U.S. financial policy

Bruce Glensky | Tax reform must include private equity

December 15, 2012 

President Obama claims a mandate for raising the tax rate on the upper 2 percent of American incomes; his tone of class warfare during the campaign is implied to have delivered that mandate from the voter. Are we likewise to assume that because he successfully defined Governor Romney’s business conduct while with Bain Capital as hostile to middle class America during the campaign, that he is likely to follow through by eliminating the tax benefits bestowed upon private equity as a necessary condition of tax reform? Let’s hope so.

Private equity, the lipstick on the pig name for leveraged buyouts, benefits from perverse incentives that are counter to long-term investment. The tax code encourages acquisitions and corporate transactions rather than investment in building brands, in research and development, and productive capital investment.

Let’s look at two buyouts from 25 years ago to illustrate the point. Beatrice Foods and Nabisco were taken private by the same sponsor: Kohlberg, Kravis and Roberts.

Beatrice Foods was a portfolio of regional food brands. Management’s strategy was to invest in the advertising slogan “We’re Beatrice” and as the Beatrice brand became more widely recognized to transform its regional brands to nationwide brand status. Upon being taken private, the company was liquidated and the regional brands sold off.

Nabisco was taken private as part of RJR Nabisco transaction in 1989. Nabisco was, and still is, a strong national brand. Here KKR chose to withdraw 3 percent of revenue per year from the advertising budget with the money saved used to pay interest expense on the debt. The company was brought public again in 1993 after the Snackwells low calorie cookie product line was introduced. As a public company, new management restored the advertising budget to prior levels.

Think about what KKR did here. Free market competition argues that competitors develop brands and provide value to customers for the long-run. In the case of Beatrice, that process was aborted at the level of brand development and competition curtailed. Nabisco, as a more mature brand, would maximize its operating profit margin, not defend its brand. On margin, the Nabisco brand was being harvested, not grown. Under both strategies the intensity of competition was reduced, employees were discarded, not hired, and no additional value was created for the customer.

That we allowed this game to continue for 25 years is appalling. The principals of the major private equity groups tend to be people with investment banking backgrounds and links to government; they are members of our entwined political and financial elite. While most business people recognized Governor Romney’s business experience qualifications as superior to that of President Obama, most business people did not like the way he did business. Romney was never able to defend Bain Capital because there was no defense available to him. Leveraged buyouts are speculation by the well-connected with the benefits concentrated for the benefit of the few. They are a cause of the inequality of wealth that President Obama’s tax the rich strategy struggles so hard to redistribute.

We grant corporations limited liability; the corporate veil prevents litigants from accessing the wealth of shareholders held outside the corporation. What does society receive as compensation for that limited liability? In short, shareholders take risk; they invest in long-term multi-generational assets that raise productivity and strengthen capital formation. Rising productivity, specifically management sharing the benefits of productivity with the labor force through increased wages, has been critical to America’s strong middle class. That this economic contract has been broken is a major contributor to the stagnation in wages over the last 30 years.

Working men and women have been duped: duped by corporate managements with stock options; and, duped by investment bankers, many highly connected to government, who have decided to serve themselves rather than their traditional clients. Society does not benefit when the time horizon of corporations shrink from the multi-generational pattern of our history to the five year pattern of the average buyout.

It is time for the Business Roundtable, as representatives of large corporate interest, to purge private equity and leveraged buyouts from the lexicon of American finance and restore long-term investment in the place of speculation. The interest expense deduction for leveraged buyouts and capital gains treatment of sponsor fees should not survive tax reform.

Contact Glensky, a former Wall Street financial manager who now lives in North Myrtle Beach, at bwglensky@sccoast.net.

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