Private equity firms—the high-flying leverage buyout specialists—have been around for decades, but only recently have they come under public scrutiny.
Private equity funds invest billions annually for their investors, mostly for public and private pension funds and high wealth individuals, and usually promise returns greater than 15 percent.
Research indicates that fraudulent activities within private equity funds consist mainly of diversion of funds by insiders. In 2006, John A. Orecchio, a partner at AA Capital Partners Inc., was charged with misappropriating more then $30 million from various funds, including five union pension funds. In 2005, Todd Berman, the founder and partner of Chartwell Managers LLC, was charged and sentenced to a 60-month prison term for embezzling over $3.5 million from the firm.
In 2009, the Securities and Exchange Commission (SEC) discovered only one lone and isolated fraud case. The SEC leveled charges against Private Equity Management Group LLC, both owned by Los Angeles financier Danny Pang.
In April 2009, the SEC alleged that a part of Pang’s companies swindled senior citizens and timeshare investors with a type of Ponzi scheme involving life insurance products.
Profiteering Under Discussion
Due to the nature of private equity funds, its partners only pay a 15 percent tax on profits. Since the funds are in the business of buying companies to later sell at higher prices, all of the earnings—distributed to its partners—are investment gains treated as capital gains subject to a 15 percent tax under the IRS code.
As such, private equity partners are only taxed at the lower rate, instead of at the 35 percent paid by other Americans for their earnings.
Opponents of this windfall to the partners, including U.S. Rep. Sander Levin, D-Mich., demand that such profit be taxed as ordinary income, as the partners’ contribution is not in cash but in work performed. The House of Representatives approved in December 2009 legislation sponsored by Levin under H.R. 3497, which addresses the tax issue.
“They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%,” said Levin in a recent statement.
In December 2009, the House of Representatives approved legislation that regulates derivatives and requires the registration of hedge funds. Private equity firms were also addressed during the hearing, as such firms are also exposed to systemic risk, which could include the involvement of banks in the structuring of debt issues. Going forward, “they will be subject to systemic risk regulation,” according to a recent House Committee on Financial Services press release.
Douglas Lowenstein, CEO of the Private Equity Council, a trade association that represents 12 of the largest private equity firms, disagrees. Lowenstein described in detail why a private equity firm is not exposed to systemic risk in his recent testimony before the House Financial Services Committee.
In his testimony, Lowenstein stated that the firms provide capital that cannot be pulled out by an investor on short notice. Besides, they invest in operating companies after extensive market studies, bring them back to health, and are not involved in derivatives, options, swaps, or listed stock.
Returning Companies to Health
In general, private equity firms are companies involved in buyout investing. These firms purchase underperforming or distressed companies that offer a potential turnaround.
Most equity firms will take an active role in the corporate restructuring that precipitates a return to good health and improved earnings, which are important to pay down the respective firm’s debt.
“We go in and we buy the debt, bank debt, subordinated debt, of fundamentally good businesses that are overlevered [sic], and we work through a process with creditors—sometimes in bankruptcy, sometimes out of bankruptcy—and we end up, hopefully, backing into control of a fundamentally good capital structure at a good price,” clarified Marc Rowan, founding partner of Apollo Management L.P. in a recent Knowledge @ Wharton (KW) report.
A private equity firm is generally comprised of general and principal partners, who manage a specific fund, and limited partners, who are the investors that provide the funds for the acquisitions, but are not involved in the day-to-day operations.
The firm holds the underperforming company for a few years until it achieves profitability, which was up to five years during the boom years. Then it will sell the company for a healthy profit and receive on the average 20 percent of the yield besides an annual management fee of between 1 and 2 percent.
“Future deals will be all-equity transactions with an investment horizon of five to eight years, not the recently common three to five years,” suggested John Caple, a principal partner at Bayside Capital Inc., during a panel discussion at the 2009 Wharton Private Equity & Venture Capital Conference, and in an article published by KW.
There are over 2,000 private equity firms in the United States with the Carlyle Group, Kohlberg Kravis Roberts & Co., Goldman Sachs Capital Partners L.P., Berkshire Partners LLC, and Apollo Management L.P. considered the largest.
Not all Doom and Gloom
“The challenge for private equity and investors generally is to have the courage of their convictions, and to come up with strategies for investing when prices are low and liquidity is not available,” said Rowan in the KW article.
Many operating companies are hungry for cash with few options in the debt market. This opens the door wide for private equity firms to acquire companies at significantly reduced prices.
One strategy, advocated by Buddy Gumina, a partner at Apax Partners, is that the private equity firms scrutinize companies’ operational activities, including business models, cash flow, market position, and management abilities before buying the debt and then begin an all-out restructuring effort after acquiring the debt.
Gumina thinks that the risk-return ratio in debt acquisitions has leaped upward, as his portfolio now will include firms that hold a good market position, but are having a hard time because of being highly leveraged (in debt).
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