Mr. Kessler begins his op-ed with an uncompromising claim:

Private equity is done. Stick a fork in it. With Kraft singles and Heinz ketchup as toppings, there are many signs that private equity has peaked as an asset class.

He then moves on to give arguments for why private equity is dead as a doornail. So, let us first summarize Mr. Kessler’s arguments:

• There are too many private equity funds and too much capital chasing too few deals: According to Dow Jones LP Source, 765 funds raised $266 billion in 2014, up 11.7% over 2013. Mr. Kessler believes that private equity is too pervasive, especially with the rise of the Swenson model among large institutional investors.
• Interest rates will rise, whether this year or next year: This will necessarily increase the cost of debt capital for leveraged buyouts.
• Banks are reducing their lending for leveraged buyouts after receiving letters from the Federal Reserve and the Office of the Comptroller of the Currency: Under the terms of this letter, banks are permitted to lend only up to a debt to EBITDA ratio of 6.0 times EBITDA, this limitation is likely to restrict the ability of buyout funds to finance deals.
• The Lee-Rubio tax reform plan will eliminate the interest expense deduction: Leveraged buyouts have benefitted from the ability to deduct interest expenses from taxable income, thus reducing the amount of taxes they pay. The proposed tax reform would eliminate that benefit.
• Private equity is a drag on the economy because it prioritizes cost cutting rather than investing in growing their portfolio companies: Mr. Kessler estimates that it has reduced GDP by between 0.5% and 1.0%.
• Private equity has run out of “fat targets” to acquire: The best companies with cash flows sufficient to pay interest and principal on leveraged loans cannot be acquired. Mr. Kessler specifically cites Apple, Google, Uber, AirBnB, Snapchat, and Pinterest.

With due respect to Mr. Kessler, I believe that these arguments do not lead inexorably to the conclusion that private euqity is done.

Conflating private equity with leveraged buyouts

Before we look at each of the individual arguments, I would like to make one preliminary observation: Mr. Kessler conflates private equity with leveraged buyouts. The term private equity includes strategies as diverse as venture capital (although venture capital tends to be separated out into a separate category by most commentators and industry professionals, and I will follow the same convention here), growth equity, buyouts,1 leveraged buyouts, mezzanine funds, and distressed private equity.

Many of Mr. Kessler’s arguments—particularly those referring to interest and leverage—apply strictly to leveraged buyouts and do not affect other strategies within the private equity universe, which do not utilize leverage. Now, to be fair to Mr. Kessler, I am going to assume that when he speaks of “private equity”, he is referring strictly to leveraged buyouts, and address his arguments only with respect to this strategy.

Too many funds and too much capital chasing too few deals

First, the figure of $266 billion that Mr. Kessler cites refers to the overall amount raised by venture capital, growth equity, leveraged buyout, fund-of-funds, secondary, mezzanine and corporate finance funds, per the Wall Street Journal’s Private Equity Beat. These strategies target different types of companies and often do not compete with each other for deals. Notably, secondary and fund-of-fund strategies acquire limited partnership interests in other private equity funds (the former on the secondary market where they act as providers of liquidity to limited partners, the latter aggregating capital from institutional investors to invest during the fundraising period of other private equity funds). The relevant number to look at in this case would be the amount raised by leveraged buyout funds, which Preqin notes was $72.2 billion as of October 2014 raised by around 118 funds. To put things in perspective, total U.S. targeted M&A, according to Dealogic, was $1.58 trillion as of December 2014.

Even if we accept Mr. Kessler’s assertion that there are too many buyout funds chasing too few deals, and we should consider it seriously given that other industry insiders have commented on this fact, it is not determinative of the fate of leveraged buyouts. The industry has experienced boom and bust cycles before, notably in the early 1990s when both total value and total number of deals fell dramatically in the U.S. The industry will eventually correct itself, with financial sponsors that are unable to raise successor funds exiting the industry. It will be painful for all involved, but it is doubtful that this would kill the leveraged buyout industry.

Interest rates will rise

Interest rates will rise. It will increase the cost of debt capital and the interest payments for leveraged buyouts. All of this is true. It will affect the viability of some deals where the company’s free cash flow (relative to interest payments and fixed charges) is marginal at best.

However, leverage buyout sponsors has operated in difficult interest rate environments before, notably in the 1980s when nominal interest rates were significantly higher than they are now. An increase in the nominal interest rates will not kill leverage buyouts, provided that the operating earnings yields on target companies is higher than the yield on high yield debt.

Banks reducing leveraged lending

Mr. Kessler further notes that banks in the United States are reducing their leveraged lending in response to directives from the Federal Reserve and the Office of the Comptroller of Currency to a limit of 6.0 times EBITDA.

Setting aside the propriety of the Federal Reserve and the Office of the Comptroller of Currency imposing a “one size fits all” limit on leveraged lending, there are two reasons why this measure is not necessarily fatal to the leveraged buyout industry.

