes.

First, CEOs at public companies, under fierce pressure to raise their stock prices, were no longer so slothful, if ever they had been. They were cutting costs, laying off workers, and spinning off divisions that didn't fit—the same tricks employed by fund managers during leveraged buyouts. This left fewer companies susceptible to easy improvement via LBO engineering.

The second change emboldened the buyout artists. Miraculously, they were LBO firms no more; they had been reborn as "private equity." The new name conjured an image of baronial elegance, as if merely to invest with a Kravis or Stephen Schwarzman was to enter a satiny world of quiet money and managerial brilliance.

Ultimately, Schwarzman bolted for the grubbier and even more bountiful world of public markets; the Blackstone Group (BX), the private equity firm he co-founded in 1985, got a jump on KKR by going public in 2007. Evidently, buyout kingpins are anxious for an exit strategy, which public shares provide.

The industry has never escaped this boom-and-bust pattern. Strong returns in the early 1990s attracted competition, leading to a crowded field and poorer returns later in the decade. The cycle was repeated in the 2000s, as deals struck in the easy-credit environment of 2006-07 collapsed, pummeling institutional investors.

How does the record look overall? Steven Kaplan, a professor at the University of Chicago Business School, has been studying private equity returns since the late 1980s. Kaplan's findings: Some firms consistently led the pack, although the industry as a whole beats the stock market by only a modest amount. And after fees, an outside investor would do as well or better with his or her money in an index fund that tracks the Standard & Poor's 500-stock index. As Kaplan put it in a recent paper, private equity "did not seem to outperform S&P net of fees." Investors, on average, have been overpaying for the industry's supposed prowess, so the marketplace has begun to force private equity fees down, especially the fees charged up front.

There is no doubt, Kaplan adds, that private equity firms make operational improvements. However, these gains are given back at the outset in the premiums paid to acquire targets. And as public company management has gotten better, the gap between private and public efficiency has narrowed.

In sum, going private adds modest efficiencies—benefits that are reaped by selling shareholders and the buyout firms. These benefits are probably temporary—since corporations go private only in order to go public again a few years later—and largely offset by the heavy burden of increased debt. As a social good, this isn't exactly on a par with curing cancer.

Which brings us to the place where private equity really can contribute to society: by paying a fair share of taxes. While the federal government taxes ordinary income at up to 35 percent, capital gains on investments held for more than one year are taxed at only 15 percent, a low rate designed to attract investment in capital markets.

Managers of private equity funds and 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 investor has the same incentive to participate regardless of the tax paid by the manager. It only makes sense if you are Henry Kravis and prefer to pay less.

The House of Representatives has three times voted to end this unwarranted privilege. After the recent financial crisis, the Senate seemed likely to concur. Then industry lobbyists stormed Congress. The matter now rests with the Senate Finance Committee, with action a long shot this year.

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 here. Private equity is hardly the engine of job creation its flag-waving lobby maintains, and the industry will survive. What is at stake is fairness: Billionaire financial engineers—whether they are being called barbarians, LBO dealmakers, or private equity princes—should pay the same rate as the rest of us.

Lowenstein is a columnist for Bloomberg News.

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