Debt Financing and PE, An Unfortunate Marriage

January 9th, 2012 at 7:10 pm

I wanted to be sure to highlight this excellent piece by Merrill Goozner on the tax advantage enjoyed by corporate investors–he focuses on private equity firms–from their ability to deduct interest payments on their debt from their tax bill.

Point #1:

The business interest deduction distorts economic activity, according to a report issued last year by the Joint Committee on Taxation. It encourages companies to raise capital through debt rather than equity, since returns to stockholders – dividends – come out of after-tax profits (and then are taxed again as part of recipients’ individual tax returns). Payments to bondholders, on the other hand, is a deduction from earnings.

Check out these effective tax rates on corporate investment from a Brookings paper a few years ago—the rate on debt financing is negative!  No wonder we’re stuck in an economic shampoo cycle: bubble, bust, repeat.

Source: Brookings Hamilton Project, Bordoff, Furman, Summers.

Point #2:

No industry has taken better advantage of the business interest exclusion than private equity investors like Bain Capital, which is Republican presidential frontrunner Mitt Romney’s former firm. Private equity is actually a misnomer, since the modus operandi of those investors is no different than the leveraged buyout firms that pioneered junk-bond financing in the 1980s. Private equity firms generally finance anywhere from 60 to 90 percent [my bold–JB] of their purchases with borrowed cash. Interest payments on those debts are treated just like any other expense, and are therefore deductible from earnings.

Moreover, Goozner cites research that the leveraged buyouts tend to be associated with cuts and job losses; spinoffs from larger conglomerates, on the other hand, tended to add jobs.

To be clear, I’m not saying this makes LBOs bad; sometimes, such cuts are necessary.  But I am saying that any PE or hedge fund investor who says they’re in the business of job creation is spinning.  They’re in the business of finding efficiencies at best, tax breaks and fast profits (at the expense of future growth) at worst.

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6 comments in reply to "Debt Financing and PE, An Unfortunate Marriage"

  1. James Edwards says:

    I have often thought that Reagan ushered in an era I’ve called a Plunder Based Economy. It’s when no more value is added, but wealth is made by stripping and selling off the hard work of previous generations.

    I just found out about Mancur Olson and his book “The Rise and Decline of Nations.” As I understand, he contends that rent seeking becomes the ultimate demise of a society since so much effort is devoted to making money, but not creating wealth. This additional cost is shifted to consumers who see declining rather than increasing value for money in a profit driven economy.

    Sadly I had never heard of him or his book before this. Could you comment on him and his work and do you think that he turned out to be a Cassandra regarding what actually happened since the publication of his book in 1982 and even more so what happened after his death in 1998 regarding the ultimate in rent seeking, these financial products that were pure plunder? How was he regarded in the field? What was his aqua stance visa vi brine concentration?

    Thank you in advance.

    • Jared Bernstein says:

      His book informed my thinking and that of many others–he was widely taught when I was in grad school though I’ll bet less so now–ergo, the problem. His field–institutional economics (the study of the influence of the various institutions that dominate the political economy, from unions to lobbyists to corporations and gov’t itself)–lost favor to “rational expectations,” “efficient market theory,” and other theoretical fairy tales.

  2. readerOfTeaLeaves says:

    I know there is a relationship between debt financing and the capital gains tax rates, but I can’t quite distill it.

    I thought another money quote in that article was this one: “…the so-called carried interest loophole, which allows private equity investors pay taxes on earnings at a lower capital gains rate…”

    Isn’t all that leveraged debt taxed — when it actually is taxed! — at the lowest capital gains rate? IOW, isn’t this a means of job destruction through tax dodging?

  3. save_the_rustbelt says:

    In order to have an “income tax” we must calculate “income” and it would be rather bizarre to calculate “income” without deducting interest. Dividends are a return of capital, and the two are in no way equivalent.

    Without defending all of the actions of PE firms and hedge funds (two completely different creatures) the use of debt is a necessary finance function in any sort of corporate finance (try to model a company with 100% equity financing and it doesn’t work well).

    Leverage is a part of finance. Excessive leverage eventually bites us. Inadequate leverage let equity languish. In the real world people have to make difficult decisions.

    • perplexed says:

      -“In order to have an “income tax” we must calculate “income” and it would be rather bizarre to calculate “income” without deducting interest. Dividends are a return of capital, and the two are in no way equivalent.”

      Actually, far from being “bizarre,” its done quite frequently. EBIT, EBITD are commonly used measures in finance. Dividends can be a return of capital or a distribution of earnings. The issue is that earnings distributed to debt holders in the form of interest is not subject to corporate “income” tax while earnings retained by the corp. or distributed through dividends are.

      Organizing as a corporation is choice investors make to protect themselves from liability in excess of their investment. This way damage done by the corporation in excess of what the shareholders invested is transferred to creditors up to the extent of their “investment” and beyond that, to the public (i.e. environmental cleanup, transfer of pension obligations to the government, etc.) Thus, the corporate tax can be better understood as a payment for a form of insurance that only applies to earnings that are retained or distributed as dividends; not to earnings distributed as interest. Increasing the leverage reduces the cost of the “insurance” relative to the magnitude of the earnings stream.

      Investors choose this form of organization primarily for one reason: its much cheaper than it would be to buy the insurance through the “private marketplace.” If it were cheaper to buy it elsewhere, they would do it. But having the public provide the insurance at a deeply discounted rate (the relatively small amount paid on EBI) is a pretty sweet deal for most oligarchs to turn down. Ultimately its a form welfare the public provides; mostly to the “needy” 5% of the population (and some wealthy foreign investors) that own almost all of the shares in these organizations.

      This is one of those “quiet room” things though so be careful about discussing it in public.

  4. Fred Donaldson says:

    This debt financing is why the NYSE company, where I headed a division, always talked about EBITDA, earnings before interest, taxes, depresiation and amortization.

    We had a huge interest load that finally sucked up most all earnings – just before the company went bankrupt, and my $20 options weren’t worth much as the stock had polunged to 25 cents a share.

    However, top folks pulled out millions in stock options and salaries, while staying up nights figuring out how to slice a penny and sell the metal shavings.