In any other year, Mitt Romney’s financial experience might be a selling point for his political campaign. Anyone in finance knows the private equity business, and many more know the firm Romney led – Bain Capital.
But now Wall Street has a marketing problem. Given America’s love-hate relationship with the wealthy, his experience in private equity is a tough sell.
Private Equity 101
Private equity is one of the main money centers of modern finance. Private equity firms raise funds – not all that different from mutual funds, really – from wealthy individuals, pensions, and other investors to buy out underperforming firms as a private owner.
The difference is the fund’s short life cycle. Typically, funds are opened and closed within a decade. Within this short period of time, private equity managers buy out whole companies and resell them years later, often after stark improvements in the company’s business model.
There are a few inherent benefits to the private equity model:
- All or nothing ownership – Owning a whole firm is naturally much more valuable than being one of many shareholders. As a sole owner, a private equity shop can implement changes it wants to see without any pushing back by Wall Street. While shareholders do have the right to submit proposals for a vote for most public companies, proposals that receive a majority vote by shareholders are not legally binding. But, if you buy a whole company – you own it.
- Synergy – Not just for sales pitches and resumes, synergy allows private equity shops to use their newly purchased firms as effectively as possible. To give an example, a private equity firm might purchase a company for $300 million that has business processes, talents, or patents and trademarks worth $1 billion or more to another company in its portfolio.
- Leverage – A controversial feature of a small segment of private equity, the leveraged buyout allows private equity managers to buy multi-billion dollar firms with less than a few hundred million dollars in cash.
In one classic leveraged flub by Bain Capital, it purchased retailer KB Toys for more than $300 million. Bain leveraged the position, putting up only $18 million in cash to buy the company. Within the year Bain paid itself a cash distribution of $85 million, making a return in excess of 300% in a single year. Later, over-levered and without enough liquidity to attempt a turnaround, KB Toys would file bankruptcy.
Bain’s creditors were caught holding the bag. Employees went from routine paydays to unemployment lines. Bain Capital, of course, came out with a massive return for its investors.
Bain Capital’s Brain Capital
Bain Capital was a pioneer in hiring brains over brawn. The private equity management company believed that if it could hire really intelligent people – even people with limited experience – their creative capacity could make for a much better performing company and fund.
Mitt Romney was a perfect recruit. He graduated in the top 5% of his class at Harvard Business School, and had an interest in improving and designing new business models.
A story from the Economist highlights why Bain’s brains made it such a powerful force in private equity. It also leads into why this story is such a negative story for Romney’s campaign. The article states that before Bain, most companies believed in the idea that “management was just a matter of applied common sense.â€
A New Kind of Capitalism
Imagine a Midwestern manufacturing company run by a 40-year veteran of the company who worked his way from the graveyard shift to the CEO’s desk. He probably knows everyone’s names, their favorite color, and even the names of their children and grandchildren. He greets everyone by the first name, and expects the same of his workers. He’s been there and done that; he knows his company, his business, and the people involved in it.
Now imagine that same company ran by the best 20-something engineering and economics students from world-class universities from the Northeast.
This might just be the very definition of a culture clash. Economists and engineers have no tolerance for inefficiency. Lost profits take over the feeling of “doing good†by workers. Why bother manufacturing a product in the United States when it can go overseas?
The old boss might have kept an under-producing arm of the company so as not to create strife with a family he’d see at church later that week. As for the new boss from miles away and with no connection to the firm? He sees inefficiency, lost profits, and the potential for a blockbuster turnaround for his newly launched private equity fund.
Romney’s Effective 14% Tax Rate
Adding insult to injury for many people is Romney’s effective tax rate on his earnings from Bain funds and later investments. Seeing as the fund was a buyer and seller of companies, earned income from the funds is passed on to investors like any other financial distribution. The earnings aren’t income; the earnings are dividends, and thus taxed at the favorable 15% rate.
Early in his career with Bain Capital, Romney would enjoy capital gains taxation rates even without fund investments of his own. As a partner, he stood to make millions in fees for his active participation in buying and selling companies. Even as active as Romney was in the business, his income is not personal income in the accounting sense, but capital gains. Yes, this includes the money he earned in fees as a partner of each private equity fund.
(Read: Romney certainly worked for much of his income, but he didn’t and does not pay into the traditional income tax brackets for working wages.)
In an election year of tax discussion, Romney’s light tax bill won’t win him too many voters. I, for one, pay 15.3% on my non-interest income just to cover Social Security. Romney managed to pay an effective tax rate of 13.9% in 2011, meaning his last dollar was taxed at a lower rate than my first dollar earned. Overseas holdings allow Romney even better returns and lower tax bills thanks to accounting and legal teams.
