I've written often about the "two and twenty" arrangement for hedge fund managers who are able to treat most of their compensation as though it were a capital gain, paying much lower taxes than ordinary people pay on their salaries or wages.
Adding fuel to the fire, much of the activity carried on by private equity funds is destructive rather than constructive. A reader criticized my comments about the destructive nature of private equity funds, suggesting that if they were able to sell assets at a gain, then the activity must be positive and constructive rather than destructive. That kind of comment misses the point--the capital markets often reward short-term activity that is destructive in the long term.
The private equity managers created a new coalition, the Private Equity Council, to present their story in Washington. These lobbyists liken the private equity managers to entrepreneurs. But we might do better comparing them to marauders, especially when the funds engage in leveraged buyouts. Those are deals where they find a business that looks ripe for a takeover, buy it with considerable leveraging that will generate tax deductions (essentially getting the fisc to fund the takeover), lay off workers and outsource activities to cut costs (even when that outsourcing may destroy the community in which the business is located and may cause the business to cease a large part of its activities), sell off the best assets piecemeal and then sell off whatever is left, reaping significant management fees at every step and earning compensation as preferentially taxed capital gains.
Congress considered changing the rules that let these firms make such huge gains with preferential taxation but hasn't done anything yet. These Wall Street moneymen wield unfortunate power and ordinary taxpayers' interests are easily disregarded when lobbyists like the Private Equity Council come to town. The Council argues that endangering the moneymen's profits would ultimately hurt Wall Street and freeze up money needed by business. I've commented that these appear to be rather empty threats--if you earn $400 million and have to pay twice as much in tax as before, you still have hundreds of millions. These managers aren't going to pull out of the business if their free ride finally comes to an end. The threat of pulling out if their free ride doesn't continue is the real class warfare that is going on every day in Washington as inequality mounts. Here's the way Andrew Ross Sorkin described this last year in the New York Times.
Let’s be honest: it is a charade that private equity firms have claimed their 20 percent performance fees at the lower capital gains rate. To qualify, they invest a nominal amount of their own money to demonstrate that they have put something at risk, but it’s a ruse. They are paying capital gains rates for doing their job, which should be taxed at the regular income rate. Andrew Ross Sorkin, Of Private Equity, Politics and Income Taxes, Mar. 11, 2007, NY Times.
The lobbyists have done everything possible to paint a sympathetic picture of the managers who pocket millions for managing funds and pay only a pittance in tax because of the preferential capital gains rate they claim under unclear partnership rules. David Ignatius of the Washington Post ran a good story on the pay issue, and noted the lobbyists' claims that the capital gains rate is a just reward for the "sweat equity" the managers invest.
The giant private equity funds are nervous enough about the pressure building for tax changes that a few months ago they created their own Washington trade group, the Private Equity Council, which is already producing studies to justify the existing tax breaks. Its Web site explains that although fund managers may be putting up little of their capital, they deserve special tax breaks because they are contributing "sweat equity." Try telling that to the guy on the shop floor who's actually sweating -- and paying taxes at a far higher rate. David Ignatius, A Backlash Against Billionaires, Washington Post, July 19, 2007.
Ignatius' actually had a couple of quotes from private equity managers who admitted that it was absurd that they should be taxed at the preferential capital gains rate on their compensation. One unidentified financier had the following to say:
"Amusing what is going on in the tax charades of the money managers. How in the world anyone can uphold those [making] egregious amounts of money paying low or no taxes is really becoming laughable. . . . The private equity guys I know admit they do not have an argument that holds water." Id.
For more, you can read a book by the founder of the Economic Policy Institute (and a Distinguished Fellow there), Jeff Faux, The Global Class War, or an article by Nomi Prins, Barbarians at the Gate: Private Equity, Public Enemy, Nov-Dec 2007, Mother Jones.
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