Update 400 — HFSC Hearing on S. 2155,
The (Stop) Wall Street Looting Act of 2019
As 2019 draws to a close and Congress moves toward adjournment by December 20, attention in Washington is on the narrowing windows of legislative opportunity. In the economic policy arena, the focus is on the FY 2020 budget (the current CR will be likely extended until January) and but a handful of discrete tax bills, which we will be covering.
Outside of DC, on the hustings and debate stages across the country, voters continue to hear new ideas, messages, and themes from candidates. The intersection of public and private equity was at a House Financial Services hearing last week. The panel debated message-oriented and ironically numbered S. 2155, Stop Wall Street Looting Act — a potpourri of financial regulatory bills serving notice that Wall Street should not get too used to the administration’s deregulation campaign.
On Nov. 19, the House Financial Services Committee held a hearing on legislative solutions to the manifold depredations of private equity on Main Street. Private equity (PE) is playing a fast-growing role in the economy. The industry controls $5.8 trillion in global assets in 2018, up eight times since 2000. In 2018, PE-owned companies employed nearly nine million Americans and the sector invested $685 billion in more than 4,700 businesses across the country. Still, many have public policy concerned about private equity firms’ practices and outcomes.
Perhaps most controversial is the leveraged buyout transaction, in which a PE firm funds a buyout with large amounts of debt using the acquired company as collateral. The PE firm will then often strip and sell the company’s profitable assets, walking away with profits while the acquired company is crippled by an impossible debt burden. This often leads to bankruptcy and mass layoffs. Ten of the last 14 retail company bankruptcies were owned by PE firms.
The negative externalities of this practice require solutions, but there is a distinct difference between regulatory and criminal approaches. Solutions should be considered through a “public equity” lens, with an emphasis on protections and guardrails that protect against impropriety and fraud. We assess the merits of current and potential legislative solutions to the excesses of private equity, below.
The Stop Wall Street Looting Act
Last month’s HSFC hearing examined H.R. 3848, The Stop Wall Street Looting Act of 2019. The Senate companion introduced by Sen. Warren is S. 2155, a bill number that will send shivers down the spine of many who fought against the banking deregulation legislation with the same bill number last Congress.
Sen Warren’s S. 2155 contains two notable provisions, one of which we’ve seen before, and the other of which addresses unfinished business from Dodd-Frank:
- Carried Interest — This tax loophole allows private equity fund partners and managers to receive a portion of their compensation taxed at the same rate as long term capital gains. The tax break unfairly benefits the Wall Street elite. The carried interest loophole has long been in the crosshairs of Democrats. The House voted to close the loophole in 2007.
- CLO Risk Retention — Warren’s S. 2155 would reinstate Collateralized Loan Obligation (CLO) risk retention. Last year, the DC Circuit Court of Appeals ruled that the risk retention requirements imposed by Section 941 of Dodd-Frank did not apply to open market CLO managers. The rules require firms to hold some of their investment risk — making sure they have skin in the game — a direct response to problems in the trillion-dollar leveraged loan market; CLOs are the largest buyers of leveraged loans.
Other titles in the bill propose a number of new measures that seek to reign in private equity malpractice:
- Risk-Sharing — The bill seeks to require private equity firms to share in the downside risk between themselves and the portfolio companies they acquire during a buyout. During the November hearing, Rep. Maloney highlighted the issue of the zero sum dynamic of certain private equity practices, particularly during a PE buyout. She described the prevailing mentality as “heads I win, tails you lose.” Per Eileen Appelbaum, co-director of the Center for Economic and Policy Research, private equity firms buy out large viable companies and use their assets as collateral to take on risky levels of debt that the company, not the PE owners, has to pay.
Appelbaum highlighted Toys “R” Us as the poster child. It was purchased with $5.5 billion in debt and went from a capital structure of 87 percent equity and 13 percent debt before it was acquired, to an upside-down 17 percent equity and 83 percent debt. Yearly interest payments exceeded $400 million dollars and $470 million in total advisory and other payments went directly to the private equity firm. The Stop Wall Street Looting Act would end this practice by requiring the private equity firm and general partners to be jointly liable with the company for debt repayment, legal judgments, and any outstanding pension-related obligations.
- Post-Acquisition PE Finance — The bill places restrictions on how quickly a private fund is able to issue post-acquisition dividends, distributions, redemptions, and buybacks after it buys another company. The firm will have to wait two years beginning on the closing date to engage in any of the prior activities.
- Bankruptcy Priority Reform — The bill codifies several protections in bankruptcy law so private equity firms aren’t absolved of responsibility when a company owned by a PE firm files for bankruptcy, including:
- prioritizing worker pay should a PE-owned company file for bankruptcy
- protecting jobs and giving workers an opportunity to stay or move on to another job
- ending private equity immunity from legal liability when a portfolio company breaks the law
- Increasing transparency for investors — PE firms will be required to disclose activities such as fees, returns, and political expenditures to allow investors to monitor their investments.
In 2014, the SEC found “violations of law or material weaknesses in controls over 50 percent of the time” in its examinations of the handling of fees and expenses by advisers to private equity funds. The SEC at the time called this a “remarkable statistic.” Violations of the law can and should be punished by a criminal standard, rather than a regulatory approach, that can have limitations. Rep. Gottheimer put it succinctly: “Our job is to punish bad actors while not interfering with those that produce good returns.”
At the Nov. 19 hearing, many Committee Democrats had nuanced thoughts on the debate over private equity. Rep. Foster said that not all private equity activity is nefarious, and not to be thrown out with the bath water. Hearing witnesses testified that PE buyouts are, on balance, a net positive for small- and medium-sized companies. Problems with PE takeovers of larger companies could be remedied by increasing supervision on these specific kinds of transactions while keeping the regulatory status quo for the small- and medium-size company buyouts.
Rep. Sherman indicated that large PE-owned companies bore the brunt of much of the industry’s bad practices. He suggested that larger PE-owned companies should be held to the same kinds of disclosures that are required of publicly-held companies. Dr. Appelbaum agreed and argued that other investment funds, such as mutual funds, do not engage in the same kinds of high-risk leverage practices because they are subject to different, stricter regulation — “the problem with leverage is not the use of leverage, it is the excessive use of leverage.”
A Word of Caution
During the hearing, Applelbaum noted that during the last economic downturn, 27 percent of highly leveraged firms filed for bankruptcy, warning that PE-owned firms today are highly leveraged as a consequence of the malign incentives that encourage debt loading and asset stripping. Although PE-owned companies comprise a relatively small slice of the business sector as a whole, their precarious financial position will rapidly deteriorate in an economic downturn, leaving many workers and communities devastated.
As private equity’s role in the economy grows, so must the scrutiny on the industry. The Stop Wall Street Looting Act contains provisions that would severely crack down on many of the bad practices of private equity firms that advantage Wall Street over Main Street. That said, there are many other worthy, perhaps more feasible, resolutions to the issues surrounding private equity practices that focus on criminal enforcement and public protections.