Defending private equity

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What do J. Crew, Toys “R” Us, Petco and Dunkin’ Donuts all have in common? Besides being some of America’s most recognized retail establishments, they are part of a growing breed of successful companies owned and operated by private equity firms.

Private equity is a frequently misunderstood part of the U.S. economy. Far from being the sinister force some have portrayed it to be, private equity is simply a flexible form of ownership that creates successful operating environments for companies.

Yet the misunderstanding about private equity has now reached a fever pitch. The chairman of the Senate Finance Committee, Sen. Max Baucus, and the ranking member, Sen. Charles Grassley, are pushing a bill that would dramatically raise taxes on publicly traded partnerships and prove harmful to the industry.

Not only do Messrs. Baucus and Grassley want to raise taxes, but they want to do so in a matter of days, even though they have never held a hearing, and there has been no analysis of the proposal by the U.S. Treasury, the Internal Revenue Service or Congress’ own Joint Tax Committee. Such a dramatic tax increase can only have a major adverse effect on the industry and a host of unintended consequences — as we’ve learned the hard way from the Alternative Minimum Tax.

Private equity firms play an important and positive role in our economic growth. A punitive tax increase on these firms will invariably diminish their ability to foster growth at the same level as they do today.

If one wants to see the kind of role private equity firms play in our economy, one need only look at the large quantity of direct investors in private equity funds, such as pension funds, university endowments and foundations. From 1991-2006, they realized $430 billion in net value from the world’s private equity firms, according to Doug Lowenstein of the Private Equity Council. Those returns enable pensions to be more secure, universities to be better funded and foundations to be more liquid and make more grants.

More broadly, private equity investments generated 600,000 new jobs from 2000-03, according to the consulting firm A.T. Kearney. That job creation has almost surely become more impressive over the past four years — a period when private equity has grown as the public markets have been shackled by regulations such as Sarbanes-Oxley.

Private equity firms are also a valuable source of liquidity, particularly for troubled companies. Last month, Cerberus paid $7.4 billion to purchase an 80 percent stake in Chrysler. But more typical is for private equity firms to invest in young companies that have great potential, but are in need of capital and management expertise to help them grow.

The A.T. Kearney study highlights three general strategies private equity firms employ to drive growth. They improve performance (reforming everything from inventory management to salaries), reduce complexity in order to concentrate on core competencies and “buy and build” (engage in mergers and acquisitions, innovation and alliances).

The former head of Morgan Stanley, Phil Purcell, has highlighted another role private equity investors play. “They try to reduce excess capital — capital tied up in inventory, payables, receivables, and other forms of working capital. When a portfolio company is sold, the capital is reallocated to opportunities with higher returns. The result is rapid reduction of capital in mature industries and increased investment in growing industries.”

Finally, a distinctive feature of private equity firms is their ability to focus on long-term growth at their portfolio companies. That often means undertaking a variety of restructurings that would be more difficult to pursue in an environment with a high degree of public scrutiny coupled with short-term earnings pressures.

Thus, the findings of a Harvard Business School study by Josh Lerner shouldn’t come as a surprise. It found that public companies backed by private equity firms for more than a year achieve higher growth in their stock price than public companies not backed by private equity.

As Messrs. Grassley and Baucus consider a massive tax increase on private equity firms, we should remember that, far from the demons they are made out to be, these firms are a positive force in our economy. The law governing publicly traded partnerships has been in existence since 1987 and has never been the subject of any controversy. The fact that this industry has been enormously successful shouldn’t make it the source of controversy today.

Pat Toomey is president of the Club for Growth.

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