joseph stiglitz Win McNamee/Getty Images

The private-equity industry has been extracting wealth from the US economy for investors at the expense of the American economy for too long.

The private-equity industry is too secretive, loads takeover targets with too much debt, and pushes companies to lay off too many workers.

Given the problems with private equity, Congress is right to try to crack down on the industry with the new Stop Wall Street Looting Act.

Joseph E. Stiglitz was awarded the Nobel Prize in Economics in 2001. He is a professor at Columbia University, and his most recent book is „People, Power and Profits: Progressive Capitalism for an Age of Discontent.“

Joseph E. Stiglitz was awarded the Nobel Prize in Economics in 2001. He is a professor at Columbia University, and his most recent book is „People, Power and Profits: Progressive Capitalism for an Age of Discontent.“ Visit Business Insider’s homepage for more stories.

Over the past decade, a large body of research has confirmed what many of us have long suspected, namely that American capitalism is a far cry from the textbook model of a competitive, efficient economy. Instead, the United States is now home to far too many of what economists call „rent seekers.“

These are economic actors who take advantage of others through market power, through individual vulnerabilities, and through inside or unequal information. They grab an unfairly large slice of the pie at the expense of other people, rather than adding to the nation’s wealth.

Markets where rent-seeking is prevalent are neither efficient nor fair, and they help explain America’s increasing inequality and weakening growth.

One of those rent-seeking sectors is finally getting the attention it deserves: private equity.

The private-equity industry has exploded in size over the past two decades, from $700 billion in global assets in 2000 to $5.8 trillion in 2018. In the US, it now controls 8,000 companies, more than twice as many as are traded on public markets. This all came about without any debate over whether this immensely influential industry is playing by the right rules.

As they stand, the rules ensure that private-equity barons win, no matter who else loses. Of course, not all private-equity players are exploitative. But even the good actors play on a field advantageous to them, as they exploit rules that create opacity, prevent accountability for their harmful effects, and preserve unjustifiable tax advantages.

Reining in the private-equity industry

Legislation introduced this summer by US lawmakers, including Sens. Elizabeth Warren, Bernie Sanders, Sherrod Brown, and Tammy Baldwin, and Reps. Mark Pocan and Pramila Jayapal, proposes at long last to change that.

Now, from the presidential campaign trail in Iowa to the financial press in New York to Washington policy wonks, we are discussing this set of new answers to how we address abuses in private equity that have turned parts of this massive industry into straightforward wealth extractors, not creators.

Start at the beginning of the life cycle of a private-equity fund with the investors who entrust their money to firms that promise them a healthy return. Markets deliver efficient outcomes if there is transparency. Behind a cloak of secrecy, exploitation can run rampant.

The allocation of capital can be efficient only if both investor and asset manager have credible information about the track record of the private-equity firms and their portfolio companies. Alas, even some of the most sophisticated investors on the planet — pension funds, university endowments — can’t obtain that data from private-equity firms.

For example, the industry’s preferred metric, the internal rate of return, is notoriously prone to manipulation. Private-equity firms often exclude money they have not yet invested when calculating a rate of return. But they will not hesitate to include that money when calculating the management fees that make the business particularly lucrative, regardless of how successfully executives invest. In the market for dollars that private equity raises, the information investors have to go on is simply not clear.

The bill introduced this summer, the Stop Wall Street Looting Act, would bring a measure of standardization and transparency for the benefit of investors by creating standard, annual, disclosures that would allow comparison shopping.

The bill would also ban efforts by private-equity firms to contractually squirm out of the fiduciary duty they owe investors, an all-too-frequent phenomenon. And it would curb fees charged to portfolio companies that are added on to the fees charged for fund management and performance often for nonexistent services, to dodge taxes.

The private-equity debt problem

Then there is the debt. Private equity’s business model is built on acquisitions via debt — 70 or 80% is not unheard of. And Wall Street banks provide this debt in a way that creates perverse incentives. Banks lend the money for private-equity firms to acquire target companies, and then turn the loan into securities they sell to other investors, leaving the bankers with no stake in the outcome.

And when the company acquired by the private-equity firm is loaded with debt, private-equity firms can fire workers and sell assets to pay it down debt and generate capital for distribution to the owners — themselves. This problem is not theoretical; it’s exactly what happened at retailers such as Toys R Us, Sears, and Shopko.

The new proposal would introduce a suite of changes to combat this practice including a limit to the tax deductibility of debt and a requirement for banks that finance these deals to retain a portion of the loans they underwrite.

Crucially, the Stop Wall Street Looting Act would extend the liability for the obligations of a target company to the private-equity firm itself, ensuring that the private-equity executives are on the hook for some of the risk created by loading a takeover target with debt, and do not simply reap the rewards.

Private-equity benefits from an even more outrageous provision called „carried interest,“ whereby managers in these enterprises are taxed on their returns from managerial activities at the very favorable capital-gains tax rate, about half the rate that those engaged in other managerial activities or workers are taxed. This is not only unfair, but it encourages the growth of these nontransparent exploitative enterprises. That would end under this bill.

Stopping the destruction of jobs

Finally, a recent study by groups including Americans for Financial Reform found that private-equity bankruptcies in the retail industry alone cost 600,000 jobs. One of those laid off, Giovanna De La Rosa, told of her experiences in this publication. The best outcome would be fewer bankruptcies, but when they happen, the welfare of workers needs to be at the top of the list, not at the bottom.

Private-equity cannot simply reap the rewards of cost-cutting and let others bear the dislocations in the lives of the workers and the communities in which they operate. So the legislation would tweak bankruptcy laws to improve the treatment of worker severance, limit executive payouts, and favor purchase offers that preserve employment.

What enables a market economy to serve American society is informed competition with a fair set of rules where decision makers bear the full consequences of their actions. A system in which private equity can hoodwink investors, rely on debt to fund acquisitions — raised by banks that pass the risk on to others — and then extract wealth from viable going concerns, is a far cry from a just market economy. It is a creation of already rich Wall Street financiers who win even if everyone else loses.

If private equity is to work to the benefit of all stakeholders, then Congress needs to demonstrate the same talent for making markets work that bad actors on Wall Street have shown for sabotaging them.