The World Is Not So Flat in Istanbul...

Don't Panic Folks: Capitalism Will Save Us!

All morning, I’ve been reading articles about the inevitable decline of capitalism as we know it.

All a bunch of hubris. Capitalism is alive and is doing very well, however I believe it is being undermined by this unprecedented and tremendously ineffective ‘bail-out’ plan.

I think the very statement of ‘capitalism on the decline’ refers to the concept of ‘economic bubbles’.

Economic bubbles are a common phenomenon in nations whose industries work under highly unregulated systems where the concept of ‘oversight’ is nothing more than an institution responsible for tracking statistical data. Yes, I'm referring primarily to the US system here. We have to ask ourselves why we don't see purely 'European' economic bubbles (note that the current troubles in the European and Asian economies can be traced primarily to the practices of US companies).

Economic bubbles come and go in cycles of 10 years or so. The Savings and Loans(1980-90), Internet (2000) and now the Financial (2008-??)...

The solution is not 'bail out' but 'prevention'. This entire financial debacle could have been prevented and you only have to dig below the surface of only one of the conspirators’ (AIG) investment practices to know why.

I am a spectacular believer that capitalism works and it works well - only through careful and prudent oversight by truly 'independent' regulatory institutions. If these institutions (SEC) happen to fail, I believe they should also take partial responsibility of the crisis.

At this point, our argument is that AIG and its posse were able to con so many institutions and governments around the world that it 'cannot' be allowed to fail because if it does, then it would bring down the rest of the world. There is no doubt that the failure of these massive institutions will cause havoc, however forcing each and every US tax payer to save these companies is only akin to taking money from your left pocket and putting it back into your right pocket.

It is not a solution.

The closure of these institutions will leave a legitimate void in the system and there are other companies all around the world that were prudent enough not to take on faulty practices, who will fill in this void. This is how capitalism works. The closure of these toxic institutions will not drive us back to the stone ages. As painful as this transition of power will be, there is nothing to worry about.

One good example of this is the closure of so many of the investment banks. There are thousands of profitable and 'working' investment houses that are now taking over the role of their bankrupt and careless 'brothers'.

Contrary to common belief, we should all view the capitalist system as one that is dynamic, self preserving and continuously evolving.

 

 

Why Taxing Private Equity Will Not Work

I’ve said this many times and I will say it again: The ongoing debate about taxing private equity and hedge funds is only a media campaign for those who want to take advantage of the public misunderstanding with regard to the workings of these two sectors.

There is an alternate way to look at this situation: Trying to tax the private equity and the hedge fund sectors (or bringing them under SEC control, as it is proposed in the United States) is no different than certain governments who are actively trying to block websites (youtube, blogs, etc…) from the reach of their citizens. It is absolutely impossible.

As difficult as it may be for regulators to admit, there are an infinite ways of stepping around any tax/regulatory barriers placed in front of financial institutions. Just think about how our current financial crisis came to be? It wasn’t that the SEC or other regulatory bodies were caught sleeping at the wheel, it was because the financial institutions (and their army of international tax lawyers) were able to circumvent them in order to provide new investment instruments to their ‘trillion dollar’ client lists. Consequently this is why throwing money at the problem will not solve anything, but that is another Pandora’s Box I will not open.

This is not about evading the law. This is about competition and it is about investor satisfaction… which inevitably boils down to maximizing returns and minimizing taxes. It is as natural an instinct as getting out of the way of an oncoming vehicle.

Many of the private equity and hedge funds in the United States are already registered in foreign countries through what are referred to as ‘feeder funds’: for the US it is generally the Cayman Islands and for Europeans, it is Guernsey. This sector is remarkably flexible and seems to be able to adapt to any challenge. It is driven principally by investors and therefore it is determined with the capital of the very people who are actually trying to obstruct the sectors operations.

Having said all this, I have to admit that I often see some companies take spectacular risks with investor capital. There is no law against risk (and without taking any, there would not be progress), however I do believe that the sector should be more transparent and responsive to its primary clients: pension funds, practically every government institution, municipalities and oh yes… the private sector investors as well. The sector needs to communicate the risks they are willing to take in order to make their clients make more money. If their clients are not comfortable with the levels of risk, they should be allowed to pull out.

Upon a continuous barrage of news on the topic on Bloomberg and President Obama this morning, I found myself in front of the blog trying to articulate my two cents.

Is Private Equity Really Evil?

My personal disclaimer: Now, please don’t misunderstand me while you read this post. I’m not advocating the virtues of greed here. I only wish to examine all the points being made against the private equity industry in the hopes that we can better understand and hopefully lead change where it’s required. There is my disclaimer so let’s get on with the post…

What does ‘private equity’ have in common with ‘hedge funds’, ‘derivatives’, ‘nano-technology’ and ‘stem cells’?

