Surowiecki: Private Equity

Here's an explanation of how private equity works from James Surowiecki of the New Yorker:

Private Equity, by James Surowiecki: ...the people who run America’s private-equity funds must be ruing the day Mitt Romney decided to run for President. His fellow Republican candidates, of all people, have painted a vivid picture of private-equity firms ... as job-destroying vultures, who scavenge the meat from American companies and leave their carcasses by the side of the road. ...

But the real problem with leveraged-buyout firms isn’t their impact on jobs, which studies suggest isn’t that substantial one way or the other. ... The real reason that we should be concerned about private equity’s expanding power lies in the way these firms have become increasingly adept at ... deriving enormous wealth not from management or investing skills but, rather, from the way the U.S. tax system works. Indeed, for an industry that’s often held up as an exemplar of free-market capitalism, private equity is surprisingly dependent on government subsidies for its profits. ...

In the past decade,... Having already piled companies high with debt in order to buy them, many private-equity funds had their companies borrow even more, and then used that money to pay themselves huge “special dividends” ... to recoup their initial investment while keeping the same ownership stake. Before 2000, big special dividends were not that common. But between 2003 and 2007 private-equity funds took more than seventy billion dollars out of their companies. These dividends created no economic value—they just redistributed money from the company to the private-equity investors.

As a result, private-equity firms are increasingly able to profit even if the companies they run go under—an outcome made much likelier by all the extra borrowing—and many companies have been getting picked clean. ...

As if this weren’t galling enough, taxpayers are left on the hook. Interest payments on all that debt are tax-deductible; when pensions are dumped, a federal agency called the Pension Benefit Guaranty Corporation picks up the tab; and the money that the dealmakers earn is taxed at a much lower rate than normal income would be, thanks to the so-called “carried interest” loophole. ... It’s a very cozy arrangement.

If private-equity firms are as good at remaking companies as they claim, they don’t need tax loopholes to make money. ... Time to change them.

Paul Krugman adds:

Summers and Shleifer argued back in 1988 that buyouts are often aimed at “value redistribution” rather than “value creation”; specifically, a lot of the gains to the buyout specialists come from breaking implicit contracts with “workers, suppliers, and other corporate stakeholders.”

They make one especially keen point: if it were really about adding efficiency, why do the same people lead takeovers in many industries, instead of people with specific expertise in each industry doing the job? Their answer is that these specialists are specialists in deal-breaking, not value creation.