First, while this directive applies to financial institutions supervised by the Office of the Comptroller of Currency, the Federal Reserve, and the FDIC, it does not affect other financial institutions that are not regulated by these regulators, such as foreign banks that do not accept U.S. deposits.2 The impact of this will be to change the source of leverage loans by shifting more of it to offshore financial institutions that are not subject to the limits faced by the traditional sources of leveraged financing in the U.S.

Second, the reduction in the ability of regulated banks to provide leveraged lending above 6.0 times EBITDA does not affect the issuance of high yield debt through Rule 144A private placements to qualified institutional buyers (QIBs), provided that the transaction does not require bridge loans from regulated banks to provide short-term financing until the high yield bonds are sold to investors. Now, leverage buyout firms do not like high yield bonds because they offer less flexible terms (limits on prepayments of principal) than leveraged loans. That does not mean that they could not devise methods of financing their deals with a greater proportion of high yield bonds if necessary. At the margins, this might reduce the number of highly levered deals that can be successfully financed, but is not necessarily lethal to the ability of leverage buyout firms to locate successful deals.

Elimination of the interest expense deduction

I am less optimistic than Mr. Kessler that the interest expense deduction will be eliminated by either the Lee-Rubio tax reform plan or some subsequent tax reform plan. While there have been prior proposals to either cap the amount of interest expense that corporations are able to deduct or eliminate the interest expense, it is unlikely that this reform will pass through Congress. The interest expense deduction has been on the tax code since 1918, when it was enacted as a temporary measure to equalize the effect of the excess profits tax imposed during World War I. It was retained after the excess profits tax was repealed in 1921, with no explanation by Congress in the legislative history.3 It weathered the 1986 reforms of the tax code under the Reagan administration. I am skeptical that it will prove any less resilient to the current attempts to reform it.

First, the interest expense deduction has become an entrenched part of America’s tax code and it is relied upon by numerous corporations as they make long-term decisions about their capital structure. Repealing this deduction would have immediate costs to corporations that would have to change their capital structure to reduce their dependence on debt financing. Indeed, it might push debt-laden, capital intensive corporations such as utilities and telcos into insolvency. It would be curious if Congress took such drastic steps while the American economy is still as fragile as it currently is.

Second, an interest expense deduction is a part of virtually every corporate taxation regime in the world. While most jurisdictions have taken steps to limit the abuse of the interest expense deduction, they have not questioned the availability of an interest expense deduction for interest expenses incurred for bona fide commercial purposes. Repealing the deduction—without any other corporate tax reforms that makes America more attractive—could adversely affect the global competitiveness of the United States for corporations, particularly since even jurisdictions with low corporate tax rates such as Singapore and Hong Kong have interest expense deductions.

Third, as a practical matter, the interest groups that would be adversely affected by the repeal of the interest expense deduction are both concentrated and economically powerful.

Fourth, as a report by the Heritage Foundation argues, the interest expense deduction is an offsetting measure to address the fact that interest income is taxed in the hands of the lenders. Assuming that lenders incorporate the amount of taxes that they will have to pay on their interest income into their decision on the appropriate interest rate to charge to borrowers, the tax code will raise the cost of debt financing. The interest expense deduction serves to offset the increase in the interest rate caused by the tax on interest income, and prevents the tax code from altering the decision of businesses on whether to seek debt financing. I am not entirely convinced by this argument, but in light of the first three arguments above, I do not feel the need to rely on this argument to refute Mr. Kessler’s argument that repealing the interest expense deduction is likely to happen.

A drag on the economy

Mr. Kessler also claims that leveraged buyout firms prioritize cost cutting measures over investing for growth. This is a more difficult argument to refute because the data is certainly ambiguous. It is true that leveraged buyout firms frequently engage in cost-cutting measures to improve EBITDA margins. It is not, however, the entire story. In my experience doing mid-market buyouts, leveraged buyout firms pursue growth opportunities in addition to cost-cutting measures and operational rationalizations. These can include assisting the portfolio company to expand from its local market to adjacent regional markets or globally, or guiding the portfolio company to reformulate its strategy to target new markets.

I have no data to show clearly that leveraged buyout firms are not a drag on the economy, but I think the answer is likely to be a more nuanced than what Mr. Kessler argues.

No more “fat targets”

It is true that there are fewer targets for the headline grabbing “mega buyout” category of multi-billion dollar acquisitions. However, while the market for mega buyouts may decline, there are still numerous leveraged buyout firms pursuing more modest mid-market targets that do not make the front pages of the morning newspapers.

The mega buyout space is likely to be moribund for the near future (2015 — 2016) due to expensive valuations and lack of suitable targets. However, this has simply caused larger leveraged buyout firms to seek opportunities elsewhere, whether in mid-market companies or in industries such as infrastructure or oil and gas.