Private Equity Deconstructed

Atlantic senior editor Clive Crook weighs in on the private-equity business—why it's booming, where it's headed, and what it means for American capitalism.

Last February, private equity baron and Blackstone co-founder Stephen Schwarzman marked his 60th birthday with a celebration fit for a king. Hosted at the Park Avenue Armory, a massive fortress-like building on Manhattan’s Upper East Side, the party drew Wall Street titans, media stars, politicians, and Hollywood celebrities. In rooms redecorated to resemble Schwarzman’s own $40 million Park Avenue apartment, 500 of Schwarzman’s closest friends enjoyed free-flowing wine, a massive gourmet menu, and a private performance by pop star Rod Stewart. A giant portrait of the birthday boy (borrowed from Schwarzman’s home) formed the centerpiece of the room, reminding partygoers of the honoree.

Schwarzman’s name is not typically spoken in the same breath as, say, Bill Gate’s or Michael Bloomberg’s. His wealth does not even register among Forbes 50 richest people in America. (In 2006, he ranked 73rd out of 400, all of whom had assets of at least $1 billion.) But his wealth and professional success (along with his willingness to flaunt both) has attracted the attention of everyone from gossip columnists at the New York Post’s Page Six to lawmakers on Capitol Hill. Suddenly, an industry that has historically conducted its business quietly and discretely has many wondering: What exactly is private equity and where is all this money coming from?

As Clive Crook points out in the September issue of The Atlantic, the private equity business isn’t new: firms like Blackstone, Carlyle, and TPG have been around for decades. The term private equity refers to a range of financial activities—including hedge funds, venture capital, leveraged buy-outs—related to investments made in privately owned companies (those that have not listed their stock on a public exchange). Blackstone, like many other private equity firms, has made much of its money in the buyout business—acquiring undervalued public companies using borrowed money, taking them private, improving them, and reselling them at a profit. In recent years, helped by strong stock prices and low interest rates, this type of business has boomed, allowing firms and firm executives to rake in huge profits.

“Is it all a bubble?” Crook asks. How much of these gains reflect real economic value? Is the relative strength of the stock market acting as a temporary crutch for an otherwise unstable industry? If the bond market continues to cool as it’s been doing in recent months and long-term interest rates continue to climb, could this market crash? And above all, Crook wonders, does the flourishing state of the private market imply that American capitalism has lost its effectiveness?

A deeper and more important question about private equity is this: Supposing even some of the gains in value achieved by these leveraged buyouts are real—and that seems likely—then what is wrong with the public capital markets? Why does a firm need to be taken private to be better managed or more intelligently financed? You could see the success of private equity as an indictment of American capitalism. If Wall Street were working as it’s supposed to, you might argue, private equity would have found no space to overrun in the first place.

Clive Crook, formerly deputy editor of The Economist, is now a senior editor for The Atlantic, a columnist for National Journal, and chief Washington commentator for The Financial Times. We communicated by email on August 2.

—Abigail Cutler

You refer to the private equity phenomenon as possibly a bubble. What might cause the bubble to burst and what might such a scenario look like?

The biggest risk for the industry as a whole is probably higher interest rates. The striking feature of private-equity deals is the heavy reliance on debt to “leverage” investors’ returns—and also, since the two things go together, to raise the investors’ risks. The industry has boomed thanks partly to a global glut of risk-tolerant capital and low interest rates. Outsiders can’t say for sure what a spike in interest rates would do to the private-equity firms’ existing portfolios of assets. We’ll just have to wait and see. But even the gentle rise in interest rates that we’ve seen so far makes it harder for the private-equity firms to keep applying the same template to new projects.

Another unknown is what the collapse of a big private-equity firm might do to the rest of the industry. The firms need confident investors willing to trust them with their capital. So far, the firms have justified that confidence by earning their investors excellent returns. If that should change, and especially if a big firm goes under, taking investors’ assets with it, that eager inflow of new money might dry up across the industry.

In general, we’ve seen private equity operating under very favorable conditions. Everything has gone their way until very recently—low interest rates, lots of capital greedy for risk, a regulatory regime (Sarbanes-Oxley) that turned against public companies, and more. We won’t know what to make of the industry as it’s now run until we’ve seen it weather bad times.

Can you talk a little bit about foreign investment in these funds? When Blackstone went public back in June, China purchased a $3 billion stake in the firm. What was behind that big investment and what are its implications?

China’s investment in Blackstone was interesting. China’s central bank holds huge amounts of dollar assets—mostly U.S. Treasury bills—in its reserves. These are the counterparts of its balance of payments surplus. By buying dollars, the government holds down the value of the renminbi, which in turn helps keep China’s exports competitively priced. The problem from China’s point of view is that these assets generate very little income, and the dollar’s weakness on global currency markets makes them a poor investment. Switching a little of this money into other investments, such as Blackstone, is an effort to get a better return.

