Sen. Elizabeth Warren is gunning for the private equity industry, but she also could damage the broader financial services industry, including pension funds, endowments, foundations and mutual funds. That's because she has named the bill she has proposed the "Stop Wall Street Looting Act" — not the "Stop Private Equity Funds Looting Act," and if the bill gains traction it could harm investor confidence in the fairness of the capital markets. The bill's name implies that all of Wall Street is looting its clients, and that anyone who opposes it supports Wall Street's supposed greed.
No doubt Ms. Warren will make much of the bill and its fate during the presidential election campaign.
The act is unlikely to go anywhere while Republicans control the Senate, but it shows what could happen if Democrats should gain control of Congress as well as the White House 15 months from now. The private equity industry could find itself targeted by provisions such as those in the bill.
Ms. Warren's bill is not aimed at all of Wall Street, as its name implies, but at the private equity industry, which she and others believe has adopted practices that benefit the general partners at the expense of their target companies and their employees, and often the limited partners and the whole economy. These practices, she argues, mean the general partners benefit even if the target companies fail, and this comprises "looting."
Ms. Warren and her co-sponsors argue that private equity firms should have stakes in the results of the actions they take at the companies they acquire and take private using substantial leverage. The bill would make private equity funds share liability for the debt and other legal obligations of the portfolio companies. In effect, it eliminates the principle of limited liability for some private equity firms.
It would limit recapitalization dividends (paid to funds from junk bonds issued by the portfolio companies) within 24 months of a leveraged buyout and apply a 100% tax on monitoring and transaction fees. It also would strictly limit the deductibility of interest expenses by portfolio companies. Critics argue recap dividends, and monitoring and transaction fees, allow general partners to recover their investment quickly, while draining the resources of the portfolio companies and leaving workers holding the bag if the portfolio company fails.
The bill would raise the priority of worker back pay and severance payments and limit executive pay during the bankruptcy proceedings. It would classify carried interest as regular income. It would also require annual disclosure to the SEC of debt held by private equity funds and their portfolio companies, information that also would be available to the public. And it would make such funds fiduciaries under ERISA of the pension funds that invest in them.
Clearly Ms. Warren believes private equity partners are taking advantage of clients and ultimately workers at target companies. She gets some support from academics.
For example, Eileen Appelbaum, co-director of the Center for Economic and Policy Research, Washington, has written that the bill's debt-sharing provisions would align the incentives of the private equity firm and the target companies, and limit actions that strip value from those companies.
She noted that in 2018, 58% of private equity firms required their portfolio companies to pay them monitoring fees and 85.8% required them to pay transaction fees.
Part of the problem is that companies that fail after being taken private by private equity funds, such as Toys R Us, receive much publicity when workers are laid off and operations are shut down, while struggling companies that are successfully rescued by private equity firms receive little publicity.
The private equity industry must become more open and publicity conscious. It must trumpet its successes to offset the negative news of the failures. It must show the successes greatly outweigh the failures, and that the returns generated by these successes help pension funds and other investors, and not just the general partners.
It also must be prepared to answer the questions Ms. Warren's bill raises:
Why shouldn't private equity firms share the losses when portfolio companies, which they have loaded with debt, fail under that burden?
How much debt should private equity funds require target companies to take on? Industry proponents argue that leverage makes managements strive harder for efficiency and higher earnings, but critics argue the debt burdens often are too high.
What are the justifications for the transactions fees, monitoring fees and the recapitalization dividends?
What is the justification for carried interest being treated as capital gains and not ordinary income?
Is it true that private equity returns have declined since 2008 and now are barely equal to the broad market returns? If so, what is the justification for private equity investing?
Ms. Warren is unlikely to leave the Senate any time soon, unless elected president, and seems certain to continue to make noise about her bill and the alleged "looting" by private equity firms. This will hurt all of Wall Street.
The private equity industry must be prepared to publicly debate the issues she raises and provide convincing responses. It must publicize how many companies and jobs the industry has saved and is preserving.
It must become more open and less private.n