August 07, 2020
The American Prospect
Over the past decade, private equity has crept and crawled into all corners of our lives. Everywhere you look across our ruinous, virus-riddled landscape, private equity is there. It is behind many of the understaffed and underprepared nursing homes through which COVID-19 tore, the surprise medical bills that will greet those lucky enough to make it home, and the evictions sending people out onto the streets amidst a global pandemic. It is also getting ready to pounce on many of the high-profile companies to have fallen since the pandemic’s onset.
Paradoxically, even as their investments founder, private-equity firms themselves are likely to emerge relatively unscathed. With over a trillion dollars in investor money (so-called “dry powder”) waiting to be deployed, the industry may just be poised to expand its control even further.
But it’s not a given that private equity will completely evade accountability. Even if the industry’s rising infamy is not enough to push the sort of radical transformation that would result from passage of the Stop Wall Street Looting Act, a President Biden will have numerous financial regulatory tools at his disposal to curb the industry’s most egregious practices. It’s just a matter of whether he’ll be willing to use them.
With rare exceptions, private equity firms extract value rather than creating it by:
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Relying on aggressive financial engineering (things like tax arbitrage or excessive use of debt that it loads on companies it acquires)
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Transferring resources from the company to its private equity owners (by charging it monitoring fees or requiring it to sell junk bonds and use the proceeds to pay itself a dividend)
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Asset stripping (e.g. selling off real estate in sale-lease back agreements with sale proceeds going to the PE firm and the portfolio company left to pay the rent)
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Rapid consolidation by buying up competitors or suppliers to a portfolio company and “adding” them onto it.
This is hardly a recipe for stability, let alone long-term business success, but thanks to hefty management fees and other tricks, private equity firms often make out well even if their tactics drive companies into bankruptcy (tanking the investments of their limited partners, often pension funds, in the process) and cost workers their jobs.
Undermine the industry’s ability to play these neat little tricks, however, and private equity will struggle to create returns. Through a few key appointments at the Securities and Exchange Commission (SEC), the Treasury Department, and the Federal Trade Commission (FTC), a Biden administration could upend business as usual within the industry by both strengthening regulations and ramping up enforcement of laws already on the books.
Available evidence suggests that private equity firms are failing to adhere to the too-lax rules that currently govern their behavior. In a 2014 speech, Andrew Bowden, then-director of the SEC’s Office of Compliance, Inspections and Examinations, remarked that when examining private equity firms his office found “violations of law or material weaknesses in controls over 50 percent of the time.”
The Obama administration belatedly brought just a handful of actions against the industry, however. The reason likely has to do with Obama’s director of enforcement, Andrew Ceresney, who decamped to his old Big Law firm Debevoise & Plimpton alongside notorious SEC Chair Mary Jo White. There, Ceresney represents corporate clients investigated by his old agency—including “A private equity firm in an SEC investigation focused on technology investments,” according to Cerseney’s own bio. A more public-minded, less captured director of enforcement could deliver a great deal more in the way of accountability, perhaps even fulfilling the job’s intended purpose and leaving fraudsters too scared of jail time to break the rules.
Private equity also pads its profits by exploiting tax loopholes and pushing tax planning to the breaking point. In many cases, it pushes tax planning past the breaking point but counts on the IRS’ chronic underfunding and general weakness to shield it from any consequences.
Biden’s IRS commissioner will have the power to decide how the agency’s limited funds are allocated, meaning they could shift the vast majority of its resources away from auditing Earned Income Tax Credit recipients and toward auditing corporations and the ultra-wealthy, who are responsible for the lion’s share of the tax gap (the difference between taxes owed and taxes collected). If it did, the private equity industry would have reason to be worried. IRS auditors might, for example, pursue enforcement actions for the use of Management Services Agreements, an arrangement that requires portfolio companies to pay advisory fees directly to their private equity owners, thus allowing the firms to skirt taxation by disguising what are effectively dividends as tax-deductible expenses for the portfolio companies.
The regulatory side offers other opportunities. Biden’s SEC officials could, for example, reconsider and strengthen regulations governing investment advisers’ fiduciary duty to their clients. That would mean that PE firms could no longer charge hefty, unnecessary consulting fees to portfolio companies. With that cash flow cut off, firms might have greater incentive to keep their investments afloat.
Similarly, officials within the Treasury Department’s Office of Tax Policy could narrow or close tax loopholes, as Victor Fleischer explained in the Prospect last year. To cite just one example, the Treasury Department last year drastically expanded the pool of investments that qualify for an Opportunity Zone tax credit by allowing the benefit to be applied retroactively to existing investments. This entirely undercuts the supposed purpose of the program, to bring new investments to areas that have struggled to attract them. It also pads the pockets of wealthy real estate investors (among whom private equity figures are well-represented). There is, therefore, likely significant room to raise these titans’ tax bills by revisiting past interpretations of tax law.
The private equity industry relies heavily on mergers and acquisitions, so strong new merger rules will be key to undercutting the industry’s power. Firms in the health-care space in particular, have relied on a “stealth consolidation” strategy that evades federal antitrust scrutiny under current merger guidelines. By purchasing many small hospitals and doctors practices in deals that fall under the threshold that would trigger antitrust review, these companies can quietly build formidable market power. Commissioners at the FTC have the power to revisit the guardrails so that they better address consolidation strategies such as these.
Executive actions that target other industries’ abuses will often also sweep private equity’s investments up with them. The right secretary of education, for example, could transform the for-profit college industry, in which private equity is active. For-profit colleges make their money by harvesting federal student aid dollars and offering as little education as they can get away with in return. By merely raising the bar for what constitutes a “good enough” education to qualify for federal aid, officials in the Education Department can stop this scam.
Private equity’s pharmaceutical profits could also come under threat, if key health officials decided that they were sick of subsidizing private pharmaceutical gains. The next secretary of health and human services could undercut pharmaceutical profiteering by seizing drug patents when companies set astronomical prices. Or, a motivated director of the National Institutes of Health’s Office of Technology Transfer could stop many egregious abuses on the front end by setting more stringent conditions on companies who market drugs that were created via public research (which is a lot more than the industry would have you believe).
The list goes on and on. Federal law enforcement officials could cause private equity’s investments in detention and carceral technologies to soar or crash. Federal officials charged with acquisition and procurement policy, people like the undersecretary of defense for acquisitions and sustainment or the administrator for the office of federal procurement, could throw private equity’s stake in federal contracting companies into jeopardy by raising standards around safety and wages, or by simply prioritizing bringing more capacity in-house.
Simply put, the Biden administration would not be powerless to channel rising public anger at private equity into action. These steps are not a panacea, but they are a start. And that’s better than nothing.
