It’s easy to point the finger at a Democratic president who wants to reform the corporate tax code, but the real enemy is a lot closer to home.
FORTUNE — Many private equity investors are convinced that President Obama is their enemy, not only because he wants to defeat former Bain Capital boss Mitt Romney in November, but also because of a new corporate tax reform proposal that could make private equity deals more difficult to finance. The industry’s most dangerous enemy, however, is not in the White House. It’s in the mirror, due to private equity’s pervasive use of dividend recapitalization — a noxious financial strategy that perverts the industry’s mission and threatens its future ability to raise capital.
Here’s how it works: When a private equity firm buys a company in a traditional leveraged buyout, it typically uses bank loans to finance much of the purchase price. Since the company being acquired takes out the bank loans, it’s the one on the hook for future interest payments — not the private equity owner. The extra twist comes when, often years later, private equity owners instruct the company to take out even more bank loans. Those proceeds are then funneled to private equity investors in the form of a “dividend,” rather than being used for corporate purposes like buying new equipment or hiring new employees.
In most cases, companies can handle the extra debt load. But sometimes the interest payments become unbearable and the company folds, as in the case of Bain’s investment in medical diagnostics specialist Dade International. Not only did private equity not increase the company’s value, but its actions actually helped destroy value.
Even when the company survives, it’s difficult to argue that the added debt has contributed to anything other than private equity’s bank balance. And calling it a “dividend” is just plain deceitful, since dividends are supposed to come from legitimate earnings.
According to Standard & Poor’s, there was more than $28 billion in dividend recap activity last year and nearly $7 billion during the first two months of 2012. That’s just a small fraction of overall private equity activity, but it still represents an unacceptable burden on companies whose only crime was to be acquired by firms that talked a big game about “value added.”
So what can be done to stem the tide? The best solution would be self-policing. Unfortunately, that would be like asking kids to choose apples over miniature candy bars while trick-or-treating. That leaves government intervention — not a prohibition against dividend recaps, but tax policy that would discourage their use.
Last month President Obama proposed a corporate tax reform package that would, in part, stop encouraging corporations “to finance themselves with debt rather than with equity.” Among the proposed fixes was an unspecified reduction in the amount of interest that companies are allowed to claim as a tax deduction (now 100%). Depending on the specifics — and possible exceptions, such as for small-business loans — such a move could make private equity firms much less likely to engage in dividend recaps by increasing the cost of such capital.
Obama’s proposal may sound like an attack on private equity, but it’s not quite that simple. While dividend recaps are quick and easy money for the industry, they’re bad for business in the long term. Investors in private equity funds — including public pension systems — have begun talking a lot about “sustainable” investments, rather than just buy, sell, and move on. These investors also have large public equity portfolios and don’t like the idea of private equity removing value from companies that may be taken public, or killing a company, which contributes to unemployment and helps trigger larger macroeconomic troubles. These influential investors could reduce their private equity allocations if they see it happening too much.
So if President Obama’s primary goal was to destroy private equity, he might try to encourage even more dividend recaps. Luckily, for all involved, he’s doing the opposite.
This story is from the April 9, 2012 issue of Fortune.
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