This time, I nominate Ann Coulter for the job, since I know she looks good in bondage gear, and Maureen Dowd is all tuckered out from whacking Holman Jenkins' butt as punishment for his previous misdeeds.
Mr. Fox, who styles himself over at Time magazine as "The Curious Capitalist," has blundered into my field of fire with the following comment, which he appended to an otherwise anodyne catalogue of corporate tax rates around the OECD:
As I've studied the private equity taxation debate, I've become more and more convinced that the private equity boom of the past decade in the U.S. has been driven in large part by tax arbitrage. By buying corporations and then loading them up with enough debt that they no longer have any taxable earnings, then paying their partners with "carried interest" that for reasons that have more to do with history than logic is taxed as capital gains instead of as ordinary income, the private equity firms are doing an end run around the U.S. tax system. When things like that happen, it's always worth asking whether we should be saying shame on those private equity firms or shame on the U.S. tax system. [emphasis his]
Arrrrggghh! No, no, no!
By saying that the spectacular growth in private equity over the recent decade "has been driven in large part by tax arbitrage," Mr. Fox stumbles pell mell into the same reductionist trap that Holman Jenkins did just a week or two ago. Attentive readers will remember that I pilloried Mr. Jenkins in these pages for asserting without qualification that "any tax is a disincentive" to economic behavior. Mr. Fox now appears to proudly display the opposite side of the same counterfeit coin, viz., that tax incentives are the primary drivers of economic activity, in this case private equity.
Now, I have already acknowledged—if such acknowledgement was even necessary—that tax incentives and disincentives do indeed influence economic behavior. And, when they become large enough or comprehensive enough (e.g., the personal mortgage interest deduction), they can introduce meaningful distortions into otherwise market-driven behaviors. This is common sense, and common experience. But to aver that the corporate interest expense deduction and the treatment of general partner returns as capital gains rather than income are largely responsible for the boom in private equity is to put a very large cart in front of two very small horses.
First of all, the corporate interest expense deduction which Mr. Fox flags for our attention has been available to all corporations, of every stripe, for many, many moons. The income tax code has indeed favored borrowed money as an element of any corporation's balance sheet, so much so that the tax shield available to corporate borrowers has become enshrined as a permanent feature in our favorite unprovable financial theorem, the Capital Asset Pricing Model. The US government, for inscrutable reasons of its own, has offered companies an economic incentive to borrow for a long time. (Your Faithful Correspondent is old enough to remember when the IRS used to allow individuals to deduct personal interest expense from their tax bills, too.) Interestingly enough, most corporations, public and private, have been characteristically leery of becoming profligate debtors, notwithstanding the 35% after-tax carrot Uncle Sam has dangled in front of their noses.
Not private equity, though. Sensibly enough, they have figured out that if the tax collector is willing to juice their after-tax returns to equity with a hefty interest rebate for borrowed money, they should soak willing credit providers for all they are worth. Why not? But the interest expense tax deduction—which, as I have pointed out, is available to every corporate entity—is simply gravy. The bulk of the juice to equity returns in most leveraged buyout deals comes from buying a company at X and selling it three to five years later at (for example) 1.6X. Let's say in this example that the PE fund only ponies up 30% of the purchase price in equity and raids the pockets of Wall Street banks and their bitches, hedge funds, for the rest. Then, anyone with a functioning calculator can figure out that you will net 0.9X upon sale (assuming, as is the case now, that your creditors do not require you to amortize or pay down any debt principal), for a very respectable return of three times your money. While adding a nice little fillip to the mix, the interest expense tax shield in this instance is overwhelmed by the true economics of the trade, which is leveraged price appreciation. They won't tell you this, but private equity guys would do this type of trade even without the interest expense deduction.
Mr. Fox next alludes to the capital gains tax break which private equity—along with venture capital and partnerships of all sorts and descriptions—receives on carried interest. Now this is indeed a very nice tax break for the private equity professionals who do the work of buying, overseeing, and selling portfolio companies. With it, they get to pay lower capital gains taxes on their earnings, even though they get a 20% slice of the profits but only contribute somewhere in the neighborhood of 3 to 5% of the actual equity to a buyout. I have blathered on in these pages repeatedly about this little goody, so I won't repeat myself here. Suffice it to say, however, that all this tax preference really does is encourage more people to become PE professionals, since it allows an ambitious finance professional or hanger on to pay (lower) taxes on his or her labor as if he or she were an investor, rather than a common wage slave like a CEO or investment banker. But the limited partners who pony up the vast majority of funds used in the PE business already get capital gains treatment on their investments—like every other slob with a Charles Schwab account and 300 shares of Microsoft—so capital gains treatment for carried interest has the exact effect of nada, zilch, zero on their decision to allocate funds to that asset class.
And here we come to the rub. Private equity has boomed in recent years, but not for the tax reasons Mr. Fox claims. It has boomed because it has been successful, thereby attracting all sorts of LPs who want to invest their capital in an asset class (or way of investing) that delivers good returns while offering diversification from other more liquid traded asset classes. It has boomed because there has been a coincident global liquidity glut in the credit markets, which has delivered very low-rate, almost condition-free debt financing to PE firms to grease their acquisition of more and larger companies. And it has boomed—in the face of this massive dual influx of debt and equity capital—because it has continued to be able to find plenty of target companies, both public and private, which it can buy for X and sell for 1.6X. Private equity indeed comprises a larger part of the capital markets and the M&A scene than it ever did, but this is because there continues to be a very large number of underappreciated, undermanaged, and underinvested companies out there in the economy that are ripe for the kind of transformational investment private equity does so well. And it appears that there are a lot more of them now than we ever thought there were in the past.
Paying taxes is a drag, a burden, and a source of friction in economic activity. Less friction is a good thing, and makes any gainful economic activity relatively more attractive. But the economic activity has to be gainful in the first place to attract peoples' energies and capital. We all buy our lunch and pay our rent with after-tax dollars, after all.
And the last time I looked, Steve Schwarzman and Henry Kravis would still be able to afford a very nice lunch, even if they paid the top marginal income tax rate like the rest of us.
© 2007 The Epicurean Dealmaker. All rights reserved.