With Mitt Romney back in politics, running for senator from Utah, as well as the recent death of his business mentor, Bill Bain,  I thought I should revisit the legacy of the “private equity” (PE) model of corporate governance. Romney’s Bain & Co. spin-off, Bain Capital, was one of the first, and has long been one of the most financially successful, private equity investment funds. But there are some very ugly failures in that history as well, and many other PE investment groups have similar track records of big successes, at least in terms of profit to the investors, combined with messy failures very costly to employees and their communities.
Full disclosure up front: I have worked in a large company both before and after a PE buy-out, and I have seen personally how it can get really destructive. But my biggest argument is that PE primarily exists, and possibly only exists to its current extent, in the U.S. because of its ability to exploit flaws in the tax and bankruptcy systems here. It is in this sense that I use the pejorative “corporate welfare” moniker, because it is difficult to prove that it is doing anything beneficial to the country as a whole, and lot of evidence that it is sucking away preferential tax dollars, and in the process harming other parts of the economy. Without the tax preferences, many PE deals, I contend, would never happen.
Lest you think this is a personal beef against the Romney family, please see my earlier post fondly “Remembering Lenore and George Romney.”
The rise of PE theory
Mitt Romney and I overlapped our years studying corporate finance in graduate school in the mid-1970s, he at Harvard and me at the University of Michigan. One of the hot topics of the time at both schools was the emerging potential to move away from the publicly-held corporation model that had fueled most post-WWII economic growth, and move toward this new model where you could leverage a relatively-small amount of equity capital using much more corporate debt than was seen as wise under previous norms. That higher leverage means greater investor wealth, even without business growth, mostly gained through some loopholes in the tax and legal systems. But you had to run mostly “under the public disclosure radar” to pull this off, thus the need for privately-sourced, not publicly-solicited equity dollars.
The general consensus at the time was “Yes, you can earn a boatload of extra money here, but only by stretching tax rules to their limit and putting otherwise-profitable acquired companies at a much higher risk of bankruptcy.” At the time, analyses we had done at Michigan indicated a potential bankruptcy rate of 20-30% of acquired companies just due to the high-risk financing strategy, independent of the good or bad qualities of the underlying business, a prescient prediction in Bain’s case. But Mitt Romney and others said, “Hold my beer!” (Well, maybe not Mitt, but you get the point.)
The private equity business model is really only preferential to public equity, and likely only feasible at all, under three conditions. First, you need to max-out two “tax preferences,” (1) the “carried interest” rule and (2) the tax deductibility of interest paid on long-term business debt. Second, you need to be willing to “milk” as much cash as possible from businesses derogatorily called “cash cows,” a term coined in the 1970s describing long-lived companies with low debt and steady cashflow. Third, you need to take full advantage of bankruptcy laws to the legal limit, even when your own actions were primarily responsible for the bankruptcy. No “women and children first” allowed.
Tax preference #1: Carried interest
Narrow political interests and their lobbyists are always trying to manipulate the tax law to create, as invisibly as possible, tax preferences. Whether by different tax rates, deductions used by only a tight group of individuals or business, or unique tax credits, the idea is to make some types of income (i.e., their own) advantageous over others. Economically, this is little different from just handing out cash to these politically-favored companies and individuals, and so I call it “tax welfare.” Private equity is the master example of this strategy.
The first of these preferences, carried interest, is an exclusive-club lower rate of tax charged on a share of a company’s profits that are paid to a private equity or hedge fund manager as a performance bonus, even if the manager has little or no personal investment stake in the fund. The term itself is an anachronistic misnomer, going back to the origins of the practice among investors in sea voyages around the turn of the 16th century, not coincidentally about the time double-entry accounting was invented by these same mercantilists. 
It is hard to find any tax expert who can defend why we continue to give this type of income a preferred tax rate, historically 20%, or explain what makes it different from an ordinary bonus paid to managers in every other business, which is taxed at normal, higher rates (up to 39.6%). Yet despite some fleeting consideration to remove it, the preference was extended in the most recent tax legislation, and no member of Congress involved could explain (or admit) why it re-appeared in the final bill.
The amount of tax savings for PE managers of large companies can be huge, up to millions of dollars per year, making an otherwise marginal and highly-risky way to do business profitable just for the tax benefits. Worse, “creative accounting” can spin reported net income and management fees in the short run to maximize these payments, drawn from the cashflow of the “cash cow” company at the very same time it might be struggling cope with new and extremely-high debt levels. This is especially easy to pull off if you are not a publicly-traded business entity.
Tax preference #2: Interest on corporate debt
But where did the new debt come from? This is the second tax loophole exploitation. Since interest on long-term corporate debt has been, up until recently, tax-deductible without limit, the question was asked in 1970s business schools, “How high could you leverage a company with debt?”
The classic Modigliani and Miller approach to capital structure, going back to research out of the University of Chicago in the 1950s, says that, different from personal debt, corporate debt is more correctly thought of a variant of ownership from stock shares, where lower, but guaranteed, returns on the investment are taken by investors in exchange for having little-to-no say in the management of the firm, except during bankruptcy.