There’s an irony, though—a circular effect. The uncertainty in financial markets over China’s intentions for its foreign exchange reserves has been one of the factors pushing interest rates up this summer. China’s interest in the Blackstone IPO was a signal that its monetary policy was changing, and that something big might be about to give way in global capital markets. So it was a kind of precursor of higher interest rates; and higher interest rates are the biggest risk that Blackstone and the other big private-equity firms currently face. In some ways, China unsettled Blackstone’s business by expressing confidence in Blackstone’s business.

Last year’s attempted Dubai ports deal generated an enormous amount of controversy back here. Why is the idea of foreign countries investing in our publicly held companies such a contentious issue?

The Dubai Ports issue raised special issues, of course. People were scandalized by the idea that an Arab-owned company would be running some big American seaports—the fear was that this would compromise security. I didn’t see much merit in that view, myself. What difference does the ownership of a port make? Regardless, the port’s owners will face the same demands and standards so far as security is concerned. These requirements are imposed, and then either directly carried out or closely monitored, by the government. These are not things the company is left to work out for itself. Would a Dutch firm, or a Brazilian firm, or an American firm for that matter, require less oversight?

As for the wider issue of foreign ownership of companies in the U.S., this already happens on a vast scale—and attracts less attention, arouses less political controversy, than you might expect. Which is a good thing, in my view; long may it continue. I’m sure the country gains from a mostly open regime of inward and outward direct investment. U.S. companies own a ton of productive capacity abroad, and foreign companies own a ton in the U.S. In general, there is no economic downside to that; it’s good for everybody. I think it’s fine that the broader issue at the moment generates so little political heat.

How might the upcoming elections affect the private equity industry?

Tax is a big political risk for the industry—or for its managers, at least. But I’d be surprised if that wasn’t settled before the elections. Private-equity general partners, the people who manage the investors’ money, have been getting a fabulous deal on tax. Most of their income is paid in the form of “carried interest”—a bonus paid in proportion to the profits on the firm’s assets under management. This is then taxed at the low rate currently applied to capital gains rather than ordinary income. This treatment seems to me indefensible—and so far as I know, the only people even trying to defend it are the beneficiaries and their representatives. The issue is open and shut. Carried interest should be taxed like ordinary profit-related pay. This will make the most successful private-equity managers a bit less rich. I suppose that’s OK.

Some politicians and economists have suggested that the U.S. is reentering a protectionist period like the ’60s and ’70s. Is there anything to that argument?

You’re right that there’s a new mood of skepticism or worse about the benefits the U.S. gets from trade. It’s very striking that all the Democratic contenders for the nomination are way to the left of where Bill Clinton was on this issue—very Old Democrat. And I suppose it does tie in with the politics of private equity, through concerns over rising inequality, the relative stagnation of middle-class earnings, and the stupendous increases in incomes at the very top. But, as I say, the tax part of the private-equity issue is a no-brainer. I’ll be very surprised if this isn’t dealt with soon. But I don’t think it will do much, or even anything, to defuse the broader concerns about trade, jobs, and wages. That has its own momentum right now. It will be a big issue in the election, regardless of private equity, and, depending on what happens in November ’08, it could make a big difference to the future direction of American economic policy. I’m worried about that.

What are the possible consequences of all this attention on the private equity industry?

First and foremost, higher taxes for private-equity general partners, as I just mentioned. More generally, a building mood of discontent over income inequality, and the idea that all the benefits of economic success these days are going to a tiny clique of über-rich. That will surely feed into the broader tax-reform debate—which might be a good thing, in my opinion, because the U.S. tax system sure needs a stiff dose of reform. It’s not just a matter of unwinding the Bush tax cuts and increasing the progressivity of the system, though. Changes need to go further than that. The system is now insanely complicated and completely dysfunctional in terms of intelligible economic objectives. If the private–equity phenomenon—including Steven Schwarzman’s birthday party—has helped spur the country’s appetite for a new, hard look at the tax system, that’s good. It’s long overdue.

You note that the bond market shuddered last June as Blackstone was preparing its IPO. Last week, there was another story on debt investors growing decidedly cautious. What impact will the cooling debt markets have on private equity trends—both in terms of acquisitions and in terms of the amount of leverage private equity firms use to fund them?

That’s right, there’s new turbulence in credit markets. It’s affecting interest rates and weighing on the stock market too. The biggest recent worry is the sub-prime mortgage market. A lot of shaky loans were issued at low rates, often with temporary sweeteners that made the initial costs to borrowers even lower. Now we see interest rates nudging up, and house prices falling in most areas—a huge and growing stock of houses for sale, and not enough buyers at these prices. It’s one of those times when you see a so-called flight to safety in the capital markets. A few hedge funds got their bets all wrong on securities that bundle these sub-prime mortgages together. That got people worried too.

