How Stephen Schwarzman became private equity’s designated villain.

...

Despite the 1987 crash, the ensuing collapse of the junk-bond market, and the recession, the nineteen-nineties were the beginning of a golden age for private equity. As with leveraged buyouts, the power of private equity, and the wellspring of its remarkable profits, is leverage—the use of borrowed money. The private-equity fund raises capital from rich investors, often pension funds or large institutions. (The fund is “private” in that only invited investors are allowed to participate.) It uses the capital to buy an asset, typically a publicly traded company or a unit of a publicly traded company; restructures it financially to add layers of debt; manages it aggressively to cut costs and boost cash flow; then, after five to seven years, pays off the debt and resells the company or relaunches it on the public markets at an enormous profit. The power of leverage is vast: if you invest ten dollars in an asset and sell it a year later for twelve, you have earned twenty per cent. If you invest one dollar, borrow nine, pay a dollar in interest on the debt (an eleven-per-cent rate), and sell the asset for the same twelve dollars, your return is one hundred per cent.

Much as private-equity firms like to extoll the brilliance of their M.B.A.-holding partners and associates, this isn’t a difficult concept, which raises the question of why public companies don’t embrace the same high-leverage, high-profit model. The reason is that private-equity funds exist to generate capital gains, which are taxed at fifteen per cent; public companies focus on earnings, which are taxed at a much higher rate. Public companies are typically valued at a multiple of earnings, and the interest payments associated with high leverage may all but eliminate earnings. Private companies don’t report earnings. Freed from any preoccupation with quarterly earnings reports, private-equity firms like to praise their long-term perspective, but “long term” means between five and seven years, at which point they sell the asset to realize a capital gain and move on to new conquests. Most public companies are managed so as to exist in perpetuity. Even so, in recent years public companies have added huge amounts of leverage to their balance sheets, often by buying back their shares or taking on debt for acquisitions.

In addition to the turbocharging effects of leverage, private-equity operations like Blackstone benefit from an exceedingly generous compensation structure. The private-equity manager takes a management fee—two per cent is common—of the capital raised from the firm’s investors and twenty per cent of all gains (a stake known as “carried interest”), under the formula known on Wall Street as “two and twenty.” What’s left over is returned to the investors. The fees have no relation to the size or sophistication of the deal or the hours worked. Private-equity bankers reap the same twenty-per-cent carried interest on a multibillion-dollar deal as on one involving several million. A few firms have pushed higher, to twenty-five- and even to thirty-per-cent carried interest, but few have been willing to undercut the standard. Investors have tolerated the exorbitant fees, as long as they have been able to get results that surpass what they can earn in conventional stock and bond funds. ...

---

The New Yorker