I've seen a lot of lamentation about PE eating the world, but very few people discuss *why* PE got so huge.
PE is popular for one reason and one reason only: taxes. PE generally makes money on a trade called a leveraged buyout (LBO), where they take out a massive loan to buy a company. Because interest on debt is tax-deductible, going debt-heavy increases the take-home profits of the company (this is called a "tax shield"). Because the profits are higher, the value of the company is higher, and the PE firm makes money on their trade.
What this means in practice is that if you run your company sustainably (low debt, lots of assets). You become a target for a PE firm to attempt a hostile takeover of the company, all while claiming (defensibly, actually) to be doing whats in the best interest of the shareholders. So good companies will try to ward off these attacks by taking on lots of debt and going asset light to minimize the value gain a PE firm might have.
In short, both PE ownership and the brittle, debt-heavy nature of the American economy today can be traced to the tax advantaged nature of debt. For reasons I can't quite understand, nobody seems to be advocating for revoking this tax deduction. I can only surmise this is because everyone hates taxes.
Thank you for coming to my TED talk, your take home exam is a short essay on what you think the mortgage interest tax deduction (started in 1913) did to household debt.
> For reasons I can't quite understand, nobody seems to be advocating for revoking this tax deduction.
Why can you not understand why the US would prefer people to be invested in the future of the US?
That's essentially what putting your money into US debt means.
You are in the interest of the US not exploding in the middle of the night.
I do think that the typical 90% debt to 10% equity LBO ratio is toxic and should be regulated down. I can see this incentivizing the types that would put in 10M now to get 100M now - spending that on coke & hookers now, and then hoping the US collapses and they don't have to pay anything back.
Presently I believe if you have a company making $1m profit and the company is owned by investors holding bits of paper classified as debt the whole $1m gets paid out. If they hold bits of paper classified as equity, 21% tax is deducted before paying out.
Investing in US enterprise is good but favouring one type of paper over the other is dubious. If anything you might think the government would want to favour equity holdings as that makes the whole set up more stable in downturns.
> Why can you not understand why the US would prefer people to be invested in the future of the US?
I can understand investing in the future of the US. I add an interest in investing in the present of the US, e.g. wages that support the consumption needs of the populace, including but not limited to food, shelter, health care, and education.
I'd be interested to see where you get your numbers. To my eye, wages for the median worker haven't gone much of anywhere in 20-30 years, while asset prices and other costs have gone up. I'd be happy for clearer vision.
I'm clearly out-of-date on data, as my assertion is more in line with your chart from e.g. 1990 to about 2015.
That said, if I've understood what we're looking at - wages in terms of buying power as measured by CPI, I'd like to admit some other data to the conversation:
1. The series I'm looking at (https://fred.stlouisfed.org/series/OPHNFB) has productivity doubling over the same time that wages went up 10%. You can argue that productivity is going down now, but the gains up to this point appear to have gone somewhere besides wages.
2. As an example, the rent component of CPI has roughly quadrupled over the same time period, https://fred.stlouisfed.org/series/CUUR0000SEHA ... which I take to mean that less is being spent on other components of the CPI. That's a factor in what's available for present needs.
3. As a percent of the population, there are about as many workers as there were in 1980, down 2-5% from the 90s and 2000s. (https://fred.stlouisfed.org/series/EMRATIO)
With wages up 10%, productivity up 100% and rent up 400%, it seems to me that there's a tipping of the balance toward the future rather than the present.
Interest payments reduce profits on both a tax and accounting basis, so the profits are lower with increased debt. Otherwise, for example, Twitter/X would have been massively profitable after Musk acquired it with debt financing. (The interest on that debt is over $1 billion/year, and is a large part of why Twitter/X is struggling.)
When finance bros talk about "interest shields" they forget to include the interest payment in calculating the total cost of the shield. For example, if two companies are identical except that one has equity financing and the other has debt financing, the one with debt financing will always end up in a worse position after accounting for taxes and debt service even though they will pay less in taxes. For companies that wish to remain a going concern, cash flow is more important than effective tax rates. It's possible to survive for decades with a high effective tax rate, but negative cash flow can kill a company in months.
That being said, I agree that allowing for corporate acquisition-debt to be deductible is the factor that artificially props up the entire private equity scam, since they use it to shield debt-funded "distributions" from the their victims and they generally load up their victims with more debt than is actually serviceable (see for example, Toys R' Us).
Hostile takeovers are a very small fraction (single digit percentage) of PE buyouts and have been for a long time.
And if taking on debt were so advantageous in and of itself you would think the executives of these companies that solicit PE buyout offers would just issue the debt themselves and enjoy their increasingly valuable options packages.
For some reason I don't understand, the debt ends up on the balance sheet of the purchased company, not the buyer. That's why the debt repayments can be used as a sort of tax-free dividend.
Because is secured by the company and serviced by the cash flows from the company. Since the debt only exists if the transaction (acquisition of the target company) goes through it is really the company funding its purchase through the issuance of debt.
Btw you can get an SBA loan to purchase a small business. It works exactly the same way, and there are people who raise equity capital plus get an SBA loan to buy and run small companies, in effect they're running a very small PE deal and installing themselves as CEO.
This is only one quarter right. Public companies can also take on a lot of debt.
The bigger reasons are twofold: 1 - the biggest one is that pension funds etc get to avoid the constant vol in stock prices. They get to stick their head in the sand and imagine asset prices not moving around. 2 - the annoying parts of being a public company can be avoided (public eye, some sec regs, constant need to "grow" rather than generate cash).
> your take home exam is a short essay on what you think the mortgage interest tax deduction (started in 1913) did to household debt
If what you describe holds true for mortgage debt, then we would expect the US to be in a uniquely bad position as a lot of other western countries do not have such tax benefits. But if anything, the real estate market in the US is more affordable, compared to the average salary, than in other western countries.
Thank you. This explains the motivation behind companies like Toys R Us deciding to blow their legs off with leveraged buyouts that I never quite understood.
PE is popular for one reason and one reason only: taxes. PE generally makes money on a trade called a leveraged buyout (LBO), where they take out a massive loan to buy a company. Because interest on debt is tax-deductible, going debt-heavy increases the take-home profits of the company (this is called a "tax shield"). Because the profits are higher, the value of the company is higher, and the PE firm makes money on their trade.
What this means in practice is that if you run your company sustainably (low debt, lots of assets). You become a target for a PE firm to attempt a hostile takeover of the company, all while claiming (defensibly, actually) to be doing whats in the best interest of the shareholders. So good companies will try to ward off these attacks by taking on lots of debt and going asset light to minimize the value gain a PE firm might have.
In short, both PE ownership and the brittle, debt-heavy nature of the American economy today can be traced to the tax advantaged nature of debt. For reasons I can't quite understand, nobody seems to be advocating for revoking this tax deduction. I can only surmise this is because everyone hates taxes.
Thank you for coming to my TED talk, your take home exam is a short essay on what you think the mortgage interest tax deduction (started in 1913) did to household debt.