There are broader fears about how far the fall in house prices might go, and whether that could even push the economy into recession. And partly it’s a global issue, not just a problem for the U.S. Whether the flight to safety becomes an outright panic, we’ll find out. It wouldn’t be the first time. And sure, it’s bad news for the private-equity people. They thrive on cheap credit and a big appetite for risk. Up until this summer, they had the perfect financial environment. Some will doubtless adapt to the new situation, and carry on doing well. Not all, though.

You note in the piece that the Sarbanes-Oxley law “is only one aspect of a regime of corporate regulation that seems, by international standards, increasingly persnickety, complex, and hazard-prone.” Is this your take on Sarbox, too?

I’m not a huge fan. Congress was addressing a real problem, mind you. Auditing and financial reporting certainly needed tightening up. Enron, WorldCom and the others made that pretty clear. But I think Sarbox was a classic hasty reaction. It went too far. It raised compliance costs much more than necessary. A lot of people blame Sarbox for encouraging companies to list in London and elsewhere instead of in the U.S., and I think there’s some truth in that.

And I think Sarbox also helped to spur private-equity too. One of the attractions of taking a company private is that you escape Sarbox; it only applies to public companies. You’d have seen some of this response, obviously, even if Sarbox hadn’t gone as far as it did—any tightening of the rules would have given foreign listings and private equity a bit of a push. But to the extent that Sarbox overshot, there was more of it than there needed to be. The Securities Exchange Commission has just made new proposals for implementing Sarbox more flexibly. That would help.

How do you feel about the recently proposed regulation of private equity firms here in the U.S?

I’ll keep an open mind, but I don’t think they need tighter regulation. I’ve not seen that argued convincingly. They’re serving investing institutions and other financial firms. Customers like that should be able—and indeed should be required—to look after themselves. And don’t forget that private equity firms serve a very useful function when they buy firms, restructure them and make them work more efficiently. It would be a bad idea to punish that, or put it at a disadvantage for no clear reason.

As I’ve already said, though, I think that the tax regime for private-equity managers needs to be changed. And since I also mentioned broader tax reform, let me make a point about that as well. There are three main ways for a company to finance its investment: by selling shares, by borrowing, and by spending retained profits. The U.S. tax system distorts that decision. This is one of the things that needs to be fixed. Tax rules discriminate strongly in favor of borrowing, as opposed to issuing equity. Private-equity firms, you can argue, are entities specialized to take advantage of that discriminatory treatment. If tax reform attacked that pro-debt bias, as it should, it would put a dent in private equity’s customary way of working. But in that case, it would make sense to do it, because the change would be serving the bigger aim of tax neutrality between different kinds of investment. It would be removing a kind of subsidy.

You write that in London, litigation that puts company directors at personal risk is less of a danger. What does this mean? Are there executives like Schwarzman in Britain?

Oh sure. London is at least as big a center for private equity as New York. But London is growing as a financial center in other ways, too. It definitely believes that one of its advantages is a lower risk of litigation. This is much on the minds of public-company directors in the U.S.—that they can find themselves in court for (as they would see it) making honest mistakes, as opposed to malfeasance. The U.S. is a very litigation-friendly country. The UK, and Europe in general, do not have that tradition. I’m sure that’s true, but I’m not sure how much difference it makes. There are lots of anecdotes, lots of complaints, it’s surely a concern, but what it all amounts to I’m not sure. The evidence on this, so far as I can tell, is mixed.

How much should we read into Blackstone's decision to go public? Is it possible that Schwarzman foresaw a possible crash and chose to hedge his bets early?

You can’t help but wonder about that, can you? It would be hard to think of a better time to cash out than the one they chose—or at least, so it seemed when they made the decision. The market was a bit shaky when the time came—and one of the things contributing to the gloom was the suspicion in some minds that the Blackstone IPO would mark some kind of peak. Quite a tribute, in a way, to the financial prowess attributed to Schwarzman and his team.

Can you speak briefly about how you came to cover economics and finance as a journalist?

Well, I started out as an economist but for as long as I can remember the work I’ve always enjoyed most is, in one way or another, essay-writing. Many years ago, my early professional background first gave me an in at The Economist as an economics writer, and I’ve stuck with it. For a long time now I’ve been as interested in politics as in economics, and really it’s the overlap between the two that I find most fruitful as a commentator. I have the concept of comparative advantage on my mind right now since I’ve just finished a new piece for The Atlantic on that subject—and I believe that my comparative advantage as a writer lies in the fact that I’m both interested in politics and somewhat knowledgeable about economics. For reasons I’ve never understood, that’s an uncommon combination in journalism. This helps me believe there is a point to what I do—aside from needing the money, of course.