Readers,
Should private equity partners enjoy low capital gains tax rates on income they earn in fees?
If Romney and I both worked for a living in any given tax year, why should his earnings be taxable at the capital gains rate and mine at the appropriate federal income tax bracket?
Article by JT at MoneyMamba, a blogger who wouldn’t mind being part of private equity’s big paydays.
{ 11 comments… read them below or add one }
Fair article, but couldn’t you also say in a few cases if it weren’t for Bain the company would be no longer in existence? Bain I’m sure gutted a few companies (and I have no issue with that in itself either), but also came in and helped them.
Though as I talk about Mitt Romney tax rate on my site.
You cannot blame Romney for minimizing his taxes to the full extent of the law. Everyone does this, including Buffett.
In his case he was in the private sector until approximately 10 years ago, and never worked in Congress (who makes federal tax laws). Though I can’t speak if they had any lobbyist that pushed for tax reform.
Hey IJ,
I think aside from questions whether what private equity firms do is good, bad, or a mixture of both, the taxation issue is an interesting one.
See, these rich guys already do pay a much higher federal tax rate from W-2 income of course. But with Romney’s income coming from “carried interest”, dividends and such, they’re taxed at a much lower rate. So, is that fair? I guess on one hand, one could envision a tiered system for those forms of taxation as well, but many would argue that it’s important to keep investment taxes like dividends, capital gains and carried interest much lower to spur investment. The thinking goes that if those tax rates were raised, we’d see less investment in businesses and more in the risk-off bets and even tax-advantaged stuff like say, munis.
It’s tough to say what would happen if tax rates were increased on investment income but I suppose it’s fair to say that it’s a vehicle the rich certainly partake in, hence, the main street view that the rich are getting away with a lower tax rate. Then again…. 47% of Americans don’t pay a dime in federal taxes, so in my opinion, they should keep their opinions to themselves until they pitch in.
Great one JT, can’t wait to hear reader replies – very controversial topic!
Speaking as one who would gladly see *all* income taxes abolished, I nevertheless see the inherent advantage that this tax loophole grants to the financial elite would appear “unfair” on its surface.
Then again, what good is power to buy off politicians and ghost-write legislation if it’s not used?
Thanks to Buffett for highlighting this discrepancy! But beating poor Romney for this isn’t fair. He played by the rules. He could’ve avoided some of the bad press by not delaying his returns.
The tax loophole is really unfair to the working class. We should all pay lower taxes! I agree with 101C.
If the private capital company receives fees, it should be ordinary income and taxed as such. The loophole is the capital gains treatment when they buy a company. I think investors should receive this advantage, but not the company. The protion the company takes should be taxed as ordinary income.
Romney paid $3,000,000 to the income tax guys for 2011. Romney, Buffett et al are lawfully gaming the system, which is what we all do. It’s legal, so the rich guys and the income tax guys are all getting their fair share. Incidentally, life is not fair.
Hence a post I created on that very subject:
http://investorjunkie.com/2153/life-isnt-fair-now-get-over-it/
It’s dishonest to pay even $3 million dollars at a very low tax rate and only offer up $50o billion in spending reductions by 2016. If Romney digs paying low taxes, then he should do better to balance the budget to make sure those low taxes stay in place.
For now, Romney’s paying less than many other taxpayers in percentage terms while planning to cut very little from the budget. If he likes his low tax rate, fine, then actually plan to cut the budget to keep taxes low.
I like to think of carried interest versus ‘plain’ capital gains in another way – generally, a partner entitled to carried interest has helped to grow a company. To say that only people who already have money should be able to capture the 15% rate is a ridiculous argument.
Take Facebook, for example. Here is a site that Mark Zuckerberg bootstrapped to create a (potentially $100 Billion) empire. My point is he didn’t put much money into the site – he put a whole bunch of sweat equity into the company. He’s about to get a massive payout, and potentially will even sell some of his shares. Guess what? He’s going to pay a 15% rate, even though he didn’t put up much money to get them.
Maybe Mitt Romney didn’t put as much ‘sweat equity’ into Staples as Zuckerberg did into Facebook. That’s besides the point. An argument that only purchased shares should get the 15% tax rate is ugly – and it also denies Congressional consensus which has existed since the mid 1970s (thank you Mr. Chuck Schumer!). As long as people can develop companies by putting up things other than capital, carried interest makes sense. Removing this benefit is just stating that only those with money can access the favored rates… not those who are willing to pour their blood and sweat into a company’s success.
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