How Private Equity Firms Would Deal With a Tax Hike

How much did Steve Schwarzman’s fabled birthday party really cost? Whatever estimates you’ve seen, they probably aren’t high enough.It’s highly unlikely the estimates include a cost incurred directly as a result of the party: the funding of the Private Equity Council, a lobbying group hastily assembled after the lavish celebration shed a spotlight on the riches generated by the private equity industry, and ushered in congressional efforts to revoke favorable tax treatment. Are such efforts a tempest in a teapot?Based on several conversations conducted on background, it is evident that most of the private equity players we spoke with consider the possible hike in taxes an annoyance but not a fatal blow to the industry, partly because they expect to quickly figure out a way to circumvent the new levies.“Lots of smart people will work day and night to develop ways around the change,” one said.Although few firms would cut back on their investments, there might be some change in the mix of preferred or common stock allocated to the general partner and, at the extreme, some might go offshore. All, though, are unhappy to have been transformed into “most overpaid” from “most admired” overnight.The private equity players are hoping that public sentiment will be swayed by analyses such as a recent study of the top 2006 transactions by Ernst & Young. The accounting firm reports that companies managed by private equity concerns produced better growth in enterprise value than the average public corporation. Though this outperformance benefited from higher leverage and the ability of sponsors to pick and choose their targets, the firms also generated better organic sales growth and improved efficiency. Contrary to the widely held perception that such firms slash work forces to generate profits, employment was the same or higher in 80% of the companies reviewed.Because of such achievements, the private equity firms have profited handsomely. Most are paid a flat management fee of 1% to 2% of fund assets, and receive a percentage, normally 20%, of the increasing value of the fund’s portfolio.The lesser flat fee is taxed as ordinary income. The 20% is called “carried interest,” and it is the subject of the current tax dispute. When an asset is disposed of, and the resulting profit distributed, the 20% retained by the firm is taxed as a capital gain, or at 15%. Here’s the question: Is “carried interest” a capital gain, or is it income?Most private equity participants argue that it is a capital gain. The Private Equity Council’s Robert Stewart points out that all publicly traded partnerships — those investing in oil and gas, real estate, or mining, for instance — have been allowed since 1987 to treat carried interest as capital gains. He argues that their ownership interest is based on their partnership agreements, and does not depend on monies invested. He likens it to a situation in which two brothers team up with their parents to restore a house for a profit. The house is bought by their parents while the work is done by the brothers. When the job is complete, and the house is sold for a capital gain, each party walks away with part of the gain by way of compensation. Each party’s profit is taxed as a capital gain, even though the sons did not invest a penny in the house, but only their labor.The managing partner of Inter-Media Partners, Leo Hindery, refutes this interpretation. He has been a private equity participant since 1988, and currently runs funds totaling about $750 million. He says: “There are millions and millions of people running things for other people in this country. They are paid base compensation and a performance fee or bonus. All of them are paying ordinary income tax. Our group of managers, numbering in the thousands, is paying 15%.”He raises the “capital at risk” issue. “There is no investment by me,” he says. “I just manage the asset. There is no loss potential. Capital implies ‘could lose.’ That’s the idiocy of the situation. When, in 2003, the capital gains rate was cut, no one cut their fees. If the business model really was based on tax treatment, someone should have cut fees.”Mr. Hindery has been called a traitor by some of his colleagues, but in truth many in the industry are today more worried about tightening credit markets than about a change in tax treatment. Some point out that in 2010, the capital gains rate reverts to 20% when the Bush tax cuts expire, so the impact will be dulled in any case.Today, Congress is considering two bills. The first, introduced by Rep. Sander Levin in the House (along with Rep. Charles Rangel and others), would change the treatment of publicly traded partnerships in all areas — including real estate, hedge funds, and oil and gas. The second, proposed by Senator Baucus, a Democrat of Montana, and Senator Grassley, a Republican of Iowa, would apply only to financial partnerships, excluding real estate, oil and gas, and ethanol (Iowa: Get it?).It seems probable that the narrower view will be more palatable as we approach an election year. Congress will not want to alienate quite so many constituents as would fall under the broader House bill, or wind up further weakening the battered real estate industry.If the rules are changed, what other consequences might there be?“The argument that capital will flee from PE if the tax rate changes is laughable,” one player says. However, he suggests that the large brand-name firms such as KKR and Blackstone will likely raise their fees. The major limited partnerships “desperately want to invest with brand names so, in the end, after a lot of barking, they will pay the higher fees,” he says. “The result will be that the mega players will come out whole and their investors [often representing pension funds and other public entities] will earn less. The firms that will be hurt will be the middle market PE funds that don’t have the brand name cache.”Our view? The private equity industry has been an effective goad to publicly owned companies. It has been appropriately critical of the short-termism of Corporate America and has made American companies more competitive. Going forward, we doubt that private equity returns will match those in recent years, as the cost of debt is rising, the amount of money chasing targets has increased enormously, and the multiples being paid for publicly traded companies in attractive sectors have increased. Also, industry profit growth may slow. Less favorable tax treatment will further dampen the profitability of the industry.Overall, these very sharp operators will have to scramble to maintain their incomes, and we have no doubt they will do just that.peek10021@aol.com

How Private Equity Firms Would Deal With a Tax Hike

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