Join the PEC Network
Focus On:
The truth about Private Equity and the banking industry
The Service Employees International Union (SEIU) has argued that private equity partnerships should be prohibited from investing in U.S. banking institutions, despite the public comments of Federal Reserve Chairman Ben S. Bernanke and U.S. Treasury Secretary Henry Paulson that such investments would be good for the industry.
The following piece offers a detailed response to the SEIU’s arguments.
Fiction:
Banks are a ripe target for private equity firms seeking returns of 20 percent to 30 percent or higher over relatively short periods because they have built‐in cash cows in the form of mortgages, credit cards and accounts subject to an endless array of fees and interest‐rate hikes.
Fact:
If banks really are “cash cows,” why aren’t they besieged by potential investors? They’re not, because banks are not an attractive investment opportunity these days.
It’s true that private equity investment partnerships deliver superior returns to their investors, the largest single group of which are public, private and union pension funds, university endowments and charitable foundations. These and other investors receive 80 percent of the profits generated by private equity investment.
But, contrary to the SEIU’s assertion, private equity takes a long‐term investment approach – often investing in companies for 5 years or longer – and by providing capital, time, energy and talent to strengthen companies and return them to profitability and financial stability.
The reality is that our banking industry is in dire need of fresh capital. Given the unprecedented financial challenges facing our nation’s banks, private equity is uniquely suited to provide both the necessary capital to stabilize the flagging sector and the leadership to make our financial institutions global leaders once again.
Fiction:
Private equity investment will encourage risky banking practices.
Fact:
This defies common sense. Private equity firms are putting their own money into these investments. If they then take their long‐term capital and race to the investment equivalent of Las Vegas, they will lose billions for themselves and their investors, and in the process alienate those on whom they depend for capital for future investments.
Fiction:
Shareholders pay the price for private equity investments in banks.
Fact:
Shareholders of banks and other financial institutions have indeed paid a price, but it has nothing to do with private equity investment. The sliding stock prices and slashing of dividend payments by banks that have cost shareholders billions of dollars are a result of the subprime and credit crises.
Private equity investment is a solution that shareholders should embrace. Private equity can create value for shareholders by stabilizing banks with much‐needed capital infusions and the patience to see through management decisions made in the interest of long‐term growth.
The truth is, many banks are literally desperate for infusions of capital. Dennis Berman, writing in April in The Wall Street Journal, described the predicament of National City Bank before it received a private equity investment: “…people involved in the auction described the situation as very, very serious. Another potential bidder was less diplomatic, saying that absent rescue capital, National City was ‘going doughnuts,’ a term used when a stock drops to zero.”
The SEIU’s reference to TPG’s recent investment in Washington Mutual as an example of the negative effect of private equity investment on shareholder value is baseless. Shares of the bank lost more than 50 percent of their value in the months prior to TPG’s investment, falling from a high of $21.82 on February 1, 2008 to $9.24 on March 17, 2008. TPG and WaMu announced the private equity firm’s investment in April.
Fiction:
Private equity firms are providing a back‐door entry to U.S. banks for sovereign wealth funds.
Fact:
Actually, the situation is quite the opposite. Rather than seeking a “back door” entry, sovereign wealth funds are walking in the front door to invest large amounts of major U.S. financial institutions, including Citigroup, Merrill Lynch and others. So far, they have lost big on those investments.
As private equity fund investors, SWFs are not asking for – nor are they being afforded – any more rights or any more control over portfolio companies – including banks – than any other limited partners, including all of the major U.S. public pension funds.
Fiction:
Ultimately, private equity funds have no place in the country’s retail banking system.
Fact:
Why not? Private equity partnerships have a long and well‐documented history of strengthening and turning around the companies in which they invest. Private equity investment can be a vital source of capital for struggling banks on the brink of financial disaster.
In a recent op‐ed in The Wall Street Journal, former Under Secretary of the Treasury Randal Quarles and Olivier Sarkozy, a colleage of Quarles at the Carlyle Group, wrote: “Over the past 20 years, private equity firms have demonstrated the ability to shoulder risk and to improve the efficiency and profitability of the companies they invest in.
They are exactly the kind of investors we should attract to the financial‐services industry. Restrictions and disincentives, however, dramatically and unnecessarily reduce the pool of capital available to the industry. In addition to increasing the industry’s cost of capital, these limitations increase the risk that taxpayers will ultimately be called on to assume some of these burdens.”
Economist and former Harvard University President Larry Summers also weighed in, writing recently in The Financial Times that regulators should: “rapidly complete the review of regulations that limit the ability of private equity capital to come into the banking system.”
Fiction:
Private‐equity firms have made a lavish living on making big bets when no one is looking. Unlike banks and thrifts – which are regulated, transparent and generally publicly owned enterprises – private‐equity firms operate in secret, virtually free from regulation.
Fact:
This argument is a canard. The infusion of private equity capital into struggling financial institutions adds stability and security to the banking system, but has no effect on transparency or regulation.
Publicly traded institutions that accept minority investments from private equity funds are still publicly traded. Banks and other financial institutions would continue to be regulated in just the same manner as they are now, and would continue to be subject to all of the same reporting requirements.
Furthermore, there is substantial disclosure involving private equity investments; arguably, investors know more about their PE investments than average investors know about their mutual fund or stock market holdings. PE firms engage in extensive, thorough disclosure to their limited partners, including detailed performance and return information, as well as substantial detail about each company they own and operate.
Further, the majority of large PE portfolio companies issue public debt. As a result, these companies are obligated to file the same 10k report as public companies, with the same level of detail, all readily available on the U.S. Securities and Exchange Commission’s website.
Fiction:
Private equity firms use tax loopholes around carried interest – and deduct interest payments on the debt they use for buyouts – to extract huge profits from the companies they buy.
Fact:
Private equity partnership profits are taxed just like profits earned by venture capital, real estate, and all other partnerships, including ones created by families in which a parent provides equity while a child provides labor and ideas to build something of value.
With income tax rates varying from 15 to 35 percent, the typical private equity partner actually pays taxes at a much higher rate that the average American, even those who are well off. According to the latest figures from the Congressional Budget Office, Americans with average annual pre‐tax income of about $85,000 paid an effective federal income tax rate of six percent in 2005. The top one percent of all American tax payers paid an effective federal tax rate of nearly 20 percent.
Every business in America, small, large, public, private, is entitled to deduct from its taxable income the interest expense its pays on the money it borrows to finance its operations, whether conducting business as a sole proprietorship, partnership or corporation. PE firms are no different.
The interest deduction is intended to encourage borrowing for investment purposes. For every business or individual that deducts interest expense from their taxes, there is a corresponding lender – whether it is a savings and loan association or a large investment bank – that pays federal taxes on the interest income it receives from the borrower.