Elizabeth Warren’s Private Equity Plan May Harm Public Employees

Last week, Sen. Elizabeth Warren (D-MA), a 2020 presidential candidate, proposed a plan to rein in private equity funds that engage in leveraged buyouts—acquiring companies with large amounts of borrowed money. Although the idea of cracking down on financial engineering is attractive to many, it could have the unintended consequence of lowering asset returns for public employee pension funds, thereby jeopardizing retirement security for teachers, police officers, firefighters and other government employees and/or increasing local sales and property taxes to make up for the lower returns.

Sen. Warren’s plan would reduce the ability of private equity funds to collect fees from the companies they acquire and lower the amounts they could recover in the event of a bankruptcy filing. It would also impose new reporting requirements on buyout funds and eliminate the carried interest deduction that allows private equity fund managers to pay income taxes at lower capital gains tax rates. The cumulative result would be to make leveraged buyouts far less profitable, sharply curtailing this activity.

Warren and her supporters argue that leveraged buyouts are a form of looting by Wall Street bankers: they load up companies like ShopKo, Sears and Toys R Us with unsustainable amounts of debt and drive them into bankruptcy, extracting exorbitant fees and destroying jobs in the process. Opponents of the Warren proposal argue that leveraged buyout funds are trying to shake-up companies that are already troubled, potentially saving them from liquidation.

But whatever its merits, Sen. Warren’s plan would be disadvantageous to the many large public employee pension systems that invest in private equity funds. Due to widespread pension underfunding and rock bottom bond yields, funds have been stretching in search of better returns in recent years. Although the stock market has done well, many pension fund managers do not believe that it can reliably return the 7-to-7.50 percent annual growth rates targeted by most public pension plans. As a result, pension fund managers have been turning to so-called alternative investments, of which private equity funds are the most prominent.

Union activists and other progressives may be disappointed to learn that public pensions invest in leveraged buyout operators, but this is a byproduct of earlier policies. State and local governments increased pension benefits while skimping on the pension contributions needed to fully fund those retirement promises. To bridge the resulting gap, pension system asset managers have found the need to invest in high-yielding investment vehicles that Warren and her supporters decry.

Pension systems could reduce or eliminate their reliance on private equity investments if their return targets were lowered. This would require governments and public employees to increase their pension contributions or adjust benefits. The federal government could foster this transition by requiring public employee pension funds to use conservative discount rate assumptions, just as it required private pension plans to do under the Employee Retirement Income Security Act of 1974.

Lower target rates of return would potentially allow pension funds to move more of their assets into high quality bonds. Such a transition would make even more sense if the Federal Reserve would finally withdraw the extra liquidity it pumped into the banking system during and following the 2008 financial crisis. This would allow interest rates to return to more normal levels, making investment grade bonds a more viable option for pension funds. While the Federal Reserve is nominally independent, President Trump is pressuring Chairman Powell to lower rates, juicing the economy ahead of the 2020 elections.

Although Warren’s advocacy of debt forgiveness suggests a preference for borrowers over savers, maybe she could pleasantly surprise us by advocating for better returns on investment grade bonds along with more prudent management of public employee pension assets. Those policies would go a long way to ameliorating the risks posed to public employees and local taxpayers by her efforts to rein in private equity.

This commentary originally appeared on the California Policy Center website.