Attack on Private Equity — Politics or Probity?

Attack on Private Equity — Politics or Probity?


With only two months left before voters cast their ballots in this year’s presidential election, Republican nominee Mitt Romney’s former firm, Bain Capital, is back in the headlines along with about dozen other private equity firms — this time over tax strategies.

Questions surrounding the tax treatment of income have dogged the private equity industry for years. The latest twist on this theme, however, is slightly convoluted: According to news reports, New York’s Democratic attorney general is looking at whether firms like Bain, TPG Capital and Kohlberg Kravis & Roberts, converted one form of income into another, which would carry the lower tax rate.

It all boils down to the fact that a typical private equity fund — like venture capital and hedge funds – charges its investors two separate kinds of fees. The first is the management fee, typically around 2 percent, which is levied to cover the firm’s overhead expenses and keep the lights turned on and all the employees paid. This is taxed as ordinary income. The second — which generates the lion’s share of returns for investors – is what is known as “carried interest.” This is what all the fuss is about. Carried interest is a kind of incentive fee, payable to Bain when it generates profits for its limited partners, and typically hovers around 20 percent of whatever those profits are once a certain threshold has been crossed. (Some very successful hedge funds charge much higher “carries,” with Steve Cohen’s SAP rumored to have asked its investors to pay it as much as half of all profits on some of its funds.)

The kerfuffle? New York Attorney General Eric Schneiderman, who has ties to the Obama administration, is probing a tactic used by some of the largest private equity funds. Many of them don’t need to use all of the management fees to cover their costs — their funds are large enough (in the billions of dollars) and they have enough in the bank to keep operating without needing the 2 percent or so they collect each year. So, some of the financial wizards toiling within the buyout firms (or their equally wizardly accountants) thought to themselves, hey, why not take that fee income and divert it into investments? That way, when the investments pay off, the taxes owed will be at the current federal capital gains rate of 15 percent, rather than the top bracket of 35 percent on ordinary income.

Schneiderman, whose office has subpoenaed documents from a cluster of the top private equity shops (including Bain) may have a tough time making his case, however. It’s certainly arguable whether carried interest should be taxed at the capital gains rate; after all, the investments made by a buyout firm aren’t at all like those that you or I might make when we decide to invest a few thousand dollars in Apple or Microsoft stock. Regardless, that’s how the tax law stands today, and unless and until it is changed, that’s the tax rule that applies to carried interest. Schneiderman may have to prove that the reason that the buyout firms convert this fee income into investment income is to avoid paying taxes at a higher rate. At present, this is a legal grey area — long after the U.S. Internal Revenue Service acknowledged it was studying such tax techniques, but then failed to follow up with any kind of public announcement or action.

Certainly, winning more favorable tax treatment for their income is a consideration, as buyout managers would tell you privately. After all, they are rational beings. But almost all of them would assert – and a majority of them would truly believe — that the tax issue is just a side benefit. They’d argue, with conviction, that the primary reason behind these “management fee waivers” isn’t to duck taxes, but to seek to maximize returns by investing fee income that they don’t need to pay out or bank to meet other needs. They’re taking the risk – they might lose their shirts completely — so they deserve the reward, they will argue. In other words, it will boil down to the same old familiar argument about how carried interest is taxed.

But there is a wrinkle in all this. To the extent that Schneiderman’s office finds, in the midst of all the documents it has subpoenaed, a pattern showing that this kind of fee conversion took place in any unusual way — for instance, that management fees were directed primarily to funds that clearly were poised to outperform, or that this only took place in some years, then the New York attorney general will have some ammunition at his disposal. Any signs of selectivity when it comes to management fee waivers may signal that this wasn’t routine business practice, but done only when the buyout shop figured it stood a lower chance of losing any money. That, in turn, begs the question of whether the money was ever really “at risk,” and thus whether any profits deserve to be taxed at the lower rate.

The real question here is at what point either the private equity industry or its critics are prepared to holler “uncle” and give in. The debate surrounding the appropriate tax treatment of carried interest is one that just won’t go away, and this year it’s likely to lodge itself firmly in the spotlight, given Romney’s past history at Bain. His wealth comes at least in part from the fact that he has paid a much smaller percentage of his income on tax in many years than an average American. At a time when the wealth gap appears to be widening, that is difficult to explain, especially when small businessmen — all of whom also take risks with their own small companies — don’t benefit from the lower tax rate on their own earned incomes.

Ultimately, this is a question that can only be decided in Congress. Perhaps Schneiderman can make life painful enough for private equity firms that they will be willing to cut a deal, but it’s unlikely. Any kind of settlement may well be viewed as a tacit admission that current tax treatment of carried interest is open to question — and that’s a “no go” area for the buyout industry and its supporters. Look for the next few months to generate a lot more headlines — but no real solution.