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John Engle
John Engle
Articles (408) 

Private Equity Faces Mounting Political Pressure, Pt. 1

Elizabeth Warren wants to overhaul the PE industry

September 18, 2019 | About:

With the 2020 presidential election drawing ever nearer, the field of would-be Democratic challengers to incumbent President Donald Trump has remained remarkably crowded. In an effort to differentiate themselves from their internal party rivals, candidates have sought signature issues to define their campaigns.

Senator Elizabeth Warren, a frontrunner from the start of the election season, has struck a particularly strident tone on the subject of finance. While most Democrats have lambasted big banks to one degree or another, Warren has singled out a more niche target: private equity (PE) firms.

Taking on the PE “vampires”

On July 18, Warren published a post on Medium in which she detailed her plan to take the “private equity vampires” to task:

“We should start by transforming the private equity industry — the poster child for financial firms that suck value out of the economy. Private equity firms raise money from investors, kick in a little of their own, and then borrow tons more to buy other companies. Sometimes the companies do well. But far too often, the private equity firms are like vampires — bleeding the company dry and walking away enriched even as the company succumbs. Washington has done little to rein these firms in or to ensure that their incentives align with the best interests of the economy. As a result, the firms can use all sorts of tricks to get rich even if the companies they buy fail. Once they buy a company, they transfer the responsibility for repaying the debt they took on to the company that they just bought. Because they control the company, they can transfer money to themselves by charging high “management” and “consulting” fees, issuing generous dividends, and selling off assets like real estate for short-term gain. And they slash costs, fire workers, and gut long-term investments to free up more money to pay themselves. When companies buckle under the weight of these tactics, their workers, small business suppliers, bondholders, and the communities they serve are left holding the bag. But the managers can just walk away rich and move on to their next victim.”

As soon as her Medium post went live, Warren took to Twitter to further expound on her dim view of PE, and what could be done to rein in the industry’s perceived excesses:

“My plan starts by ending this looting and fundamentally changing the industry. Private equity firms will only make money if the company succeeds. And if they make bad investments, they'll be held accountable instead of walking away with millions.”

Critics push back

In essence, Warren’s plan calls for a complete overhaul of the PE industry. Her call to eliminate or curtail a number of features, such as the treatment of carried interest, would force a fundamental overhaul of the way the industry functions. That has gotten many industry players and advocates rather upset. The American Investment Council was quick to respond, issuing a strongly worded statement mere hours after Warren’s dropped her blog bombshell:

"Private equity is an engine for American growth and innovation — especially in Warren's home state of Massachusetts. Extreme political plans only hurt workers, investment and out economy.”

Unsurprisingly, the U.S. Chamber of Commerce also took issue with Warren’s proposal:

"Senator Warren's financial service plan to limit private equity firms is another brick in the wall to stop growth, job creation and creating return for retirement. What the US needs are policies to promote a growing dynamic economy, and Senator Warren's plan fails to meet that test."

Buyout firms are hardly the evil caricatures that Warren portrays them to be. Oftentimes, poorly run or inefficiently managed companies can be turned around by the ministrations of a disciplined and professional PE firm. Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) is a public company and does not operate under a PE fund structure, but its approach to buying valuable companies and helping them grow is a key component of many PE firms’ strategies.

Verdict

Corporate raiders are hardly new phenomena, but the amount of private capital flowing into PE buyout firms has hit historic levels since the end of the Great Recession. Warren’s sweeping proposals seek to get at the root of perceived excesses in the PE industry. She is targeting those firms that simply seek to extract as much value from portfolio companies, often without regard for the long-term viability of their actions. While such practices can be good business from the PE firm’s perspective, they are often costly to the employees and customers of those businesses being hollowed out.

While the PE industry is not likely to experience the overhaul Warren promises, even if she is elected, her calls for reform have already started to shift the public debate. When the idea of eliminating PE’s carried interest advantages is proposed by a serious political player, especially one in contention for the presidency, the threat cannot be taken lightly.

Investors with exposure to PE should move with great caution in the months ahead. PE is fundamentally illiquid. A major change to securities laws and taxation could cost allocators and investors dearly. While still a low-probability eventuality, it pays to be prepared.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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