Thursday, September 20, 2012

Private Equity Privileges


Private Equity Privileges

Marc Leder, the co-CEO of a Sun Capital Partners a private equity firm, was the host for the $50,000-a-plate dinner at which Governor Romney made his now famous comments about the 47%.  Mr. Leder and his wife have given $5,000 to the Romney campaign, and his firm has donated $314,000 to Governor Romney’s associated committees and $450,000 in contributions to Super Pacs supporting the Governor’s Presidential bid.  Where did this kind of money come from?

Don’t give up on this comment because it contains a bunch of numbers.    If you want to understand how successful private equity executives, like Marc Leder, or Henry Kravis of KKR, or Governor Romney got rich you need to follow the math.  The math is by and large Clintonesque arithmetic, not calculus.

Very Unlikely (1999)


First clear your head about all the talk of private equity creating jobs or slashing jobs.    While slashing jobs and cutting expenses play a role, and creating positions and developing new products are part of the picture, the biggest contributors to making money are: the private equity trinity: (i) the investors, (ii) the tax code, and (iii) the financial markets. 

We’ll look at one modestly sized deal to give you an idea how the wealth is generated.   Suppose private equity buys a company for $100 million and sells it for $200 million five years later.   Who profits and who pays?  Well private equity isn’t going to invest the full $100 million; let’s say they borrow $60 million from a group of banks, so they only have to pony up $40 million.  The $40 million isn’t their personal money – they’ll only put (being generous) about $1 million of their own money at stake.  The rest of the equity ($39 million) is investor money – could be from your pension plan or favorite university endowment.

So private equity owns the company, does a bunch of stuff, and at the end of 5 years there’s $100MM to split up.  After the bank is paid off, and the private equity firm takes out its fees there’s about $65 million for the outside investors.    The PE firm takes about $20 to $25 million in fees, and the rest is eaten up by a variety of expenses and deal costs.  So private equity owes its first big ‘thank you’ to public employees, unions and not-for-profits for sharing 30% to 35% of their gains.

While private equity owned the business they got to deduct the interest on the $60 million acquisition loan from the business’s taxes, and when the business was sold, the partners got to pay the capital gains tax rate on a large portion of their fee  (known as carried interest).  Obviously the deal also generated some revenue for the tax authority, but the net cost to tax payers is about $25 million, and the private equity partners saved about $3 to $5 million on their personal tax bills.  So thank you tax payers.

We can’t get away from the fact that our little business doubled in value, whether by growing or shrinking the company.  It must have been a lot of hard work to take a $100 million business and turn it into $200 million.  It is a lot of hard work, but so is teaching school or collecting the trash.   However, private equity, particularly in Governor Romney’s day in the 1990s had one huge thing going for it: rising stock prices.  It’s like having a huge wind at your back.  When it’s time to sell you not only get the benefits of your hard work, you also get the lift of being exposed to equity.  So another nice chunk of the gain, say $25 to $50 million, depending on market conditions, comes from being in the right place – owning stock.  Investors could have achieved much of the same result by borrowing money and investing in index funds at minimal expense.  So thank you stock market.

Remember the $1 million the partners put into the deal, they’ll net out about $750,000 in profits a nice sum on their investment, but that won’t really fund campaign and Super PAC contributions.  The real action is the $20 to $25 million they made in fees (or $17 to $21 million after taxes).   Now you’ve got the money for a $50,000-a-plate fundraiser.

Run this set of mathematics through $5 billion and $10 billion funds a la Blackstone, Carlyle and KKR and you’re talking about real money for private equity partners and as well as significant costs to taxpayers who subsidize this activity. 

How do they do it?   The recipe for this meal is simple:  mix great marketing and big promises in order to extract the investors’ money for your funds.  Next, stir in a generous dollop of campaign contributions (by the way private equity and hedge fund managers don’t limit their largesse to presidential races) built on our lax campaign finance laws; particularly post-Citizens United.  These contributions help to protect private equity’s welfare benefits imbedded in the tax code.

Why does private equity sometimes win when their businesses fail?   It’s getting late and your head already hurts.  We’ll save it for tomorrow.

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