How the US Election could change private equity

Tomorrow, American voters will line up at their local polling stations to check a name on a ballot and end what has been a particularly eventful election season.

Mitt Romney

Mitt Romney’s candidacy threw private equity in the public spotlight; what was once a relatively esoteric investment strategy suddenly became an everyday political talking point. This intense focus was probably greater than the industry had anticipated – and arguably more than it was equipped to handle. 

But once the dust settles, what will be the lasting consequences of this election campaign? Here are five areas to watch:

1. CHANGES TO THE TAX TREATMENT OF CARRIED INTEREST

Bain Capital is a very successful private equity firm, so it shouldn’t come as a surprise that Mitt Romney – who led Bain until 1999 – has done quite well for himself.

Unfortunately for Romney, his estimated $250 million fortune proved to be a political liability over the course of the campaign. He’s likely to pay an effective tax rate of around 15 percent for the $21.7 million he made last year, virtually all of which came through ‘profits, dividends or investments’, according to The Washington Post. 

Romney’s effective tax rate is low compared to that of average Americans, which opened him up to attacks that he was out of touch with the electorate. But it didn’t help that the bulk of his wealth was acquired through carry, and that the economic benefits of carry’s current tax treatment are difficult to communicate.

“The public only understands that Governor Romney pays a much lower tax rate than they do. Carried interest is a very difficult concept to understand,” Democratic Representative Charles Rangel told Private Equity International. 

In light of all this attention, Democrats are now confident that the carry “loophole” will soon be closed. Rangel told PEI that it will probably be considered if Congress undertakes tax reform next year. 

2. CHANGES TO THE TAX TREATMENT OF DEBT

Private equity executives may fret about paying more tax on carry. But perhaps a more damaging threat to the industry’s long-term prospects involves the deductibility of interest payments on corporate debt.

In February, President Barack Obama announced a tax plan that would reduce the corporate tax rate from 35 percent to 28 percent, while reducing tax deductions that provide advantages to companies with high levels of debt financing. 

Although the proposal doesn’t offer specifics on how he plans to limit the deductibility of interest payments, if firms “can’t deduct it, it becomes [effectively] more expensive to buy a company,” one market source said. 

That would be bad news for private equity investors, says The Jordan Company founder Jay Jordan. “Changing the treatment of deductibility on interest payments would devastate public pensions … Their returns would basically be cut in half,” he says.

As the government struggles to find new sources of revenue in its effort to combat the rising deficit, the current deductibility of interest payments could be vulnerable – particularly if Obama chooses to make it a priority.

Mitt Romney’s tax policy, available through his campaign website, makes no mention of this issue. The campaign told PEI that they haven’t taken a position on it.

3. A MORE INTELLIGENT DEBATE ABOUT JOB CREATION

There’s been much controversy about Romney’s job creation record. He claimed his Bain investments led to the creation of approximately 100,000 jobs – a figure that raised a lot of eyebrows, especially when it emerged that Bain had never tracked this metric. Equally, many of the attacks on him focused on lay-offs and redundancy.

Whether private equity should be trumpeting its job creation stats is a moot point. Sometimes it will create jobs, but often it will not. And some would argue this shouldn’t be its priority anyway.

Nonetheless, the row over Romney’s questionable stats did encourage the industry to get some positive messages out about its jobs record. 

US portfolio companies employ more than 8 million people worldwide, according to the Private Equity Growth Capital Council, which also released a series of videos highlighting investments that created (or saved) US jobs. These stand in stark contrast to ads released by the Obama campaign, which featured laid-off workers from former Bain investments slamming the firm for its lack of regard for their well-being. 

To date, the PEGCC has explored investments from firms like Kohlberg Kravis Roberts, The Blackstone Group and The Carlyle Group – all of which show how, when done well, private equity can have a positive impact on local economies and job markets. This PR line will no doubt continue after the election. 

4. A MORE ACTIVE ROLE FOR BIG LPs

Everyone knows – especially now – that private equity firms make a lot of money if their investments are successful. But what gets less attention is that investors make even more.

Limited partners have traditionally not commented about their investments on the record. But several came to the defence of private equity during this year’s election season, and to great effect – not least because it reminded people that some of private equity’s most prominent beneficiaries are public pension systems.

“It is important for everyone, including politicians, to understand the facts about private equity investments. The fact is that the asset class is a valuable piece in TRS’ overall portfolio allocation,” Teachers’ Retirement System of Texas private equity chief Rich Hall told PEI in June.

Hall’s comments, as well as those of other prominent LPs, injected an important element of realism amid all the politicking. While other asset classes faltered, private equity helped drive returns for public pension beneficiaries like teachers, firefighters and police officers.

This will continue to be a hugely significant argument in private equity’s favour. Hopefully in the future more big LPs will now feel emboldened to speak out on behalf of the industry, so this point remains front and centre of the debate.

5. MORE (AND BIGGER) POLITICAL DONATIONS

Politicians have never been shy about asking for money. But this election opened the door for private equity to give.

Although industry executives have always been free to donate to whomever they please, this is the first election since the Supreme Court eliminated certain donation restrictions. 

This ruling led to the creation of super political action committees, which are not subject to certain donation limits, as long as they don’t coordinate with the campaign of whichever candidate they are supporting.

Private equity executives greeted this change with open cheque-books: some donated as much as $1 million to the Super PACs.

Romney-friendly PACs certainly benefitted from the industry’s largesse. Super PAC Restore Our Future had raised more than $9.6 million from individuals employed by private equity or venture capital firms like Sun Capital, Bain Capital and Kohlberg Kravis Roberts.

The industry also extended its political influence through its own political action committee. The PEGCC PAC had raised more than $271,000 from its member firms since inception, donating $102,500 to federal candidates as of 23 October, according to watchdog Opensecrets.org.

The bulk of this went to Republican candidates and organisations, specifically targeting sitting congressmen with influence over legislation that could affect the private equity industry.

Expect more generous support for friendly politicians in the future.