Friday, November 2, 2012

Private Equity: Dinner or Dessert?

Private Equity:  Dinner or Dessert?

The largest private equity firms in the United States have almost all lined up solidly behind Governor Romney and Republican candidates in 2012.   They are understandably worried that President Obama and Democrats would eliminate the preferential tax treatment of carried interest and otherwise raise taxes on the wealthy.  They may be backing the wrong horse and worrying about the wrong threat.

For the past twenty years pension plans have funded the explosive growth of private equity funds and made a bunch of people fabulously wealthy.  When the endowments and foundations first discovered private equity, funds were relatively small, and the industry was a bit player in the capital markets.   However, as public pension plans, like CALPERs, began to make commitments, private equity funds were able to grow in size by 5 times or even 10 times, while fees remained at 1.5% or 2%.  What began as a nice little spread became a mighty fine meal.  With low tax rates on carry (15%) and even on ordinary income (35%), private equity also enjoyed a delicious dessert.

Mutual Fund Votes (1999)

Slimming down or eliminating public pension plans is a big part of the Republican policy agenda.  It is a key component of pushing toward smaller government and balanced budgets.   It is also critical to eliminating the purported disparity in the compensation and benefits afforded public employees versus the private sector.  We’ve seen this battle play out in Wisconsin and other states.  There’s only one problem with this strategy if you’re a private equity maven (or for that matter any money manager).  Your six course meal is going to go away.  If public pension plans are frozen or converted to defined contribution plans, private equity is going to lose its preferred seat at the table.  A frozen pension plan will look to lower risk investments, like bonds, to match their remaining liabilities.  Defined contribution plans will require liquid investment options, such as mutual funds, to meet participant needs.  The huge commitments by pension plans to private equity plans will be off the menu.

Perhaps, as is often the case, they aren’t looking down the road far enough.  By focusing on their tax bill, they’re fixated on the sweet taste of dessert, instead of protecting their major source of sustenance.   Perhaps the private equity industry has gained so much weight from gorging on pension funds that it’s looking to lose some weight and doesn’t mind seeing pension clients disappear.  


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