Elizabeth Warren's Private Equity Proposal Encourages Abuses

(Bloomberg Opinion) -- Elizabeth Warren’s “Stop Wall Street Looting Act of 2019” is designed to curtail abuses by private equity funds. Most of the resulting commentary has focused on whether private equity is good or bad, or whether the Act would be effective. However you feel about those things, a more important point is the Act seems designed to encourage the abuses it decries.

In a typical PE deal, a fund combines the equity capital from its investors with a lot of borrowed money to buy a public company and take it private. The fund may sell some of the company’s non-core assets and restructure what’s left to create a company that in five or 10 years can be sold back to the public markets. The fund’s main reward is a percentage, often 20%, of the total collected from sales minus the initial equity investment. It also collects management fees from investors in the fund as well as for services provided to the company it controls.

One of Warren’s main complaints is PE firms initially sell too much of an acquired firm, leaving the surviving entity smaller and less viable. So she proposes a 100% tax on the fees that PE funds collect from the companies they control. It’s possible that in response, a PE fund would merely bill its investors, who are the ultimate payers in either case, but either way it creates a strong incentive for PE funds to sell more assets, and keep fewer. The PE fund will prefer to sell businesses and assets rather than incur the costs of managing them, if it cannot charge to recoup those costs. Moreover, money from sales is not confiscated.

Warren, who is a Democrat Senator from Massachusetts, wants PE funds to target struggling companies and save them, rather than buying healthy companies. She proposes making PE funds, as well as many of their employees, contractors, service providers, and all their relatives and lawyers, personally on the hook for target company liabilities.

This makes any struggling company—especially one with hard to predict pension, litigation or regulatory problems—radioactive. If you strip doctors of all assets if a patient dies, you won’t improve healthcare; you’ll make surgeons and oncologists switch to cosmetic dermatology.

Warren’s final complaint is that PE funds profit at the expense of investors, creditors, workers, customers and communities when target companies file for bankruptcy. But bankruptcy or even liquidation is not necessarily failure. It does mean that not everyone gets everything that was promised, but it may be a better deal for everyone than alternatives.

When Toys “R” Us (one of the examples listed in Warren’s proposal) filed for bankruptcy, the demand for toys in the U.S. didn’t change. Toys “R” Us sales, and the associated jobs, went to other retailers. Its real estate was put to other uses. The overall effect might have been net positive or net negative—or most likely, positive for some people and negative for others—but it’s not obvious they would have been better with different management, nor that the PE firms involved should be punished.

A free-market believer would note that investors, creditors, unions and governments are sophisticated entities capable of looking after their own interests. Individual workers and customers may not be, but PE funds are no different than other profit-maximizing managers with respect to them. We already have worker and consumer protection laws—plus investor, creditor and union protection laws, and governments make the laws. If laws need strengthening, strengthen for all, don’t bill-of-attainder PE funds.

Even if PE funds are uniquely dangerous, the “protection” throws out the baby with the bathwater. High-yield investors lend to PE fund-owned companies to get high interest rates, knowing some bonds will not repay in full. If PE funds are personally on the hook, they won’t issue high-yield debt. Similarly, a 100% tax on fees doesn’t mean PE funds will work for free; in fact, they won’t work at all. Investors won’t save money. Unions won’t get scammed trading pension funding against layoffs—they’ll be no trades if pensions are in trouble or layoffs are on the horizon. Workers, customers and communities won’t be fooled by optimistic promises, because there won’t be promises.

Perhaps PE fund regulation should be changed, but if you believe Warren’s view of the problems, you’ll want the opposite of the changes she is proposing.
 

This does not by any means describe the full range of the 35,000 private equity deals currently operating, nor their complex fee structures, but it will do for the purpose of discussing this Act

It’s true section II-201 prevents money from sales being paid to fund investors in the first two years, but that’s much better than not getting anything. Moreover, the funds from sales can be used to pay down high interest rate debt so when the PE fund can touch the money, it will have grown by the interest savings.

Warren goes full Old Testament in section 3-9’s gleeful expansion of indirect liability, you can almost hear “visiting the iniquity of the fathers upon the children unto the third and fourth generation”

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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