Features » October 29, 2007

Pirates of Private Equity (cont’d)

Private equity firms justify the tax code in different ways. Primarily, they assert that even if carried interest makes up the bulk of the manager’s compensation, the investments are usually held for more than a year, qualifying them as long-term capital gains. And the Private Equity Council argues, unconvincingly, that talented women and people of color would not have been attracted to the industry without the current carried interest policy, and thus any alteration would harm civil rights.

In reality, the tax breaks that helped propel the private equity boom have only intensified the nation’s economic imbalance. According to Executive Excess 2007, a study released in August by the Institute for Policy Studies and United for a Fair Economy, the 20 highest-paid fund managers made an average of $657.5 million last year–22,255 times the average annual U.S. salary of $29,500.

“We already have this problem of great economic growth … but with the share of national income going to wage earners shrinking, and with almost all of the new wealth being taken up by a small handful of people,” says Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee. “Private equity obviously has the potential to increase that [disparity].”

Some analysts think that the industry’s bubble is slowly leaking, if not ready to burst. Financing for leveraged buyouts has reached a virtual standstill in the aftermath of the summer’s credit crunch, necessitating a freeze on most private equity deals. Yet, buyout funds have already raised $139 billion globally in 2007, according to an August report by Private Equity Intelligence, and are on pace to exceed the $212 billion raised last year, signaling that the support of institutional investors remains high. These backers have a long-term investment horizon, as well, which means that fluctuations in the world’s credit markets are less likely to cause alarm. While it’s clear private equity firms will be forced to fork over more of their own money to engage in buyouts, these trends suggest that the firms will likely remain major financial players in the coming years.

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To assuage mounting criticism and threats of legislative provisions, some private equity managers have taken steps toward self-regulation. In July, a British industry group led by former Morgan Stanley International Chairman Sir David Walker issued a report that claimed private equity firms have been “needlessly secretive,” and suggested British companies be made to supply annual reports that would include information on the top partners, the performance of their funds, their fees and their investors. But even Walker’s modest proposals were met with trepidation by managers on both sides of the Atlantic, proving they want no part of policies that may encumber their techniques or alter their pay scale. And without such intervention, private equity’s shrewd executives will continue to push workers’ benefits and long-term investment to the back burner while profiting from a regressive tax code that strips the government of cash for crucial public programs.

“As these companies grow larger and more powerful, and control more of the economic activity of society,” says Candaele, “I think it’s inevitable that some sort of regulatory process has to take place.”

Major labor unions from across the globe have been on the front line of the emergent regulation battle, publishing detailed reports, staging actions and issuing public statements, warning working people about how the private equity industry is endangering their jobs and their pensions. “The labor movement is ratcheting up their involvement in this and hiring professionals to understand this world, [which] is really key,” says Candaele. “There’s an informational mismatch when you’re dealing with all these money managers … and the labor movement needs to know much more about how finance works in order to be competitive and to help the broader population deal with and understand these dynamics.”

Now some legislators are also stepping up to the plate. In Europe, the Party of European Socialists (PES)–the European Union’s second largest voting bloc–has mounted resistance. Claiming that the industry’s methods conflict with the expectations and values of European social market economies, PES has advocated for tougher disclosure requirements, and changes to corporate governance and taxation rules. Although the European Union is the most rational arena for proposals, progress is slow, mainly because the European Commission–the executive branch of the European Union–has been supportive of private equity investment, and other voting blocs have been slow to join the fight.

Elsewhere in Europe, individual countries are implementing new regulations. In August, German Chancellor Angela Merkel released plans to curb “undesirable economic” activities by requiring funds to elaborate on their aims if they seek to raise stakes in companies beyond 10 percent, and to disclose how they finance bids. In France, President Nicolas Sarkozy has given his finance minister until October to draft a proposal for making fund managers release more information about the financial products they trade.

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In the United States, Democrats have followed suit. “I think it is very likely that financial innovation has outstripped regulation and that we need to upgrade the regulation,” says Frank. While some in the party are wary that piecemeal laws might derail more thorough tax reforms (or that some of their corporate donations may dry up if the industry is targeted), prominent Democrats have focused on closing the egregious tax loopholes that benefit equity fund managers.

In June, Rep. Sander Levin (D-Mich.) introduced a bill that would apply income tax rates to carried interest. A similar bill in the Senate, sponsored by Sens. Max Baucus (D-Mont.) and Charles Grassley (R-Iowa), among others, would more than double the taxes paid by private equity firms like Blackstone that go public. The recent instability in credit markets should generate more urgency to guarantee the industry is subject to oversight, as well.

Legislators have also begun to create transnational partnerships in an attempt to control globalized firms. In one sign of cooperation, PES and the Democrats sent a letter to Merkel and President Bush before April’s G8 Summit, calling on them to uphold workers’ rights, establish measures for transparency and launch a task force to suggest additional regulatory action.

But to ensure that these financial transactions benefit society at large, many critics think these humble legislative efforts should be supplemented by more comprehensive reforms. Congress could restrict the amount of debt a firm can accrue during acquisitions and incentivize long-term investments, thereby providing much-needed credit stability. Restrictions on forming unions could be eased and workers could have more input in buyout negotiations. And to even the playing field with publicly traded companies, lawmakers could write or amend legislation that would subject private firms to more rigorous monitoring.

Pension holders can also do their part by pressuring pension trustees to invest in socially conscious funds. Candaele points to Yucaipa American Alliance Fund, a group run by billionaire Ronald Burkle, that earns high returns while maintaining solid relationships with organized labor. “There are a lot of ways to make money,” he says, “and one of the obligations for trustees is to look at what managers are doing with the money you’re investing.”

Private equity firms will balk at such suggestions, claiming regulation will inhibit their contributions to the economy. To demolish that argument, Frank says, one only needs to look back in history.

“People who want to [counter] this argument–that if you regulate markets, you’re going to interfere with their function–should read the debates over the establishment of the Securities and Exchange Commission in the ’30s,” he says. “Then they won’t have to think of new things to say. They can just quote them.”