LBO Chop Shop
Carried interest, in particular, is clearly a loop hole written into law by the Private Equity industry, for the Private Equity industry. If they wish to be taxed at capital gains rates, then they should invest as LPs. This area is clearly indefensible, but I don't anticipate it changing.
Second is the financial engineering that comes with that tax benefits of leverage. If one is to have a tax on corporations, then there's a good argument for making interest payments on debt tax deductible. Better, though, to stop taxing corporations altogether.
Third, there is Epicurian's defense of the infamous dividend recap, where the PE firm takes cash out of the company as a dividend, and lets the firm take on more debt. If the firm goes bankrupt, the PE company keeps the money they extracted earlier.
One more wrinkle is worth discussing. This is the relatively recent phenomenon of financial sponsors borrowing additional debt through their portfolio companies during the life of their investment, and using the proceeds to pay equity dividends to themselves and their limited partners. These are known as dividend recapitalizations, or “dividend recaps.” Often, financial sponsors can use such recaps to withdraw money equal to or even in excess of their initial equity investment. This leaves the portfolio company with an increased debt burden and the financial sponsor playing with house money. Many people outside the industry, including our friends Messrs. Kwak and Surowiecki, don’t like dividend recaps, because it loads up the portfolio companies with risky debt while appearing to reduce private equity’s skin in the game. This is very true.Epicurious fails to mention whether the lenders in question get paid when they make the loan, or when the loan gets paid back.
However, having participated in or observed a number of such deals, I must strenuously disagree with Mr. Kwak’s contention that the lenders which participate in such transactions are unsophisticated dupes. They lend with eyes wide open, and an impressive amount of company-specific due diligence. Normally, a company is able to take on a bigger debt load because the financial sponsor and company management prove to new lenders that they have improved the company’s earnings power and free cash flow enough to sustain it.