private inequity

Earlier this week, I watched the documentary Page One about the inner workings of the New York Times and the dire financial difficulties daily newspapers face to survive.  It’s a great movie. It’s also a very depressing movie. Journalism is one of my passions. Every year, I lecture at the journalism schools of UC Berkeley and Northwestern, and I believe an informed citizenry is vital for our country’s economic and cultural wellbeing. That’s why it’s so disturbing to see newspapers dying all over the country while glib, superficial, and often politically slanted outlets like Gawker and the Huffington Post thrive.

The movie also touches on another depressing trend in American business–the “strip and flip” mentality of too many private equity firms, and the warped way our tax system aids and abets these destructive behaviors.

As Page One recounts, Sam Zell and his firm used a leveraged buyout to take over the Tribune Company in late 2007. In a single year, they reduced that venerable and extremely important news institution to a smoldering ruin. Any normal executive who mismanaged a company that severely would feel a sense of shame or personal responsibility. But private equity moguls like Zell play by different rules. Soon after the buyout, he and his minions paid big bonuses to themselves. That’s usually the first priority for corporate raiders. They “strip” their new purchases of cash and quality assets. The only silver lining in this sad story is that the Tribune Company went bankrupt so quickly after the financial crisis that Zell wasn’t able to “flip” its hollowed out carcass to investors via a fire sale or an IPO.

I’ve never met Zell. But in the movie, he comes across as a pompous, arrogant jerk. He mocks journalism and journalists, and seems to relish the idea of gutting the newsrooms at the once respected Chicago Tribune and Los Angeles Times. It’s sickening to watch. The man obviously has no respect for the business he bullied his way into, or the people who worked for him.

Let me be clear. Private equity takeovers are not always bad things. Often, private equity firms force needed restructurings that save companies from bankruptcy. But the Tribune mess highlights a glaring problem with LBOs:  they are the product of huge amounts of borrowed money. That benefits the banks and Wall Street brokerages that facilitate the deals, but it can lead to mass layoffs and bankruptcy if the restructured company fails. My largest investor is a longtime Silicon Valley venture capitalist. He sums up the difference between his business and private equity nicely. When VCs make successful investments, jobs are usually created, sometimes lots and lots of new jobs. When private equity owners succeed in their endeavors, the opposite is usually true. Because of all that leverage, jobs are almost always lost, not gained–and that’s in the best case scenario. If a buyout backfires, as in the Tribune Company example, a whole slew of jobs go down the drain.

But that isn’t the worst part of the private equity game. The worst part is that our tax code perversely encourages corporate raiders by allowing them to deduct the interest on the “L” in their LBOs–the massive leverage that fuels most takeovers. I have always felt that interest should be a “below the line” expense, meaning it should be paid with after-tax income, not before-tax. That would raise the cost of borrowed money, which would make many private equity deals prohibitively expensive. By that same token, as I’ve written before, I agree with many savvy economists who advocate for eliminating the mortgage interest deduction for individuals. It does very little to help the economy and It also overwhelmingly benefits the wealthy (most middle class homeowners don’t make enough to itemize their deductions). I say interest–all interest–should never be deductible. That might prevent economically unproductive LBOs and slow excessive borrowing by purchasers of higher end homes.

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