Private Equity Funds Are Good for the Economy but Should Pay More Taxes

Mitt Romney and Bain Capital have been attacked by the opposition as greedy rich folks that destroy the economy and the lives of average Americans. However, more than 90 percent of the capital invested in private equity funds like Bain is actually supplied by huge institutions such as public and private pensions whose pensioners typically receive 80 percent of fund profits.

To earn those profits, private equity funds target and acquire dysfunctional companies, add capital, inject management know-how and then recycle prosperous businesses to the economy. Most acquisitions are not hostile or forced by acquirers and target companies often recognize that their survival may hinge upon the acquirer’s capital and management talent. Many recycled companies are transformed into profitable and productive employers for the economy.

The owners of successful private equity funds make superhuman returns and tons of money because they buy good businesses cheaply from distressed sellers motivated to save their companies, leverage their tiny equity positions with huge amounts of debt and other investor equity and further enhance returns by recycling target companies to profitability quickly.

Whether private equity funds are moral or fair is for philosophers to decide. However, those activities are legal and they are as moral or as fair as anyone seeking to buy a home in this distressed real estate market by seeking out a short sale from a motivated seller eager to shed the weight of an upside down mortgage; or as fair as buying a home needy of repair or improvement with an eye toward flipping it quickly for a tidy profit; or as moral as a buyer taking on a mortgage as large and as cheaply as possible. Isn’t that essentially what private equity funds do with businesses?

Private equity funds should not be vilified for what they do. However, they should pay higher taxes. Not because they are rich, but because the capital gains tax they pay for most of their income does not derive from their capital gains. Preferential tax treatment for capital gains was enacted because of the realization that for most investors the capital they invest has already been taxed to them previously as wage or other ordinary income and because they need some additional incentive to take the risk of losing their money in investments. As indicated herein, 90 percent of private equity fund capital comes from third party investors who bear the risk of any investment losses, so most of the income earned by private equity fund owners is really contingent fee income for a job well done, and that should be taxed as ordinary income.