Over a decade of low interest rates in the United States, Europe, and Japan has fueled a chase for yield amongst investors worldwide. This chased for yield has fueled the demand for high yield debt, leveraged loans and collateralized loan obligation (CLO), where the majority of leveraged loans are packaged. The demand for leveraged loans and CLOs worldwide, in particular, has in turn propelled non-banks, such as private equity firms to grow substantially in the last decade. According to Bain and Company, “In the Trump era’s more relaxed regulatory environment, the share of [leveraged loan] deals with multiples of greater than seven times EBITDA [Earnings Before Interest Tax and Depreciation] rose to almost 40% of the total, according to Loan Pricing Corp. (LPC).”
Growth in private equity in the last decade has been significant. From 2009 to the end of 2018, private equity rose almost 170% by number of deals and over 410% by dollar deal value. It is difficult to ascertain whether 2019 will look like 2018; yet if there are interest rate cuts in the coming months, that would certainly fuel the chase for yield again.
From 2017 to the end of 2018, private equity grew in deal numbers by 10% and in dollar deal value by 18%. This represents the largest one-year growth since 2009-2010. According to Bain and Company, “The rising deal value in 2018 capped the strongest five-year stretch in history, while deal count reflected stiff competition and rising asset prices.”
Private equity’s rapid growth has attracted interest from international standard setters such as the Financial Stability Board, as well as legislators around the world. In the U.S. just last week, Senators Elizabeth Warren (D-Mass.), Tammy Baldwin (D-Wisc.), and Sherrod Brown (D-Ohio), Ranking Member of the Senate Banking Committee, along with Representatives Mark Pocan (D-Wisc.), and Pramila Jayapal (D-Wash.), proposed the ‘Stop Wall Street Looting Act of 2019. Its proposers describe the bill as a comprehensive attempt to “fundamentally reform the private equity industry and level the playing field by forcing private equity firms to take responsibility for the outcomes of companies they take over, empowering workers, and protecting investors.” Senators Kirsten Gillibrand (D-N.Y.) and Bernie Sanders (I-Vt.) and Representatives Barbara Lee (D-Calif.), Jesús "Chuy" García (D-Ill.), Ayanna Pressley (D-Mass.), Rashida Tlaib (D-Mich.), Jan Schakowsky (D-Ill.), Ro Khanna (D-Calif.), and Raúl Grijalva (D-Ariz.) joined in introducing the legislation.
The proponents of the bill summarized the bill. It is intended to:
- Require Private Investment Funds to Have Skin in the Game. Firms will share responsibility for the liabilities of companies under their control including debt, legal judgments and pension-related obligations to better align the incentives of private equity firms and the companies they own. In order to encourage more responsible use of debt, the bill ends the tax subsidy for excessive leverage, and closes the carried interest loophole.
- End Looting of Portfolio Companies. To give portfolio companies a shot at success, the proposal bans dividends to investors for two years after a firm is acquired and ends the extraction of wealth from acquired companies through excessive fees.
- Protect Workers, Customers, and Communities. This proposal prevents private equity firms from walking away when a company fails and protects stakeholders by:
- Prioritizing worker pay in the bankruptcy process, and improving rules so workers are more likely to receive severance, pensions, and other payments they earned.
- Creating incentives for job retention so that workers can benefit from a company's second chance.
- Ending the immunity of private equity firms from legal liability when their portfolio companies break the law, including the WARN Act. When workers at a plant are shortchanged or residents at a nursing home are hurt because private equity firms force portfolio companies to cut corners, the firm should be liable.
- Clarifying that gift cards are consumer deposits, ensuring their priority in bankruptcy.
- Empower Investors by Increasing Transparency. Private equity managers will be required to disclose fees, returns, and political expenditures so that investors can monitor their investments and shop around.
- Require Regulators to Address Risky Leverage. The Dodd-Frank provisions that require arrangers of corporate debt securitization to retain some of the risk will be reinstated.
This morning, I was fortunate to have a long discussion about both the pros and cons of this bill with Bilge Yilmaz, Wharton Private Equity and Finance Professor, as well as Director of the Joshua J. Harris Alternative Investments Program. According to Professor Yilmaz much discussion about private equity is “misguided and lots of education is needed in this field.” About the “Stop Wall Street Looting Act of 2019,” he said that “there are different components to the bill. Some are very legitimate. However, some segments are unreasonable and could endanger the good parts of the bill.” Yilmaz believes that having a discussion about carried interest is “a legitimate policy discussion that should be had by policy makers and voters’ voices should be heard.” He also stated that there is a nuance that is important to think about. How will changing carried interest affect the investment mentality of private equity investors. “If putting private equity investors in a higher income tax bracket does not change their long-term perspective, than this a redistribution policy question. If changing carried interest, however, changes the behavior of private equity investors to make them more short-term, this could hurt the economy.’ There are trade-offs. “There are legitimate concerns of university professors, teachers, and doctors who work very hard and who pay a much higher marginal tax rate than do private equity investors who earn much more than they do.”
Yilmaz also found that the part of the bill that discusses service agreement fees is a legitimate policy issue. Private equity investors charge advisory fees of the companies in which they invest in that come from companies’ profits. The bill proposes that those fees be taxed. “If those advisory fees are taxed, then those private equity investors or companies might just hire consulting firms. This may not be the best use of company dollars.”
In an opinion piece in April, Steve Forbes, Editor-In-Chief of this publication, wrote that “Hiking the tax on carried interest capital gains would discourage entrepreneurs who invest their time, energy and expertise in businesses like these—and America would be worse off because of it.” Concurring with Forbes is Drew Maloney, president and CEO of the American Investment Council, who stated that increasing the tax on carried interest capital gains “would unnecessarily harm entrepreneurs, business owners, endowments, pension funds, and American workers in every state and congressional district in the country.”
According to the AIC, a private equity industry association, private equity investments are in every sector of the economy in every state and 35,000 private equity-backed companies provide more than 5.8 million Americans a job. This represents about 3.7% of the employed workforce in the U.S; this number may seem small, yet, the number of private equity-backed jobs has risen 20% just in one year. These private equity-backed jobs are in every sector of the economy including technology, retail, manufacturing and healthcare, as well as for profit colleges, payday lenders, for profit prisons, and Trump’s rapidly growing detention centers for youth migrants, primarily from Central America and Mexico. The AIC showcases Dollar General, Dunkin Donuts, Hilton Hotel, ServiceKing, and Yankee Candle as private equity success stories.
Critics cite that missing from AIC’s private equity success stories are private equity’s less than stellar involvement in Gymboree, Payless, Kmart, Sears, or ToysRUs. The senators’ and representatives’ proposing the bill cited numerous reasons in favor of the 'Stop Wall Street Looting Act of 2019,' primarily ending abuses in the private equity sector and protecting workers from being fired. Comments in support of the bill from these legislators and numerous consumer advocacy groups and think thanks may be found here.
Lisa Donner, Executive Director of Americans for Financial Reform, a nonpartisan, not-for-profit consumer advocacy organization strongly supports the bill. “These powerful interests have rigged the rules to enable financial engineering that lets a tiny handful of people extract vast wealth at everyone else’s expense. It is time to change the laws to protect workers, communities, and pensions.” Marcus Stanley, policy director at AFR, explained that “The leveraged buyout acquisition model used by private equity funds desperately needs reform. This legislation would curb the incentives to load up companies with debt by ensuring that private equity managers themselves are liable for the excessive debt they impose on the companies they acquire.”
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