Photo: The Joker
It’s obvious that the private equity industry believes it’s in danger. Here’s one clue: Its lobby group, the Private Equity Growth Capital Council, has launched a whole campaign to convince America of it’s utility in the face of potentially crippling tax reforms from the Obama Administration.But Fortune’s Dan Primack says that isn’t what is going to bring the entire industry down. In fact he says the real boogie man is a little closer to home.
The industry’s most dangerous enemy…is not in the White House. It’s in the mirror, due to private equity’s pervasive use of dividend recapitalization — a noxious financial strategy that perverts the industry’s mission and threatens its future ability to raise capital.
Here’s why: dividend recaps put risk on the company and not the PE firm. In a leveraged buyout bank loans are taken out in the company’s name to finance its own purchase. The company is then responsible for interest payments and sometimes, if everything goes to south, the company is responsible for that too.
But that’s not all, says Primack:
The extra twist comes when, often years later, private equity owners instruct the company to take out even more bank loans. Those proceeds are then funneled to private equity investors in the form of a “dividend,” rather than being used for corporate purposes like buying new equipment or hiring new employees.
Obviously if a company folds it’s bad news, but if a company survives they end up with a load of debt too. Standard and Poor’s says that in the first 2 months of this year, there’s been about $7 billion in dividend recap activity, just to give you an idea of how much money we’re talking.
Primack rejects the idea that this industry can police itself (“that would be like asking kids to choose apples over miniature candy bars while trick-or-treating”), so that leaves government intervention. Obama’s proposed tax reform would reduce the amount of interest on debt that companies can claim as a tax break — smaller break, less debt.
Obama’s proposal may sound like an attack on private equity, but it’s not quite that simple. While dividend recaps are quick and easy money for the industry, they’re bad for business in the long term. Investors in private equity funds — including public pension systems — have begun talking a lot about “sustainable” investments, rather than just buy, sell, and move on.
In short, Primack thinks clients are tired of this risky situation. They have other investment options, and maybe one day they’ll exercise them. If that day ever comes, there’s no amount of PR can fix it.
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