Q&A: Private-equity returns and the Carlyle Group
By Thomas Heath,
Steven Kaplan, professor at the University of Chicago Booth School of Business, has done extensive research on private-equity returns. He spoke with The Post about the week’s news from the Carlyle Group.
What did you think of the compensation and share of the profits paid to the three founders of the Carlyle Group, and did they deserve it?
Obviously, $400 million — the amount the founders earned — is a large amount of money.
But they earned it because compensation is heavily tied to performance in private equity.
Carlyle returned at least $15 billion to its investors this year. The $15 billion represents the [very successful] performance of Carlyle’s investments in companies over the last five to 10 years.
And $400 million is less than 3 percent of the $15 billion. In years that Carlyle does not return money to its investors, like 2009, the founders earn far, far less.
My guess is that the investors in the Carlyle funds are extremely happy with the returns they have received this year even after paying the fees.
Discuss the private business model by which people can earn that kind of money.
The big investors in private equity are pension funds and endowments. In Carlyle’s case, those investors include the Maryland State Retirement and Pension System, the New York State Teachers’ Retirement System and Calpers [the California Public Employees’ Retirement System]. When private-equity fund returns are strong, a lot of pensioners and workers benefit.
Private-equity funds take this capital and use it to buy companies. When the private-equity funds buy the companies, they often use leverage, hence the common name of leveraged buyouts. These days, the leverage is usually on the order of 60 or 70 percent of the purchase price — less than the leverage in most home purchases.
The private-equity funds then work very hard to increase the value of the company. Usually, this involves looking for ways to increase the growth of the business as well as cutting costs. If the values of the companies increase, the private-equity fund and its investors will make money (when the companies are sold). If the values decrease, the private-equity fund and its investors lose money.
Private-equity funds receive an annual management fee on the money invested. For large funds, this is usually 1.5 percent per year. In addition, private-equity funds typically receive 20 percent of the profit of their investments. The founders earned so much this year because they had an unusually profitable year. (It is worth adding that funds get this share of the profits only if their investors earn at least an 8 percent annual return.)
Overall, the performance of private-equity funds has been very strong over the past 20 years. On average, each dollar invested in one has returned 27 percent more than that same dollar would have earned in the S&P 500 or other public-equity fund.
Please explain carried interest and why it is taxed at a lower rate than income tax.
The carried interest is the 20 percent share of investment profits I mentioned above. It is taxed at capital gains rates rather than ordinary income tax rates. That has been the case for a very long time.
There is a lot of debate about whether this is appropriate. Some argue that carried interest is compensation and should be taxed as ordinary income.
The counterargument is that the carried interest represents an investment return and should be taxed like other equity investments. If the carried interest were taxed as ordinary income, I think it also is likely that private-equity firms would be able to avoid much of the tax increase by restructuring the carried interest into equity investments.
Who invests in private equity and how does it work?
As mentioned above, the big investors in private equity are pension funds and endowments.
Do private-equity firms create jobs, destroy jobs or neither?
The best empirical evidence says the answer is that private equity both creates and eliminates jobs. After a buyout, employment in existing operations tends to decline relative to other companies in the same industry by about 3 percent. (This may mean employment actually grows, but just by less than at other companies). At the same time, employment in new operations tends to increase by more than other companies in the same industry by more than 2 percent. Net job losses were relatively greater in retail buyouts. This is not surprising, given that Wal-mart and Amazon have put a great deal of pressure on retailers over the past 20 years. If retail buyouts are not included, it is likely that net employment growth was positive. In other words, there does not seem to be a large net employment effect. That is not to say, however, that some people do not lose jobs. The overall pattern suggests that private-equity firms make firms more productive. They make cuts or grow more slowly when that makes sense, and they invest and grow more quickly when that makes sense.