They are some of the most widely used terms in the media these days and therefore almost all segments of society are familiar with them. The problem is that these terms are also known as ‘grey industries’ where no one really knows what they really are, who the participants are, where they are located, and in general what they really do. This is a serious vulnerability of the private equity industry that has allowed it to be kidnapped by certain politicians and economists with the aim of making personal gain (‘greed’, it would seem has many faces).

I was curious as to the accusations so I did a little research to see if I could list them. Maybe this way I could get a clearer perspective of the industry that I work for. Needless to say that by far the most vocal critic of the private equity industry are the unions and other employment organizations.
We all know why.

The sole purpose of a private equity firm is to increase the value of its portfolio of companies. This includes any which way possible; such as reducing the size of the portfolio companies’ workforce. The ideal take-over candidate for a private equity firm is one that has grown too much, too quickly, is in moderate debt, and is too cumbersome to compete effectively within the marketplace. This makes the company vulnerable and gives the advantage of the negotiation to the private equity firm (of course it is slightly more complicated than this; however it’s generally how it works). Upon acquisition, the easiest way a private equity firm can start turning the company around is to adjust the size of the workforce in order to free up operating costs and force an increase in productivity.

Many private equity firms will argue that if they hadn’t intervened, the company would eventually exhaust itself into oblivion and at that point everyone would lose their jobs.

And there you have it. This very argument will go in a perpetual circle.

The great irony here is that many private equity firms are actually capitalized by pension funds, unions, and other large institutions representing employees. They demand the high returns, the private equity firms consistently deliver these returns but it is in fact the laid off employee who knows firsthand how this ‘value’ or ‘return’ was actually achieved.

The fact is that I don’t believe the private equity firms have been very eloquent in their explanation of the intricacies, methods, and objectives of the industry. In addition, even the most ardent capitalist must admit that private equity firms should have at least some sort of social responsibility toward the employees of their portfolio companies. At this point no one has been able to come up with a sound solution to the problem.

Upon a some more analysis of the problem, one idea that comes to mind is to somehow force private equity firms to invest a certain portion of the acquisition amount towards helping to find new work for those employees who are cut. This could be capped at 2% of total acquisition price, for example. The allocation would be immediately paid to the government and be refunded back to the private equity firm once they spend the amount. This would require private equity firms to allocate double (in this case 4 percent) of the acquisition amount towards the financing of re-employment.

This could maybe replace the proposed tax hike for carried interest.

In conclusion I do have to admit that the private equity industry must show a more concerted effort in trying to educate the public as to how it goes about its business. It can no longer afford to be an entity in the background but must show the public that it too has good intentions and is here to stay for the long term.

Should Carried Interest be Taxed?

Before we deliberate our judgment on how to tax carried interest, I believe it is important to first determine how to categorize carried interest within the context of tax law.

There are two perspectives with regard to the classification of carried interest and depending on which one you choose, it will determine the level of tax you wish to see applied by the authorities. Do you see carried interest as an income from a sale of assets or as income from an investment into shares of a company? In other words, should carried interest be treated as income or capital gains?

In many countries the two rates of tax are different; however in Turkey the two rates are considered the same so this article is more in tune with US or UK funds rather than Turkish funds. However, many of the investors in Turkish funds are international (primarily from the US, UK, or the Middle East) so fund managers should pay close attention to developments concerning private equity tax structures.

In general, I will use US rates for the purpose of this article: income tax is about 35% whereas capital gains tax is 15%. The fierce debate is to categorize private equity as ‘services rendered by management’ (consulting) to a company and therefore automatically apply the higher tax of 35% on carried interest.

I am obviously biased in this matter as I work in the private equity industry. I am a believer that a prospect of a massive windfall from carried interest is the only reason why so many highly qualified people leave their posts in highly paid positions to join the ranks of general partnerships at private equity firms. The greatest asset of this industry is to have access to these super stars of business being able to grow companies. The entire point of private equity is based on the ability to take sizable positions in companies that you know your GP’s will be able to accelerate growth rates within a set time frame (two to four years). This involves tremendous amounts of expertise and the ability to calculate risk/reward in a very dynamic environment. If the rewards of private equity did not match the risks involved, the industry would simply seize to exist.

Any exit from a portfolio company should be regarded as capital gains and therefore be taxed at lower levels. Similar to buying stock, private equity funds often buy a controlling stake and guide the company to grow faster.

We should note that there is another factor that essentially makes this tax increase a mute point. The fact is that many private equity firms are structured in such complex ways such that its LP’s are often under a tax shelter of some sorts.