Elizabeth Warren wants to bury private equity. Here’s why that is a bad idea.
Free Enterprise and Private Equity
I have a love-hate relationship with private equity. As a mergers and acquisitions attorney, I spend more of my time representing sellers of companies, or even corporate buyers, than representing private equity. I have had vigorous negotiations with private equity firms and their attorneys. However, I respect the important role private equity firms have in the free enterprise system. Free enterprise is the engine of American prosperity; private capital is often the fuel to that engine. Unfortunately, presidential hopeful Sen. Elizabeth Warren (D-MA) doesn’t see it this way.
Rolling out a new plan to tighten the grip on private equity, Warren hyperbolically calls PE firms “vampires” that engage in “legalized looting.” Instead of looting the economy, as Warren’s punitive wealth tax plans would, private equity firms often play an important role in entrepreneurship and the full life cycle of a business. For instance, Ernst & Young estimates that PE-backed activity generates around 5 percent of US GDP.
The Relationship Between Entrepreneurship and Private Equity
Capitalism has a lot of critics these days on the left and right. Yet entrepreneurship is still widely praised. In fact, Warren herself recently said that “every American should have a fair shot at starting a small business.” Entrepreneurs start businesses for any number of reasons—including building a lifestyle business, pursuing a profession or craft they love, or the ambition of building a great company that employs workers and makes great products.
To build something more than a small lifestyle business, it is often necessary to take on outside finance. At an early stage, this isn’t likely to be a commercial loan. Rather, seed capital and growth capital is more likely to come from angel investors, venture capital, and private equity firms. Angels, VCs, and PE investors are all forms of private capital. Accessing private capital, whether debt or equity, is necessary for many businesses to grow their business, or invest in new technologies and equipment.
Private equity provides a common way for a founder to exit a business. Business owners decide to sell their companies for numerous reasons. After years of risk-taking and toil, an entrepreneur may want to cash out and reap the rewards for all his or her hard work. In other instances, an older founder may be on the brink of retirement. Rather than passing on the business to a too-often ill-equipped heir, the founder wishes to sell the company to professional managers who will continue to operate and grow the company for years to come. Sometimes a visionary entrepreneur takes on successful capital partners to grow an emerging company to a successful middle-market company or beyond.
A savvy entrepreneur will plan his or her exit at an early stage. An ambitious entrepreneur doesn’t take risks, make personal sacrifices, and even will forego a salary at times for nothing. The real motivation is turning that small business into a larger, growing company. The eventual sale of a company could mean millions of dollars to the founder. Building a company, then selling it for large dollars, is the real motivation for many founders. Private equity is often the one fulfilling the founder’s dream of a successful, and lucrative, exit.
There really is nothing nefarious about any of this. This is merely free enterprise.
The Private Equity Caricature
According to Warren’s caricature of the PE world:
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.
Warren mischaracterizes private equity firms as looters pillaging one victim company after another. Private equity offers a way for sellers to exit on mutually agreed-upon terms. Done right, this is a win-win situation. Similarly, the financial incentives of customary private equity fees ensure that the interests of the sponsor and its investor are aligned. When the investor prospers, so does the sponsor.
How Private Equity Really Works
Private equity funds are formed when financial entrepreneurs organize a fund, then raise investment capital from investors. The fund managers make their living by managing the funds by identifying privately-owned businesses for acquisition, acquiring them, and operating the businesses. The investors and managers may profit from well-run businesses that kick off dividends. But the real “payday” for the investors and fund sponsor (i.e., the private equity fund managers) often comes from growing a company, creating efficiencies, then selling that company for large gains in three to seven years.
Warren’s Plans for Private Equity
Warren mischaracterizes how private equity investments work, and disparages private equity professionals, in order to justify her plan to centralize control over more of the American economy. Here are just a few of her proposals.
Assumption of Debts?
The Senator’s first proposal is to put “private equity firms on the hook for the debts of companies they buy, making them responsible for the downside of their investments so that they only make money if the companies they control flourish.”
This is puzzling. If a private equity buyer acquires the stock of the target company, it already legally assumes all the target company’s debt and liabilities. If the parties agree to an asset deal, however, the buyer typically requires that all the target company’s existing debts of the seller to be paid at closing.
This hardly seems like a matter that requires federal legislation or justifies calling financial professionals vampires.
Further, in an asset deal, the seller indemnifies the buyer for any of the seller’s liabilities. This is industry practice and makes sense. Because the seller is typically paid a large sum at closing, the seller will be in a position to cover the costs of its own liabilities when they occur. It’s hard to see what the first plank of Warren’s plan accomplishes.
Warren also fails to recognize that many venture capital investments are for a minority position and many private equity investments are for a mere 51 percent control-position. If a private equity firm acquires 51 percent interest in the equity or assets of a business, why should the private equity firm acquire 100 percent of the liabilities? This not only makes no sense but would put unnecessary burdens on buyers—thus making business deals less likely.
Employee Benefits Obligations?
Next Warren vows to hold private equity firms “responsible for certain pension obligations of the companies they buy.” Again, if the buyer acquires stock, it assumes those existing obligations. If the buyer acquires assets, it may either continue the prior employee benefits or offer the seller’s employees the buyer’s employee benefits when they are offered employment with the new employer. The benefits of a larger PE-backed company may be better than the benefits provided by the seller—which often is a smaller, family-run business. This hardly seems like a matter that requires federal legislation or justifies calling financial professionals vampires.
Fees and Dividends?
Warren’s most disturbing idea is to fundamentally disrupt the private equity financial model by “eliminating the ability of private equity firms to pay themselves huge monitoring fees and limiting their ability to pay out dividends to line their own pockets.” Warren essentially wants to outlaw the well-established private equity model that financially sophisticated investors regularly agree to.
Private equity doesn’t need to be “reined in”; it needs to be unbridled to spur more economic growth.The customary fee structure for PE sponsors (PE managers) is a management fee of two percent of assets under management; plus a carried interest (i.e., equity interest granted to the sponsor) is well-known to sophisticated private equity investors. Fee structures like this can certainly be lucrative for PE managers, but they align the sponsor’s interests with the investors.
The managers do well when the investors do well. If the fund underperforms, some of the fees may be clawed back. Plus, if the managers have any hope of persuading investors to participate in future rounds of investments, the managers will need to demonstrate a healthy return on the investor’s investment. Warren would have us believe that sponsors profit when they slash and burn companies. But, the customary model properly incentives sponsors to grow profitable businesses.
Warren claims her plan would empower
investors like pension funds with better information about the performance and effects of private equity investments and preventing private equity funds from requiring investors to waive their fiduciary obligations.
Institutional investors are not babes in the woods. Such investors are fully capable of conducting due diligence on a private equity firm and each new investment opportunity. Institutional investors are managed by highly compensated, professional investment advisors who have a fiduciary duty to their investors.
When a private equity investor considers an investment, the investor, their financial advisors, accountants, and attorneys will have ample time to review a prospectus (often called a private placement memorandum or offering circular). These PPMs can be quite extensive. They describe the experience of the private equity firm, the private equity managers, the investment criteria of the fund, the use of the invested dollars (i.e., use of proceeds), and a description of the investor’s legal rights, as well as the financial statements or projections of the fund.
Not in Need of Protection
The idea that large institutional investors or wealthy families need Elizabeth Warren to look after their investment for them is laughable.
Warren’s plan is based on ad hominem attacks on financial professionals and mischaracterizations of how private equity investments work. She fails to recognize private capital’s contribution to funding innovation and fueling economic growth. Private equity doesn’t need to be “reined in”; it needs to be unbridled to spur more economic growth.