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Taxes are only half the story, the other is DEBT: Proposals to tax private equity firms are just the beginning, not the end of the debate

Few would doubt that closing tax loopholes which allow private equity firms to deprive public revenues of billions is an important and necessary step. There’s also no doubt that this is the most popular (and populist) measure that can be taken. But it’s far from adequate if governments are serious about reigning in the buyout funds. The main problem of leveraged buyouts by private equity funds is just that... leverage.

As pointed out in the IUF’s A Workers’ Guide to Private Equity Buyouts:

“A corporation will typically have a balance of 80% equity to 20% debt, on which it pays interest. In a private equity buyout this ratio is reversed, since 80% to 90% of the purchase is financed through borrowing. The private equity fund usually provides just 10% to 20% of the equity as cash and the rest is borrowed. The assets of the company being acquired are put up as collateral to secure the debt and once taken over the target company (and not the private equity fund) must take this debt onto its accounts and meet the interest payments.”

When workers first hear or read about this there’s always a pause - a moment of confusion or hesitation. Did I hear that right? Is there something I’m missing? A company pays for its own takeover through huge amounts of debt? It’s a completely reasonable reaction. In a rational and sane world this wouldn’t and couldn’t happen. But it does. And where does this leave the company that has just been taken over by a private equity fund? Massively in debt.

But the debt doesn’t stop there. Debt is also raised through "dividend recapitalizations" or "dividend recaps":

“This simply means that the company borrows money and the money borrowed is paid out to the private equity fund as a dividend. Here again we see a key difference with established notions of corporate accounting. Whereas dividends normally reflect a positive balance sheet, private equity uses debt to fund dividends and bonuses.” (A Workers’ Guide to Private Equity Buyouts)

So here is where the debate on taxes needs to be taken further. While current tax proposals focus on “carried interest” (the percentage of profit, usually around 20%, that a private equity fund manager gets when an acquired company is sold off), less attention has been given to dividend recaps. Yet these dividend recaps now account for close to one-third of all income flows back to the new owners in the global private equity sector. More importantly, we need to ask whether taxes alone are enough of a deterrent. Billions in taxes may eventually be paid, but tens of billions of accumulating debt raises a whole new set of questions.

At a seminar on private equity buyouts organized in Tokyo by UNI-JLC and IUF-JCC on 7 June 2007, the crucial issue of “sustainability” was raised. With so much debt from the time of takeover (where the debt used to buy the company is added to the books of the company itself) and with more debt added through "recaps” (borrowing more money to pay a special dividend to the fund as the one and only shareholder), plus all that interest on debt that must be repaid, the question is obvious: is this sustainable? Can a company continue to operate under such a debt burden? More importantly, this outflow of cash and rising debt means a drop in long-term, productive investment. So again we’re compelled to ask: is this sustainable?

Take the formula, “debt + cash outflow + recaps + interest payments on debt + more debt = declining productive investment “ and the implications for jobs and job security are obvious. So too are the implications for the financial system as a whole. As the head of the National Bank of Australia remarked last year, it’s likely that the private equity boom “is going to end up in tears". More recently, the UK’s Financial Services Authority (FSA) states in its report on private equity, excessive levels of debt pose serious risks for the financial system.

The question of debt is relevant not only to the viability of companies taken over by private equity funds, but also the stability of the financial system as a whole. So while politicians are just coming to terms with the need to tax private equity firms, trade unions must escalate demands for more comprehensive regulation and ensure that - before the door is closed on debate - governments deal with the whole truth of private equity buyouts, not just half of it.