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Private Equity: Can't We Have the Good Without the Bad?

David Callahan

The best defense of private equity is that this industry does both good things and bad things.

Sometimes private equity firms rescue troubled companies, pump in new capital and management talent, and make them better and more productive -- saving or creating jobs along the way.

Other times, though, today's LBO artists buy companies, load them with debt, suck them dry, and accelerate their path to bankruptcy. The bad things private equity firms do are pretty bad; just read Josh Kosmen's book, The Buyout of America.

That private equity is a mixed bag seems to be the consensus of academic scholars who have closely studied this industry, as discussed today in a Times background story by Julie Creswell. The ever balanced Matt Miller made pretty much the same point in a piece yesterday in the Washington Post.

Should the two-faced nature of private equity make us all feel better? No. On the contrary, this shows the essential problem with today's financial sector: Practices and products that can play a productive role in the economy can also play a destructive role. Derivatives, of course, have become the most famous example. Once upon a more innocent time, derivatives were mainly used by those in the commodities world to hedge against price fluctuations. Then, in the age of the greed, they were increasingly used as casino chips -- and became, ultimately, what Warren Buffett called "financial weapons of mass destruction," helping to bring down the U.S. economy in 2008.

So, too, with leveraged buyouts and corporate debt. In an ideal world, these are great tools for creating a more productive economy: Borrow money, buy an underperforming company, use more debt to invest in that company, create a better company that employs more people, and then sell it or pay down the debt with higher profits.

And often enough things go that way. But, because we don't live in an ideal world, often they do not -- as profit hungry financial engineers engage in a far less savory game.

Private equity is a fair target in this election because Americans are rightly tired of enduring the downsides of the financial sector. If we learned anything from the crisis of 2008, it's that the instruments of modern finance are too powerful to be a mixed bag. The meltdown of the MF Global and the huge trading loss of JP Morgan have been other reminders of how, when things go wrong, they can go very wrong.

The ultimate goal of Wall Street reform should be to force the financial sector to stick with good practices. What we need is a much smaller, more boring, and -- yes -- less profitable financial industry. It may sound "anti-business" to say that Washington needs to downsize finance, but actually business will do a lot better in an America where Wall Street risk-taking doesn't periodically crash the economy and where Wall Street firms don't firms don't scoop up all the brighest young college and MBA grads and harness their talents to structuring debt deals and whatnot.

Private equity is one corner of finance that needs to change, but which so far has escaped much scrutiny. Reining in this sector, so it focuses just on truly productive behavior, would involve a number of steps -- such as changing the tax treatment of debt and closing the carried-interest loophole that makes private equity so profitable. So far, few politicians are offering a clear reform agenda to stop the "vampire capitalism" of private equity firms. But we need such an agenda.

Which is one more reason it's good to be having a debate about Bain Capital.