3 Myths About Private Equity

Given all the coverage of private equity now that former big-time PE investor Willard Mitt Romney (yes, Willard is his first name) appears to be the eventual GOP presidential nominee, I thought I’d clear a few things up about the industry.

Myth #1: Private equity investors like to fire people—and, in fact, that’s the main part of their jobs.
Untrue. Private equity firms (and thus their employees) are simply in the business of making money. That’s it. They’re not out to slash jobs. Nor are they out to create them. Private equity investors—similar to individual and institutional investors who purchase shares of publicly-traded companies in hopes that they increase in value so they can pocket some cash—buy ownership stakes in private companies in hopes that these companies will increase in value, thus reaping significant rewards. In both instances—public and private equity investing—the name of the game is buy low and sell high. Which, in private equity investing, might mean buying an ailing company and turning it around by merging it with a healthier company in order to create cost-saving synergies, resulting in the loss of jobs. But it also might mean buying a company in order to grow it organically to increase its value, thus creating more jobs. In any case, private equity is neither as pernicious as Mitt Romney’s fellow Republican candidates would have you believe, nor as altruistic as Mitt and others in the PE industry would like you to think.

Myth #2: Private equity firms are solely made up of elitist, Ivy League graduates who used to worked in investment banking.
Untrue. Although there are scores of blue-blooded Harvard and Yale men in the world of PE (Blackstone’s CEO Steve Schwarzman, who attended Yale, has an MBA from Harvard, and formerly worked for Lehman Brothers, is but one example of an Ivy-educated ex-Wall Streeter), there are several PE men from small liberal arts schools such as California’s Claremont McKenna College. Or, at least, there are two PE men with degrees from Claremont McKenna: Henry Kravis and George Roberts, who happen to be two of the three founders of perhaps the most well known PE firm on the planet, Kohlberg Kravis & Roberts. KKR’s other founder, Jerome Kohlberg, did his undergraduate work at Swarthmore. (All three—K, K, and R—also once worked together in the wild world of investment banking: for the now-defunct Bear Stearns & Co. in the 1970s). Perhaps more to the point, PE firms are increasingly not simply hiring young talent out of top investment banking analyst and associate programs (which, yes, are largely made up of graduates of Ivy League and other top-tier schools) but from various industries in which PE firms would like to invest. For example, if a PE firm is interested in investing in health care firms, they might want to hire an expert in operating health care firms, as opposed to an expert in creating Excel models for health care mergers and acquisitions. And so, if you either did not make the investment banking cut out of college or grad school, or had no interest in making the cut, and now find yourself wanting to follow in the footsteps of Romney, Schwarzman, Kohlberg, Kravis, or Roberts, you still might have a very good shot at scoring a coveted PE position. I should also point out, though, that since a majority of significant PE deals are sourced through investment banks (which are typically contracted to sell the largest private companies) connections in the banking world do matter—a lot. It’s also necessary to point out that PE is still very much a white male-dominated profession, much more so than the largely white male-dominated investment banking industry.

Myth #3: Working in private equity is cool because you pay almost no taxes.
Untrue. Like Mitt Romney came clean about yesterday, most PE investors pay taxes, albeit at a lower rate than many other Americans (Mitt says his effective rate is 15 percent). Why PE investors pay a lower rate is because a significant portion of their income is taxed at the capital gains rate of 15 percent, versus the ordinary income rate of 35 percent. The portion that PE investors are taxed at the lower rate is called “carried interest,” which is the 20 percent or so fee PE firms earn if their funds increase in value. Let’s back up a bit. PE firms typically raise funds before they begin investing in private companies. The money they raise mostly comes from large entities such as endowments and pensions. So, say, after a PE firm has raised a fund worth a few billion dollars, that it buys a private company with money from one of these funds and, when it sells the company five years later, makes a profit of $500 million. Of these profits, 80 percent, or $400 million, go back to the funds’ investors (the endowments and pensions), while the PE firm keeps 20 percent, or $100 million, which is then split among the PE firm’s partners. It is this money that is taxed at the capital gains rate of 15 percent. And, while many people (mainly PE investors) maintain that carried interest should be taxed like investment proceeds (at the capital gains rate) since it comes with significant risk like an investment, there are others (inside and outside of PE and finance; Warren Buffet is one well known example) who believe that PE investors are taking advantage of a tax loophole by paying taxes at the capital gains rate, as opposed to the ordinary income rate, on carried interest. Buffett and others argue that carried interest is not an investment but, in fact, income, because it’s a fee for a service. In any case, with Romney likely the man on the GOP ticket come November, and with his tax rate now out in the open, it’s a sure bet this topic will be a hotly debated one leading up to the 2012 election.