Viewed in this way, the percentage mix of conventional stock and corporate debt that finance the assets of a business is usually irrelevant to the total economic value of the firm, except for the tax preferences. Interest on debt, which is really just guaranteed payments to this restricted class of “owners” in this view of the corporation, can be deducted from corporate taxes, while common stock dividends cannot. 
This “fuzzy line” between what is debt and what is stock is especially true in PE acquisitions. As Eric Garland had pointed out in Bain Capital’s ill-fated acquisition of big box retailer Guitar Center in 2007, “[P]rivate equity’s stake in the company is usually represented by ‘payment in kind’ (PIK) notes, a type of bond that pays crushing interest – in this case 14.09% – but requires no cash outlay until the bond’s maturity. So that 14.09% is accruing, but it isn’t due for years, ideally after the company has been sold.”  By the way, normal businesses don’t normally pay anything close 14% on their long term debt. Using the Rule of 72, you can calculate that, with 14% of annual deferred interest payments, your debt doubles every five years. 
A company with zero debt would almost never go through a messy bankruptcy; it would usually just “fade away” or be acquired if there is any residual value in the assets. Theoretically, you can add on debt to raise funds, rather than sell stock shares, until the risk of bankruptcy through debt default gets higher than your investors’ comfort level. The tax deductibility of the interest payments, however, means that additional earnings from a larger set of assets accrue to the smaller set of stockholders. So this long-standing tax preference is also a form of tax welfare. Companies with a high percentage of very risky debt are favored by the tax law with lower taxes over more conservative companies with a smaller amount of debt, and that is a unilateral transfer of the tax burden onto more prudent companies.
But what if your own PE fund’s equity investment in the acquired company is very small, and you have leveraged the company with a lot of 14% debt. And now suppose that you have already recovered your initial PE investment through carried interest and other large “management fee” cash transfers? And finally, what if you have no fear of bankruptcy consequences or of driving a once-profitable company into the ground?
If this is the case, there is virtually no limit as to how high you are willing to leverage the company with debt. And this is key to the private equity model. The higher the leverage, the more the government is effectively handing money over to the managers in the form of tax preferences for your high levels of debt. Such is the story of Bain Capital and its fellow private equity funds over the years. Some PE-owned companies can survive in this environment, but many otherwise-profitable companies fail. I will look at some of these in later posts, but the typical PE defense will always be that “other conditions” caused these companies to fail, and not the excessive debt levels.
There is little to praise in the Tax Cuts and Jobs Act of 2017, but there was one positive move to limit the tax deductibility of corporate interest payments on debt. For the first four years, this deduction will be limited to 30% of earnings before interest, taxes, depreciation and amortization (EBITDA). EBITDA is the primary measure of cashflow generated from business operations alone. After four years, this bar gets lowered to 30% of just earnings before interest and taxes (EBIT), an even tougher bar to reach. 
Now, 30% is still pretty high, and it will be interesting to see how the most highly-leveraged private equity businesses handle this change. Will it cause them to reduce debt leverage, or will it perhaps reveal that this business model is not very profitable unless you get the tax welfare? Now if we could just get rid of the carried interest rule, we might be able to put these businesses on a more equal footing with more prudently-managed businesses. My prediction is that most of these PE deals would dry up as unprofitable.
Mitt Romney and other PE managers made a LOT of money running this risky tax-welfare strategy. And I didn’t, choosing a different career path. But then, I didn’t cause dozens of otherwise-profitable companies to collapse into bankruptcy either, throwing many thousands of people out of work and closing community pillars.
Part Two of this series has been posted.
- Mittelman, Melissa. “Bill Bain, Bain & Co. Founder, Mitt Romney’s Mentor, Dies at 80.” Bloomberg.com, 18 Jan. 2018.
- A Franciscan monk, Luca Pacioli, is credited with systematizing the Venetian practice of “debits and credits” in a 1494 treatise. Pacioli was a gifted mathematician, and is credited with teaching the math of perspective to Leonardo Da Vinci.
- “Capital Structure Theory – Modigliani and Miller (MM) Approach.” EFinanceManagement, 12 Jan. 2018.
- Carland, Eric. “The End of Guitar Center.” EricGarland.co, 18 Mar. 2015.
- Guitar Center remains in precarious financial shape today after Bain bailed on the business and sold it to another PE firm in 2010. To add another interesting twist to this particular story, at this writing Trump son-in-law Jared Kushner owns, and owes a lot of Deutsche Bank debt on, a high-rent property in New York’s Times Square with a wobbly Guitar Center anchor store and a recently-closed Guy Fieri restaurant. Boomberg News. “Kushner Cos.’ Deutsche Bank–Backed Property Stung by Tenant Troubles.” Crain’s New York Business, 19 Jan. 2018.
- Richter, Wolf. “What Will the Tax Law Do to Over-Indebted Corporate America?” Wolf Street, 22 Dec. 2017.