Bloomberg Law
Nov. 4, 2019, 11:48 AM

ANALYSIS: Private Equity Firms Should Fear Warren’s Looting Act

Preston Brewer
Preston Brewer
Legal Analyst

When the next recession comes—and it will come—who will be blamed?

In 2008, the villains were the tandem of financial deregulation and banks. Financial deregulation allowed a huge real estate bubble to form, then burst. Banks exacerbated that lending problem because they took poor-quality residential mortgages and packaged them in mortgage-backed securities with unregulated credit default swap contracts, insuring enormous amounts of debt—debt that quickly became overwhelming as defaults mounted—without understanding the risks. The Dodd-Frank Wall Street Report Act of 2009 represented a concerted effort to address those deficiencies.

Increasingly mixed recent economic indicators have many worrying a recession may be in the offing. Will economists point to the impact of tariffs and slowing world trade? Will the next downturn simply represent the inevitable end to the longest economic expansion in American history? Massachusetts Senator and presidential candidate Elizabeth Warren has already submitted her nomination for the villain of the next recession. That villain is private equity.

Private equity generally refers to investment funds that buy and restructure companies. These funds are typically structured as limited partnerships, with a private equity firm serving as general partner.

Private equity has become enormously important in recent years. The American Investment Council, an industry trade association, estimates that more than 5.8 million Americans are employed by 35,000 private equity-owned companies, with $3.4 trillion invested between 2013-2018. Besides buying established companies, private equity also makes huge investments in risky start-up companies, enabling them to grow and mature. These firms later look to exit their investment, such as via an IPO or by selling the company.

Not everyone views private equity so benevolently. Private equity is hollowing out American businesses, the thinking goes. Senator Warren has condemned private equity firms as “vampires” when they purchase companies by “bleeding the company dry and walking away enriched as the company succumbs.” In this scenario, the private equity firm dismantles the target company for parts, damaging U.S. business and putting Americans out of work. According to Warren, “[f]or a long time now, Wall Street’s success hasn’t helped the broader economy—it’s come at the expense of the rest of the economy. Wall Street is looting the economy.” Private equity investors “pad their own pockets while the rest of the economy suffers.”

Warren’s solution to “end Wall Street’s stranglehold on our economy” is the proposed Stop Wall Street Looting Act of 2019.

Aimed directly at private equity and some of its most profitable practices, this proposed piece of legislation would significantly restrict private equity’s business.

So how would the Stop Wall Street Looting Act put an end to this “legalized looting” and “raise wages, help small businesses, and spur economic growth”? The key aspects of this bill seek to:

Close the carried interest loophole. Carried interest is a share of any profits that flow to a private investment fund’s general partners. The loophole is that these profits going to private equity funds and hedge funds are not taxed at normal corporate tax rates but instead receive lower, preferential tax rates. Ending this loophole would double equity firms’ tax bill.

Tie private equity profits to the success of businesses they manage.

Tax the “monitoring fees” firms pay to themselves at a 100% rate. Private equity firms typically charge clients a monitoring fee of between 1% and 3% for managing the investment fund.

Limit the payment of dividends by banning them for two years after a company is acquired.

Limit the use of tax breaks applicable to the debt private equity firms saddle on corporate acquisitions.

Improve the investment information available by requiring annual disclosure to the SEC of debt held by private equity funds and their portfolio companies.

Upgrade the priority of workers seeking back pay and severance among creditors when their employer goes bankrupt.

Impose liability on private equity firms for the debt and other legal obligations (e.g., pensions) of their acquisitions. Liability begins when ownership exceeds 20%.

Some of these proposals are less controversial than others. For example, Warren Buffet supports ending monitoring fees.

The most damaging proposal, if enacted, would be forcing private equity to share liability for the debts and retirement obligations of companies they acquire. It would likely end private equity purchases of distressed companies and lead investors towards the public markets. For the firms themselves, it would disregard their limited liability corporate structure while maintaining their other obligations. The effectiveness of this provision would seem limited, as investors would simply use a different investment vehicle, one subject to less regulation, for the transaction.

Will this bill pass? At this time, it is mostly a proposal to help Warren define herself for her presidential campaign. However, the bill has received several enthusiastic Democratic co-sponsors in both chambers, and Senator Warren has become the leading Democrat in the party’s bid to unseat President Trump. If the November 2020 election sees Democrats taking control of Congress and the White House, many of the bill’s provisions are likely to receive serious consideration.

Read about other trends our analysts are following as part of our Bloomberg Law 2020 series.