What Is This Thing Called Private Equity?
UPON what meat doth this our Caesar feed, that he is grown so great?”
I’ve been thinking about those words in the context of private equity lately. How does this business make so much money? Are there really a huge number of mispriced securities out there? Are there really a vast number of corporations whose stock is wildly underpriced so that private equity can buy them at above-market prices and then make money after a little spiffing up and wiping clean?
Maybe so, but this defies the basis of the whole theory of efficient markets. (Of course, much of the whole finance industry is based on denying and defying that extremely interesting and invaluable theory.)
Or maybe it’s that the deals are often done with the help of the acquired entity, where the managers know exactly how to change the company and make it worth more, but want to put that knowledge to work only if they can reap immense rewards from the repair job. That often seems to be what’s happening.
Or is it all sleight of hand and smoke and mirrors? Many years ago, when I was a child, a man who owned a local bus company in Washington told me something memorable. There is no easier way to big money, he told me, than to buy a public company, take it private for a while, then do some accounting tricks with reserves and allowances, make it look profitable and resell it to the public for a big profit. Is this what’s going on here? Accounting is, after all, an art and not a science at the highest levels.
Or is it that once the owners control the target company, they can sell junk bonds and pay themselves immense dividends and fees so they are cashed out with a profit even before they start to reorganize the company? Or is it a combination of all these things?
Maybe there is some degree of inefficiency in the markets, and eagle-eyed smarty-pants types can find companies and make money when they reorganize them or just hold them. (Actually, it’s more than “maybe.” There definitely is, or else my pal Phil DeMuth and I would not be able to get the fabulous returns we have been getting since 2003 from our general investing. Some stocks and some indexes really are mispriced.) This, after all, is how Warren E. Buffett became so rich, and completely honestly.
However it’s happening, it is making some lucky people very rich. That’s fine by me. I like for rich people to endow hospitals and art museums and symphonies.
Now, however, comes word that in many cases, the principals of these private equity firms are using a ploy to avoid paying ordinary earned income tax rates of about 35 percent. They contend that their pay is really a “carried interest” in a series of capital gains and therefore taxable only at capital gains rates. That comes in at 15 percent.
This whole subject was set off by the harrumphing around the Fortress Investment Group and the Blackstone Group, both of which went public recently. It was revealed that the principals at those firms are not only fabulously well paid, but pay little tax on that pay. (They also use partnership and foreign registration tax gimmicks to lower their taxable pay in some instances.) The Democrats in Congress are incensed about this. They want to change the code so that ordinary income tax rates apply to private equity firms. It makes sense to me if, in fact, the income is not from unusual, sporadic deals, but rather from a regular series of processes that approximate the normal carrying-on of a business. After all, the powers at big investment banks like Goldman Sachs basically make much of their money the same way the people at Fortress did. Why should one group get such an immense tax advantage over the other?
Perhaps more to the point, the government needs money for the military and other good purposes. Why not get it from those who have more of it than they know what to do with? What possible difference can it make to Stephen A. Schwarzman, the chief executive of Blackstone, if he makes $400 million a year or, say, $350 million? He would still be able to have big parties, and he would still be able to endow a hospital. As long as similar situations are taxed similarly, why not tax the big private equity boys at the same rate as the guys at Merrill or Credit Suisse?
For some totally inexplicable reason, the G.O.P. in Congress is defending the favored tax treatment of these private equity guys even as they shell out for Hillary Clinton and Barack Obama. But then again, I have had a hard time understanding the G.O.P. for a while now.
I THOUGHT about all of this, and then I thought of something that shook me: I might be wrong. I might be wrong about every part of it. I don’t think I am, or else I would not write it. But I could be wrong. The fact that my words appear in black and white in a major newspaper does not make them automatically true. The fact that I have a lifetime of education and experience in this field does not guarantee that I am always right.
After all, I am just a person. So are all of us who write for newspapers. So are the people at CBS and “Marketplace” and at Fox and at Yahoo. So is everyone. We have grudges we may not even be aware of. We have envy. We have class and religious resentments. We wake up some mornings feeling great and some mornings feeling terrible. We have the myriad influences of childhood, family, friends, environment. These all affect what we write and what we believe. We’re not oracles or vessels of divinity except to the extent that all children of God are.
So, when you read this, please remember: I believe it to be factual and to make sense. But I could be wrong. I was wrong about Iraq. I have often been wrong about investment decisions. I am often wrong in the way I treat people around me.
In this case, there’s something not quite kosher about some private equity dealings, or so it seems to me. There’s something maddening about the way they are taxed or not taxed.
But there would also be something wrong with my assuming that I am always right. I’m not. I’m just a slob on the bus trying to make some sense of the world, just like you.