Elizabeth the Vampire Slayer
The Wall Street Journal
By the Editorial Board
August 9, 2019
Elizabeth Warren’s favorite image for businesses is that they “suck” profits out of American society like vampires. Her latest targets are private-equity firms that invest in struggling companies, often replace management and bet on a turnaround. She wants to put them out of business.
“The Stop Wall Street Looting Act,” as Ms. Warren calls her new bill, would impose new taxes, legal liabilities and regulations that would make it more costly and risky for investors to try to revive businesses. It would also effectively rewrite the bankruptcy code.
Ms. Warren describes private equity as “bleeding the company dry and walking away enriched even as the company succumbs.” Perhaps she’s trying to appeal to “Twilight” and “Buffy” loving millennials. But her garlic-wielding caricature overlooks that private-equity managers lose money if their investments fail.
Private-equity firms make long-term investments in underperforming companies and aim to create value—and turn a profit—by fixing inefficiencies. They raise capital from institutional investors like college endowments and public pension funds, which they often supplement with debt, to buy out public shareholders.
Managers are compensated with an annual fee—typically between 1.5% to 2% of a fund’s invested capital, which is taxed as ordinary income. Only if a company returns profits over several years that exceed a “hurdle rate”—on average 8%—do managers get a cut. If returns decline, outside investors can claw back profits from managers.
This aligns the incentives of fund managers with their investment partners and encourages the long-term investment that progressives like Ms. Warren supposedly desire. Private equity has turned around Dunkin’ Donuts, Hilton hotels, Dollar General and many other companies, though most success stories aren’t known to consumers while failures grab headlines.
Ms. Warren assails private equity for loading companies with debt, which the corporate tax code has encouraged by allowing a deduction for interest payments. The GOP tax reform limited the deductibility for interest to 30% of a company’s adjusted earnings, which we supported along with the corporate rate cut. But Ms. Warren opposed that trade-off and now wants to raise tax rates and set a stricter cap on “excessive leverage” for private equity. Her bill doesn’t say what it should be, but it would significantly raise the cost of capital.
The Senator would also tax the profits above the hurdle rate of return at the ordinary income rate rather than as capital gains, which would reduce the incentive to invest in companies with uncertain prospects. Ditto Ms. Warren’s proposal to hold private-equity firms liable for the debts, legal judgments and pension obligations of the companies in which they invest. No investor will sink money into a failing enterprise if doing so requires assuming all its liabilities.
Some PE-backed businesses like Toys “R” Us and iHeartRadio have filed for bankruptcy, but they might have failed sooner due to industry-wide problems without a private-equity intervention. Moody’s has found PE-controlled businesses are no more likely to file for bankruptcy, and investor equity is typically wiped out in bankruptcy.
Senator Warren nonetheless wants to rewrite the bankruptcy law for private equity. Her bill would reorder the creditor hierarchy by requiring that company pension contributions and employee severance receive equal priority to operating and “administrative expenses.” This would push unsecured creditors further down the priority line.
While bondholders may now seek to take control of a company in bankruptcy, Ms. Warren’s bill “directs bankruptcy courts to approve the offer that best preserves the company’s jobs and maintains the terms and conditions of employment for its workers.” In other words, a buyer’s investment or financial offer wouldn’t matter if another bidder promises workers a better deal, even if it is financially unsustainable. The upshot is that creditors will be more likely to push to liquidate failing companies in a chapter 7 bankruptcy rather than try to salvage them for reconstruction.
The Warren bill would also require PE funds to publicly disclose their performance and fees. Most PE managers already disclose this information to investment partners. But the Senator is trying to please union pension funds that want more leverage over private-equity firms when deciding whether to invest.
The irony is that public pension funds have been increasing their investments in these vampires, er, private-equity funds as they shoot for higher returns to finance generous worker retirements. The 10-year average annual return for private equity is 10.2%—13.63% in Ms. Warren’s home state—compared to 8.5% for stocks and 6.7% overall. Why does the Senator want to hurt union retirees?
Senator Warren describes herself as a “capitalist to the bones.” She must have a strange definition of capitalism. Every policy she proposes would increase government control over the private economy.