An Interview with Josh Kosman on the Embeddedness of Private Equity in...

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An Interview with Josh Kosman on the Embeddedness of Private Equity in the Tax Code
Posted on January 12, 2012

As a result of a series of attacks and counter-attacks on Republican presidential candidate Mitt Romneys work with Bain, theres been a lot of discussion about private equity, buyouts of firms, and their ultimate relation to the economy. So far the discussion has been a back-and-forth on layoffs and creative destruction, with very little on how laws and regulations structure the way private equity and buyouts happen in this country. I interviewed Josh Kosman, author of The Buyout of America: How Private Equity Is Destroying Jobs and Killing the American Economy, on this topic. Bob Kuttner reviewed his book in May 2010, and Kosman was on Up with Chris Hayes last weekend discussing this topic. The interview has been edited for length. Mike Konczal: What are private equity funds, and what do they do? Josh Kosman: Private equity firms are mostly former Wall Street bankers who raise money to buy companies on credit. They used to be called leveraged buyout (LBO) firms, and when the first leveraged buyout boom went bust in the 1980s they regrouped and called themselves private equity. The big difference between them and venture capitalist or hedge funds is that the companies that they buy borrow money to finance the acquisitions. Private equity firms own more than 3,000 U.S. companies and employ roughly one out of every 10 Americans in the private workforce. This is just America, so it doesnt include companies or employees overseas. Some companies include HCA, the largest hospital chain, to Clear Channel, the largest radio station operator, to Dunkin Donuts. They are in every industry. People coming to the defense of private equity from both

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An Interview with Josh Kosman on the Embeddedness of Private Equity in...

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the left-neoliberal and conservative spaces directly invoke or allude to the market as a natural, already existing thing. But a key progressive retort to this laissez-faire view of economics argues that all markets are deeply embedded in and constructed through legal, tax, and other regulatory government codes. Your research has found that, far from being natural, private equity exists largely due to issues with the tax code. Can you explain? The whole industry started in the mid-to-late 1970s. The original leveraged buyout firms saw that there were no laws against companies taking out loans to finance their own sales, like a mortgage. So when a private equity firms buys a company and puts 20 percent down, and the company puts down 80 percent, the company is responsible for repaying that. Now the tax angle is that the company can take the interest it pays on its loans off of taxes. That reduces the tax rate of companies after they are acquired in LBOs by about half. Banks, also realizing this tax effect, were willing to finance these deals. At the time, you could also depreciate the assets of the company you were buying thats not true today. They saw that you could buy a company through a leveraged buyout and radically reduce its tax rate. The company then could use those savings to pay off the increase in its debt loads. For every dollar that the company paid off in debt, your equity value rises by that same dollar, as long as the value of the company remains the same. So the business model is based on a capital structure and tax arbitrage? Yes. Its a transfer of wealth as well. Its taking the wealth of the company and transferring it to the private equity firm, as long as it can pay down its debt. It think it is real the very early firms targeted industries in predictable industries with reliable cash flows in which they by and large could handle this debt. As more went into this industry, it became very hard to speak to the original model. Now firms are taken over in very volatile industries. And they are taking on debts where they have to pay 15 times their cash flow over seven years they are way over-levered. The most common argument for why Bain Capital and other private equity firms benefit the economy is that they are pursuing profits. They arent in the business of directly creating jobs or benefitting society, but those effects occur indirectly through the firms making as much money as they can. But even here, profits how they exist, where they come from, and how they are timed have a crucial legal and regulatory function. A recent paper from the University of Chicago looking at private equity found that a reasonable estimate of the value of lower taxes due to increased leverage for the 1980s might be 10 to 20 percent of rm value, which is value that comes from taxpayers to private equity as a result of the tax code. Can you talk more about this? That sounds about right. If you took away this deduction, youd still have takeovers, but youd have a lot less leverage and the buyer would be forced to really improve the company in order to make profits. I think that would be a great thing.

