It's Private Equity's World. That's A Big Deal
Bloomberg Businessweek|October 07, 2019
Private equity managers won the financial crisis. A decade since the world economy almost came apart, big banks are more heavily regulated and scrutinized. Hedge funds, which live on the volatility central banks have worked so hard to quash, have mostly lost their flair. But the firms once known as leveraged buyout shops are thriving. Almost everything that’s happened since 2008 has tilted in their favor. Low interest rates to finance deals? Check. A friendly political climate? Check. A long line of clients? Check. The PE industry, which runs funds that can invest outside public markets, has trillions of dollars in assets under management. In a world where bonds are paying next to nothing—and some have negative yields—many big investors are desperate for the higher returns PE managers seem to be able to squeeze from the markets. The business has made billionaires out of many of its founders. Funds have snapped up businesses from pet stores to doctors’ practices to newspapers. PE firms may also be deep into real estate, loans to businesses, and startup investments—but the heart of their craft is using debt to acquire companies and sell them later. In the best cases, PE managers can nurture failing or underperforming companies and set them up for faster growth, creating outsize returns for investors that include pension funds and universities. But having once operated on the comfortable margins of Wall Street, private equity is now facing tougher questions from politicians, regulators, and activists. One of PE’s superpowers is that it’s hard for outsiders to see and understand the industry, so we set out to shed light on some of the ways it’s changing finance and the economy itself.
Jason Kelly

Private Equity Throws Its Weight Around in Washington

As Republicans set out to overhaul the federal tax code in 2017, private equity began leveraging its influence. The industry was out to protect a wildly lucrative tax break that’s helped mint more billionaires than almost any other kind of business. And it succeeded: The idea of closing the loophole simply went away.

The tax break on “carried interest” allows PE managers to pay a lower rate on much of their income. They get paid in two ways: an annual management fee and a share of investment profits. While the fee is taxed as ordinary income, the profit share is treated like a capital gain, which can be taxed less. Critics say this doesn’t make sense, because the profit share is really just another fee paid by clients. The upshot is that superwealthy private equity managers could pay lower tax rates than their secretaries.

Ominously for PE managers, Donald Trump had vowed on the campaign trail to scrap the loophole. But soon, Kohlberg Kravis Roberts & Co.’s Ken Mehlman, a former head of the Republican National Committee who’s now the buyout firm’s global head of public affairs, was helping to persuade lawmakers on Capitol Hill to fight for PE’s cause. After an effort spearheaded by Mehlman, 22 House Republicans signed a letter to the Ways and Means Committee saying the tax break “bolsters long-term investment in American companies.”

Quietly meeting with Treasury Secretary Steven Mnuchin and top economic advisers was Blackstone Group Inc.’s Jonathan Gray, who’d later become the firm’s No. 2. And Blackstone head Stephen Schwarzman was enjoying rare access to President Trump, his Palm Beach, Fla., neighbor and regular dinner date at Mar-a-Lago. Schwarzman, worth $17.6 billion, is one of Trump’s most generous donors. He’s also traveled to China repeatedly on behalf of the administration.

Congress ultimately decided to put a limit on the tax break—money managers would have to hold their positions for three years to get it. But this barely put a dent in PE’s business model, which typically involves investing in companies for years. The very day the Senate passed the law, Schwarzman hosted a $100,000-a-plate fundraiser for the president at his Manhattan apartment.

Over the past decade, private equity and investment firms—not including hedge funds—have dropped about $400 million into federal campaign coffers, according to the Center for Responsive Politics. That’s more than commercial banks or the insurance industry. “They have managed to have influence with both parties,” John Coffee Jr., a law professor at Columbia University, says of PE.

Leading private equity’s charge in Washington is the prosaically named American Investment Council. Formerly called the Private Equity Growth Capital Council, the lobbying group—like the corporate takeover game itself—has deftly rebranded. The AIC regularly places opinion pieces in newspapers across the country to burnish private equity’s reputation. “We’re working strategically to ensure decision-makers in Washington know how private equity benefits their local communities,” says Chief Executive Officer Drew Maloney. “And during this presidential primary process, we’re sending a clear message to candidates that they are visiting towns where private equity supports local jobs and strengthens pensions for public-sector workers.”

KKR’s Mehlman—who in 2017 was chairman of the AIC—isn’t the only one to toggle between politics and PE. Tim Geithner, Treasury secretary under Barack Obama, is now president of the buyout shop Warburg Pincus LLC. Jack Lew, who took Geithner’s spot, eventually went to the firm Lindsay Goldberg & Co. Stacey Dion, head of government affairs at the Carlyle Group LP, previously worked as a policy adviser for former House Speaker Paul Ryan. Eli Miller, a managing director for Blackstone’s government relations group, used to be Mnuchin’s chief of staff.

