Private equity. Carried interest. Leveraged buyouts. Venture capital. A once-obscure corner of the capital markets has exploded into the mainstream as Republican presidential candidate Mitt Romney defends the wealth he acquired in this most lucrative sector of the financial industry.
Private equity refers to a group of large investors, such as pension funds and endowments, that supply funds to general partners to use as venture capital (to incubate new companies) or to buy public companies, take them private and restructure them, sometimes by borrowing additional money (known as leveraged buyouts). Private-equity firms take an active role in monitoring, financing and reorganizing these companies with the goal of selling them back into the public market at prices that generate superior returns for both the general partners and investors.
Money has flowed into private-equity funds because they generate generally superior returns. For large public-pension funds, the median return on private equity was 6.6% annually over the five years ended in September 2011, according to Wilshire Associates. That’s far better than the return on stocks during the same period. Over the past ten years, the Cambridge Associates Private Equity index, which tracks more than 4,500 private partnerships, returned more than twice as much as popular U.S. stock averages.
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But it is extremely difficult for ordinary investors to get a piece of this action. Investors must be “accredited” to become a limited partner (see Ahead). And even if you make the grade, some very successful funds favor established investors and have limited space for newcomers.
Does it help? On balance, academic research shows that private equity produces stronger and more-resilient companies. Although the employment growth generated by private equity is generally not as strong as Romney claims, most firms sold by private equity have lower default rates, invest capital more efficiently and turn in a better operating performance than comparable firms. That’s partly because private-equity firms can negotiate lower borrowing costs, and the equity partners are able to share their expertise with the firm’s management.
That doesn’t mean there are no abuses in the private-equity market. When the economy is booming and investors are all too willing to ignore risks, private-equity firms can easily find money to buy public companies, leverage them with debt, then sell them to the public at inflated prices.
One controversial issue in the presidential campaign is whether the compensation, or carried interest, that Mitt Romney and other general partners of private-equity firms receive should be taxed at a preferential rate. Here I must side 100% with the naysayers. Unlike ordinary investments, carried interest involves little or no capital at risk. Capital gains, on the other hand, are taxed at preferential rates because capital is at risk and there are restricted rules for deducting capital losses. But carried interest is no different from shares of stock, options and bonuses paid to employees, or even contingency fees paid to lawyers, all of which are taxed as ordinary income.
Being rich should not disqualify a candidate from the presidency, and Romney would be extremely wealthy whether his income from Bain Capital was taxed at 15% or 50%. To the extent that Romney mentored young firms and restructured old ones, that is exactly the right background for taking on the challenges of the presidency. Who disagrees that our government, with its trillions of dollars in unfunded future liabilities, needs to be restructured? But Romney must also admit that he benefited from too-favorable tax laws that need to be rewritten. In this election, it’s the candidate, and not private equity, who should be judged by the American public.
Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania’s Wharton School and the author of Stocks for the Long Run and The Future for Investors.
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