ICYMI // WSJ: Warren Would Destroy Private Equity – at Everyone’s Expense

Ms. Warren’s legislation would hold private-equity firms, but not other investors, responsible for the liabilities of the companies in which they invest, “including debt, legal judgments and pension-related obligations.” No other shareholders in the U.S. have to take on such liabilities. This excessive legal and financial exposure would dramatically reduce the incentive for firms to invest in struggling businesses. Ms. Warren would additionally ban dividends for two years after a private-equity firm buys a company, forcing the firms to tie up their investors’ funds for longer and reducing their returns.

The senator is trying to set private equity up as a boogeyman to fear. Nothing could be further from the truth. Private equity is an overwhelmingly positive component of the free-enterprise system. It generates value for investors while creating jobs and wealth for a broad spectrum of individuals and entities.

I have personal experience with the benefits of private equity as a former chief executive of CKE Restaurants. After the financial crisis crashed the stock market, CKE needed to de-emphasize quarterly earnings and focus on building the business, something the public market often punishes. So we explored the possibility of going private.

We launched a competition among potential strategic buyers, including private-equity firms, to get the best value for our shareholders. The highest offers invariably came from private-equity firms. In July 2010, we accepted one of those offers and took the company private. Over the next three years we were able to expand the company, create jobs, lay the groundwork for growth, and sell the company to a second private-equity firm. Our shareholders, employees, suppliers, franchisees, lenders and management all benefited, along with the investors.

CKE’s positive experience is much more the rule than an exception. Private-equity firms invest in businesses they see as undervalued or underperforming if they believe they can add value. This could be by bringing in new management, improving a product, promoting or manufacturing it more effectively, or reducing administrative costs. It could be by increasing the number of employees if the business is understaffed or decreasing it if the business is overstaffed. The objective is to create a stronger, more profitable and more efficient company that the owners can sell at a profit.

While banks tend to invest in relatively sure bets, private equity firms take risks, sometimes big ones, on businesses they believe have greater potential than current performance suggests. These are usually long-term investments of three to seven years, as it takes time to create value in an underperforming business. Private-equity investors need high returns to compensate for the risk involved, and because they tie up their backers’ funds for long periods in illiquid assets.

Ms. Warren’s private-equity plan is like all her other schemes—likely to hurt the people she claims to be helping. The U.S. Chamber of Commerce assessed the plan in November, and as part of its background research, it found that returns from private-equity firms “typically outperform other investments.” As a result, approximately 60% of private-equity investors are employee pension funds, foundations and university endowments. Pension funds alone have at least $149 billion invested with private equity, and would lose as much as $3.4 billion annually if they had to switch to lower-yield investments.

As with any investment, the price of superior returns is increased risk. Because the survival of every private-equity firm depends on its ability to manage risk, they always face potential failure. Ms. Warren has cited the Toys “R” Us bankruptcy to vilify private equity. In that case, the investors believed they would be able to reposition the company to withstand competition from discount stores and online retailers, and they saddled it with too much debt. They severely underestimated the headwinds Toys “R” Us faced, and they paid the price by losing money on their investment. That was always a risk.

On the other hand, the goal is always growth and value creation, not bankruptcy. Once bankruptcy becomes the best choice, it means the investment failed. If a private-equity firm has too many failures, its reputation will suffer, no one will invest with it, and no one will lend it money to finance investments. The market corrects itself fluidly and quickly.