02/14/2012 03:38 pm ET Updated Apr 15, 2012

Private Equity Funds - Neither Job Creators nor Vultures, Just Profit Makers

Even though private equity funds have been around since the early twentieth century and today manage over one trillion dollars' worth of capital worldwide, most people may not have paid attention to them until Mitt Romney chose to make his experience at Bain Capital an issue for his bid to be the next President of the United States. Two questions surround the controversy. Are private equity funds indeed the job-creators that Mitt Romney claims them to be? Are profits generated by private equity taxed at a fair rate?

Mitt Romney bases his job-creator credentials on anecdotal tales of Bain's successes with Staples and Domino's Pizza, among others. His detractors point to a Florida company Dade Behring, which Bain bought using borrowed capital but two years later had to shut down leading to 850 lost jobs in Miami alone. A new academic study shows that between the years 1980 to 2005 private equity eliminated almost as many jobs as they created, what the authors conclude were, "modest net impact on employment."

The nature of creative destruction, which private equities often engage in, will naturally cause jobs to be both created and destroyed. Counting the jobs lost via downsizing is easy but accounting for the number of new jobs created is tricky. Partly because many of the jobs created by private equity firms accrue as a result of a merger or an acquisition. But can such increases really count as job creation? Less controversial is the fact that post-acquisition, target firms often see gains in productivity, which simply means that the firm is able to produce more with fewer workers.

Mitt Romney created yet another furor when he declared, and later his tax returns showed, that he paid a lower tax rate than most others in his income bracket. IRS tax code allows profits from partnerships to be treated more favorably than other forms of compensation. Private equity fund managers typically collect an annual management fee, approximately 2 percent of the capital invested in the fund. If the fund makes a profit, usually above a certain hurdle rate, then managers collect an additional 20 percent of the future profits. This method of compensation, often called the "two and twenty" rule, allows the partners to convert labor income into capital gains, which are taxed at a lower rate. Not illegal, but certainly raises eyebrows.

A New York University Law Review paper contends that this method of compensation is "untenable" mainly because it is an "economic distortion." The current law needlessly advantages partnerships over corporations. A second concern,

"(it) allows some of the richest workers in the country to pay tax on their labor income at a low effective rate."

On the whole, private equities are not "vulture capitalists," as Texas Governor Rick Perry misguidedly called them. Private equities, along with public investment banks, play a significant role in ensuring that our capitalist system to continues redirect economic resources to their most productive use. Private equities by incubating companies to success and rescuing firms in distress are an essential lubricant in our economy.

To characterize private equities as "job creators" is also an over-exaggeration. The goal of any capitalist venture is not to "create" jobs but to maximize value for their shareholders. But in pursuing legitimate business interests, public equity managers receive special tax treatment, which ought to be an anathema to free market purists. This government subsidy gives extra help to those people who need them the least. Moreover, the lucrative financial incentives at private equity are likely to lure the best and the brightest to become financiers rather than inventors and entrepreneurs, thus in the long run discouraging innovation and creativity.

Almost a decade ago, William Greider in his book, Soul of Capitalism, lamented that even when our market based economy works as intended, it generates,

"greater maldistribution of assets and incomes and, not coincidentally, imposes on most citizens the sense of loss of self-sufficiency and independent control over one's destiny."

Setting aside the politics, the attention on private equity ought to spark a greater debate about economic fairness and efficiency. It appears that over the last two decades the system has become lopsided so as to leave the 99 percent feeling helpless and hopeless. Meanwhile special interest groups continue to rig the system disproportionately in favor of the 1 percent.