Elizabeth Warren Seeks to Cut Private Equity Down to Size

Elizabeth Warren’s Stop Wall Street Looting Act, which is co-sponsored by Tammy Baldwin, Sherrod Brown, Mark Pocan and Pramila Jayapal, seeks to fundamentally alter the way private equity firms operate. While the likely impetus for Warren’s bill was the spate of private-equity-induced retail bankruptcies, with Toys ‘R’ Us particularly prominent, the bill addresses all the areas targeted by critics of private equity: how it hurts workers and investors and short-changes the tax man, thus burdening taxpayers generally.

Not only would Warren’s legislation prohibit some of the most destructive private equity activities, but it would end their ability to act as traditional asset managers, taking fees and incurring close to no risk if their investments go belly up. The bill takes the explicit and radical view that:

Private funds should have a stake in the outcome of their investments, enjoying returns if those investments are successful but absorbing losses if those investments fail.

Needless to say, this upends the traditional private equity model of “head’s I win, tails you lose.”

Warren’s bill owes a considerable debt to the work of Eileen Appelbaum and Rosemary Batt, who have been investigating the private equity industry for many years. Appelbaum also provided detailed testimony which provided additional backup for the provisions of Warren’s bill.

Critics will say that Warren’s bill has no chance of passing, which is currently true but misses the point. When Bernie Sanders talked about universal health care and other progressive policies in 2016, the media either ignored it or treated it as unrealistic leftie. Those ideas are now part of the discourse, as elite Dems are wont to say. Warren is taking on the “value creator” myth of private equity and seeking to end or restrict their asset-stripping. Her bill isn’t just a step in the process of exposing the falsehoods that have kept the industry from being held to account. By (hopefully) putting private equity titans on the back foot, it should also help impede their efforts to allow mom and pop retail investors to partake of private equity’s egregious fee structure (which would be larded up even more to cut in retail fund management firms).

Because the bill itself has sections that amend the bankruptcy and Internal Revenue Code (meaning mere mortals can’t readily parse them), we’ll rely on Compliance Week’s summary of its main provisions as far as private equity is concerned:

…firms would share responsibility for the liabilities of companies under their control, including debt, legal judgments, and pension obligations to “better align the incentives of private equity firms and the companies they own.” The bill, if enacted, would end the tax subsidy for excessive leverage and closes the carried interest loophole.

The bill also seeks to ban dividends to investors for two years after a firm is acquired. Worker pay would be prioritized in the bankruptcy process, with guidelines intended to ensure affected employees are more likely to receive severance pay and pensions. It would also clarify gift cards are consumer deposits, ensuring their priority in bankruptcy proceedings. If enacted, private equity managers will be required to disclose fees, returns, and political expenditures.

This is a bold set of proposals that targets abuses that hurt workers and investors. Most readers may not appreciate the significance of the two-year restriction on dividends. One return-goosing strategy that often leaves companies weakened or bankrupt in its wake is the “dividend recap” in which the acquired company takes on yet more debt for the purpose of paying a special dividend to its investors. Another strategy that Appelbaum and Batt have discussed at length is the “op co/prop co.” Here the new owners take real estate owned by the company, sell it to a new entity with the former owner leasing it. The leases are typically set high so as to allow for the “prop co” to be sold at a richer price. This strategy is often a direct contributor to the death of businesses, since ones that own their real estate usually do so because they are in cyclical industries, and not having lease payments enables the to ride out bad times. The proceeds of sale of the real estate is usually dividended out to the investors, hence the dividend restriction would also pour cold water on this approach.

The bill also seeks to help workers by making the private equity firms liable for pension looting, and for giving unpaid wages and other employee consideration much higher status in bankruptcy.

I don’t mean to sound like a nay-sayer about ending the tax bennies of highly-leveraged deals, since it’s an appealing and sensible restriction. However, the Reagan Administration floated a proposal to limit the tax deductions for highly leveraged transactions. The Brady Commission report found that that was one of the two triggers for the 1987 crash. So it might need to be phased in.

Last but the opposite of least, one pro-worker measure would constitute a major change in shareholder rights and duties. The bill’s imposition of what is known as “joint and several liability” for portfolio company debts onto both the private equity fund that made the investment, as well as onto the fund’s individual investors themselves, breaks significant new ground.

Generally, a bedrock principle of corporate law in the U.S. is that stock owners are not liable for the debts of companies in which they own shares. Exceptions are rare and generally involve either fraud or some kind of legal determination that shareholders played more than a passive role and were actively involved in directing the company.

However, there is precedent in private equity for recognizing joint and several liability of an investment fund for the obligations of its portfolio companies. In a case that winded its way through the federal courts until last year (Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund), the federal court held that Sun Capital Partners III was liable under ERISA, the federal pension law, for the unfunded pension obligations of Scott Brass, a portfolio company of that fund. The court’s key finding was that Sun Capital played an active management role in Scott Brass and that its claim of passive investor status therefore should not be respected.

Needless to say, private equity firms have worked hard to minimize their exposure to the Sun Capital decision, for example by avoiding purchasing companies with defined benefit pension plans. The Warren bill, however, is so broad in the sweep of liability it imposes that PE firms would be unlikely to be able to structure around it. It is hard to imagine the investors in private equity funds accepting liability for what could be enormous sums of unfunded pension liabilities ultimately flowing onto them. Either they would have to set up shell companies to fund their PE investments that could absorb the potential liability, or they would have to give up on the asset class. Either way, it would mean big changes to the industry and potentially a major contraction of it.

I am surprised that Warren sought to make private equity funds responsible for the portfolio company debts by “joint and several liability.” You can get to economically pretty much the same end by requiring the general partner and potentially also key employees to guarantee the debt and by preventing them from assigning or buying insurance to protect the guarantor from being liable. There is ample precedent for that for entrepreneurs. Small business corporate credit cards and nearly all small business loans require a personal guarantee.

Warren’s bill also has strong pro-investor provisions. It takes on the biggest feature of the ongoing investor scamming, which is the failure of PE managers to disclose to the investors all of the fees they receive from portfolio companies. The solution proposed by the bill to this problem is exceedingly straightforward, basically proclaiming, “Oh yeah, now you will have to disclose that.” The bill also abolishes the ability of private equity managers to claim long term capital gains treatment on the 20 percent of fund profits that they receive, which is unrelated to the return on any capital that the private equity managers may happen to invest in a fund.

The policy arguments weigh heavily in favor of fee disclosure and repeal of the carried interest loophole, almost to the point of there not being much of another side to the arguments beyond the private equity industry’s strategy of misdirection and obfuscation.

Not surprisingly, the private equity industry and its hangers-on have reacted negatively to the proposed bill. Pitchbook News, one of the industry’s daily newsletters, headlined one of its daily email blasts in the last few days “Warren, AOC continue attacks on PE.” Ironically, the piece didn’t even deal directly with the Warren bill but mostly was about Warren and AOC’s efforts to get unpaid wages paid to workers at recently bankrupt retailer Shopko, which is an issue that the Warren bill also deals with. The private equity industry trade group, the American Investment Council, didn’t even try to refute the legislation, but instead put out a single sentence statement labeling it as “extreme” and claiming without evidence that it would harm Warren’s Massachusetts constituents.

The power of private equity is destined to decline as its returns continue to fall due to too much money chasing too few deals. But there’s a very real risk of the already-aggressive asset-stripping tactics of private equity firms intensifying as a way to offset deteriorating fundamentals. Thus Warren’s shot across the bow is that the more evidence they provide of the need for her legislation, the greater the odds that it will eventually pass.