The Nasty Reality of Private Equity Financing

The magic of Private Equity financing or how hedge funds work explained by Robert Reich in 8 Easy Steps.

Are critics of private equity against capitalism. They’re not. They’re against a predatory system created and perpetuated by Wall Street solely to pump its own profits. Here’s what private equity is really about: A firm like Mitt Romney's Bain Capital obtains cheap credit and uses it to acquire a company in a "leveraged buyout." "Leverage" refers to the fact that the company being purchased is forced to pay for about 70 percent of its own acquisition, by taking out loans. Private equity firms typically target profitable, slow-growth market leaders. (Private equity firms presently own companies employing one of every 10 U.S. workers, or 10 million people.)

And that's when the fun starts. Once the buyout is completed, the private equity guys start swinging the meat axe, aggressively cutting costs wherever they can – so that the company can start paying off its new debt – by laying off workers and cutting capital costs. This process often boosts operating profit without a significant hit to the business, but only in the short term; in the long run, the austerity approach makes it difficult for companies to stay competitive, not least because money that would otherwise have been invested in expansion or product development – which might increase revenue down the line – is used to pay off the company's debt.

It takes several years before the impacts of this predatory activity – reduced customer service, inferior products – become fully apparent, but by that time the private equity firm has generally resold the business at a profit and moved on. These leveraged buyouts don't only hurt businesses, workers, and the economy generally – they also short-change taxpayers, via a giant loophole in the tax code that enables companies to deduct loan interest from taxes. The provision was originally intended to encourage borrowing to build new factories, not to finance leveraged buyouts. But, according to Notre Dame Professor Brad Badertscher, private equity-owned companies paid a 22 percent tax rate before being bought, and only 10 percent the year after being acquired. That adds up to a savings of $130 billion in taxes since 2000. Rolling Stone Magazine