Financial engineering is one of the worst ills perpetuated by the Fed’s regime of cheap debt and money market subsidies for speculation. And these deformations are turbo-charged by the tax code which creates a powerful bias toward loading capital structures with tax deductible debt, and to delivering returns as lightly taxed capital gain rather than ordinary income.  In fact, stock buybacks and LBOs are the bastard offspring of the IRS and Federal Reserve.
Indeed, it would be safe to say that in an honest free market with a neutral tax regime, LBOs in particular would be as rare as a white buffalo. That’s because they inherently cause waste, inefficiency and malinvestment—–the opposite of market driven results. These deadweight losses to society are, in turn, the product of a symbiotic arrangement of convenience between an atavistic breed of money manger——private equity funds—–and institutional investors, such as pension funds and insurance companies, which have a desperate need for yield in a financial system where returns on conventional fixed income securities are systematically repressed by the central bank.
Private equity managers are tax-enabled speculators. Their winnings come in the form of a 20% carried interest on the thin slice of equity at the bottom of an LBO capital structure. The 20% share of the return earned by the limited partners (LPs), who actually put up the money and bear the extreme risk of being pinned under a mountain of debt, might arguably be considered generous. But there is no way that it should be considered a capital gain. It is nothing more than the service fee earned for managing other people’s money.
Needless to say, the taxation once over lightly of carried interest winnings as capital gains creates a humungous incentive to swing for the fences, thereby exacerbating the inherent risk asymmetry of the LBO business model. In short, carried interest driven private equity managers loose nothing on bad bets——100% of the losses go to the LPs. But 18% of what are often massive upsides in winning deals go to the titans of private equity on a tax free basis (i.e. 80% of 20%).
