Senator Warren-backed bill would fundamentally change private equity

The bill goes after carry and interest deductibility and would make firms liable for employee pensions.

Don’t look now, but politicians are making private equity a political football as the US moves into a presidential election year in 2020.

Senator Elizabeth Warren of Massachusetts co-wrote a bill called the Stop Wall Street Looting Act of 2019 that would fundamentally change the way private equity operates. The bill attacks two historic pillars of the industry: the tax treatment of carried interest and the ability of PE managers to write off the debt they use to buy companies.

The bill also would make private equity firms much more liable for the companies they buy, including for worker pensions in the case of bankruptcies.

“Far too often, the private equity firms are like vampires — bleeding the company dry and walking away enriched even as the company succumbs,” Warren wrote in a Medium post on Thursday. Warren has been a vocal critic of Wall Street since the global financial crisis. The Looting bill also reiterates Warren’s proposal to break up big banks to separate investment banking from consumer financial services.

“These changes would shrink the sector and push the remaining private equity firms to make investments that help companies rather than stripping them down for parts. Firms that make bad investments would be held accountable instead of walking away from the wreckage with millions in fees and payouts. My plan would stop one of the main sources of Wall Street looting,” Warren wrote.

American Investment Council, the industry’s lobbying group, said in a statement: “Private equity is an engine for American growth and innovation – especially in Senator Warren’s home state of Massachusetts. Extreme political plans only hurt workers, investment, and our economy.”

Private equity was in the political crosshairs in the 2012 election, when rivals of Mitt Romney attacked his private equity career. The furore from that period eventually died down, though around the same time the SEC stepped up its scrutiny of the industry because of mandates in the 2010 Dodd-Frank Financial Reform Act.

Particulars

The Warren-backed bill would do several things, including closing the so-called carried interest tax loophole. Carried interest, the share of profits private equity managers collect on sales of companies, is taxed at the capital gains rate of up to 20 percent, much lower than the regular income rate that reaches as high as 37 percent. Critics believe carried interest is income and should be taxed as such.

The tax treatment of carry has long been a target of mostly liberal politicians, though President Donald Trump during his presidential campaign briefly flirted with the idea of changing the tax treatment to the higher rate.

The proposal also calls for a change of tax rules to hinder firms’ ability to deduct the cost of interest payments from portfolio companies’ tax bills. Private equity firms buy companies by using equity from their funds, and debt the target company takes on its own balance sheet. Firms are able to write off interest on the debt, which has long been factored into the price that firms are willing to pay for their target assets.

Limiting the interest deduction affects a company’s cashflows, which in turn alters the company’s long-term value as an investment asset, Buyouts previously reported.

Congress already changed the tax treatment of interest expenses in 2017, limiting firms’ ability to deduct such costs from portfolio companies. But the Republican-led tax change also included a reduction of the corporate tax rate to 21 percent from 35 percent, which many in the PE world saw as a wash.

The bill would also make private equity firms responsible for pension obligations of the companies they buy and eliminate private equity firms’ ability to charge portfolio company monitoring fees, Warren said in her post.

This would occur three ways: it would strengthen regulators’ ability to claw back assets considered fraudulently transferred out of bankrupt entities; it makes individual PE partners, rather than the funds invested in the companies, liable for post-bankruptcy obligations like pensions; and it would give higher priority to employee claims in a bankruptcy, according to Adam Levitin, professor of bankruptcy law at Georgetown University, on a call about the bill on Thursday.

It would also limit firms’ ability to collect dividends on recapitalisations of portfolio company debt, Warren wrote. This would work by barring a target company from issuing any dividends for the first 24 months after a buyout.

The bill also goes after the financiers of PE deals – forcing lenders and investment managers that lend into buyouts to retain a share of the debt, “to make it harder for them to leave others to pay the consequences if things go wrong,” according to a summary of the bill.

Finally, the bill would force managers to be transparent about fees and performance and prevent firms from requiring investors to waive their fiduciary obligations, Warren wrote.

The Illinois state pension system, a major investor in private equity, would like to see more transparency around fees and expenses even beyond the headline terms generally available to the public, according to Illinois State Treasurer Michael Frerichs, who was also on the call.

“We want something robust: companies in the portfolio, total assets, average debt-to-income ratio of portfolio companies, number of portfolio companies in default or bankruptcy, fees, expenses, carried [interest] claims,” Frerichs said. “It’s better for capitalism if people are competing on the same playing field.”

The bill is far from law. It’s been introduced in the House of Representatives and Senate and will go into hearings across various committees in the House like those governing securities rules, bankruptcy and tax law. It requires a vote in the committees to make it to the House floor, where it would receive a full vote. If it survives that process, it would move to the Senate and go through a similar process.