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An Interview with Josh Kosman on the Embeddedness of Private Equity in...

http://rortybomb.wordpress.com/2012/01/12/an-interview-with-josh-kos...

If you look at the dividends stuff that private equity firms do, and Bain is one of the worst offenders, if you increase the short-term earnings of a company you then use those new earnings to borrow more money. That money goes right back to the private equity firm in dividends, making it quite a quick profit. More importantly, most companies cant handle that debt load twice. Just as they are in a position to reduce debt, they are getting hit with maximum leverage again. Its very hard for companies to take that hit twice. If you look at Ted Forstmann, an original private equity person who just passed away, he would rail against dividends in this manner borrowing money to pay out dividends. He was more interested in taking companies public and selling shares and paying down debts and collecting proceeds that way. I can respect that a lot more. The initial private equity model was that you would make money by reselling your company or taking it public, not by levering it a second time. Private equity and buyouts started as a way to take advantage of tax gimmicks, not as a way of saying were going to turn around companies. And now its out of control. I look at the 10 largest deals done in the 1990s, during ideal economic times, and in six cases it was clear that the company was worse off than if they never been acquired. Moodys just put out a report in December that looked at the 40 largest buyouts of this era and showed that their revenue was growing at 4 percent since their buyout, while comparable companies were growing at 14 percent. In January so just in the past 12 days Hostess, the largest bakery in the country, just went bankrupt. Coach, the largest bus company, just went bankrupt. And Quiznos is about to go bankrupt. All of these were owned by private equity. This battle is part of a larger discussion of, in Henry Mannes phrase, the market for corporate control. The tax code is set to overlever firms, which require increases in earnings to go toward debt payments instead of research and development, expansion, and other things that build the firm. What could we change to generate different outcomes? Thats exactly right. Right after this goes on for a few years, youve starved your firm of human and operating capital. Five years later, when the private equity leaves, the company will collapse you cant starve a company for that long. This is what the history of private equity shows. What Id like to see Mitt Romney do is to show an example of a buyout that went well. The only success stories hes talking about on any level are venture capital investments Staples and Sports Authority. Personally I like venture capital, I think it provides a lot of value, but thats not what he did mostly, and thats not what these takeovers are about. The big fix Id encourage is an end to interest-tax deducibility for leveraged buyouts. The tax system encourages companies to borrow as much as they can. For certain industries, like telecom, these deductions might make a lot of sense. But it was never intended for financing leveraged buyouts. If you put a cap on this you would find buyouts and private equity firms that were much more focused on building companies.
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An Interview with Josh Kosman on the Embeddedness of Private Equity in...

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11 Responses to An Interview with Josh Kosman on the Embeddedness of Private Equity in the Tax Code
Merrill Goozner says:
January 12, 2012 at 1:24 pm

I wrote about this for The Fiscal Times and posted it here: http://gooznews.com/?p=3516.
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Jim says:
January 12, 2012 at 8:38 pm

If companies are taking out more debt than they can handle, who is buying it? What is the default rate? Is it rated properly?
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Mcmike says:
January 13, 2012 at 11:53 am

The companies are also bled dry with exec pay, management fees, key asset sales, brand canibalization, and sweatheart deals with insider vendors. Another reform must be taxes on the capital gains
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Shane Taylor says:

January 16, 2012 at 10:28 am

Eileen Appelbaum also spoke to the influence of tax indulgences on private equity, particularly when it comes to interest on debt, dividends, and capital gains: http://www.cepr.net/index.php/blogs/cepr-blog/plain-talk-about-private-equity She also covered (and clarified) some of the major research thats out there on private equity.
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Shane Taylor says:

January 16, 2012 at 10:40 am

including Steven Kaplan and Per Strmberg, which you already noted in your post
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An Interview with Josh Kosman on the Embeddedness of Private Equity in...

http://rortybomb.wordpress.com/2012/01/12/an-interview-with-josh-kos...

Steve Roth says:

January 16, 2012 at 5:41 pm

Id say eradicate all interest deductions business, mortgage, the lot Encourage equity, not debt.
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