PE has more wars to fight in Washington, foremost among them ensuring that federal regulators keep their hands off. In terms of assets, Blackstone, KKR, and Carlyle now dwarf regional banks such as Fifth Third Bank and Citizens Financial Group Inc. Yet “private equity is subject to almost no direct regulation beyond some very basic transparency,” says Jonah Crane, a senior official at the Treasury Department during the Obama administration.

Among the few windows the government has into private equity firms and the risks they take is a document filed with the Securities and Exchange Commission known as Form PF. Its Section 4 can reveal the amount of debt a PE firm is piling onto the companies it’s buying, as well as where in the world firms are investing. But the industry has successfully lobbied to limit access to that information, saying it’s proprietary. Only about a dozen of the SEC’s 4,500 employees can easily see it.

Even so, advocates for private equity have been pushing back against the disclosure requirements. The industry argues that so few people have access to the information that it can’t be of much use anyway and that it may present data-security risks. Natalie Strom, a spokeswoman for SEC Chairman Jay Clayton, says the regulator takes “data protection very seriously.” Clayton’s office said in a statement that officials had met with industry and investor groups about Form PF and that it wasn’t considering scrapping entire sections of the document.

The PE industry would also like to be able to reach everyday investors who’ve long been barred from investing in their funds—and, of course, to collect fees from them. And it’s gotten a sympathetic hearing from Clayton. Although it’s unclear how far the SEC might go, Strom says “we should explore whether it is possible to reduce cost and complexity and increase opportunities.”

In an April interview on Bloomberg TV’s The David Rubenstein Show, Clayton told Rubenstein, co-founder of Carlyle, that many people might benefit from having a slice of their retirement money in private equity. The host agreed. “Probably wouldn’t be that damaging if 5% of it was lost or didn’t do as well,” Rubenstein said, speaking of retiree nest eggs. “So some percentage maybe should be allowed.” —Heather Perlberg and Ben Bain

The Returns Are Spectacular. But There Are Catches

For investors the draw of private equity is simple: Over the 25 years ended in March, PE funds returned more than 13% annualized, compared with about 9% for an equivalent investment in the S&P 500, according to an index created by investment firm Cambridge Associates LLC. Private equity fans say the funds can find value you can’t get in public markets, in part because private managers have more leeway to overhaul undervalued companies. “You cannot make transformational changes in a public company today,” said Neuberger Berman Group LLC managing director Tony Tutrone in a recent interview on Bloomberg TV. Big institutional investors such as pensions and university endowments also see a diversification benefit: PE funds don’t move in lockstep with broader markets.

But some say investors need to be more skeptical. “We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest,” said billionaire investor Warren Buffett at Berkshire Hathaway Inc.’s annual meeting earlier this year. There are three main concerns.

THE VALUE OF PRIVATE INVESTMENTS IS HARD TO MEASURE

Because private company shares aren’t being constantly bought and sold, you can’t look up their price by typing in a stock ticker. So private funds have some flexibility in valuing their holdings. Andrea Auerbach, Cambridge’s head of global private investments, says a measure that PE firms often use to assess a company’s performance— earnings before interest, taxes, depreciation, and amortization, or Ebitda—is often overstated using various adjustments. “It’s not an honest number anymore,” she says. Ultimately, though, there’s a limit to how much these valuations can inflate a PE fund’s returns. When the fund sells the investment, its true value is exactly whatever buyers are willing to pay.

Another concern is that the lack of trading in private investments may mask a fund’s volatility, giving the appearance of smoother returns over time and the illusion that illiquid assets are less risky, according to a 2019 report by asset manager AQR Capital Management, which runs funds that compete with private equity.

RETURNS CAN BE GAMED

Private equity funds don’t immediately take all the money their clients have committed. Instead, they wait until they find an attractive investment. The internal rate of return is calculated from the time the investor money comes in. The shorter the period the investor capital is put to work, the higher the annualized rate of return. That opens up a chance to juice the figures. Funds can borrow money to make the initial investment and ask for the clients’ money a bit later, making it look as if they produced profits at a faster rate. “Over the last several years, more private equity funds have pursued this as a way to ensure their returns keep up with the Joneses,” Auerbach says. The American Investment Council, the trade group for PE, says short-term borrowing allows fund managers to react quickly to opportunities and sophisticated investors to use a variety of measures besides internal rate of return to evaluate PE performance.

THE BEST RETURNS MIGHT BE IN THE REARVIEW MIRROR

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