Friday Letter: Taxing Times

As US legislators mull ways to exploit private equity and increase the tax take, buyout firms explore the benefits of going public.  

For general partners, it hasn’t exactly been smooth sailing in the US  this week. Not only has the nation’s largest labour union stepped up its private equity campaign, but the Service Employees International Union said its president will testify next week before the House of Representative’s Financial Services Committee on the impact of private equity.

Though the union has said its interest in buyouts relates primarily to how workers are affected, it has repeatedly said the industry should “play by the same set of rules as everybody else”, a subset of which it has said includes taxes.

The impending hearing and testimony is yet another sign that momentum is building on Capitol Hill to re-evaluate private equity tax structures, particularly the tax on carried interest.

In recent months, there have been rumblings on the issue from senior members of the US Senate Finance Committee. Currently, carried interest is taxed as capital gains at 15 percent, but ranking committee member Chuck Grassley and committee chairman Max Baucus have indicated the designation could be changed to personal income, resulting in a rate of 35 percent.

Legislation has yet to surface, but several exploratory, closed-door committee sessions relating to the matter have reportedly occurred, and at least one proponent of GP tax reform, University of Colorado law professor Victor Fleischer, has met with the senate committee.

The Private Equity Council’s president, Doug Lowenstein, has chalked up much of the activity on Capitol Hill as fact-finding.

Partners from major firms at a recent private equity roundtable in New York voiced similar sentiments, saying they expect more government scrutiny as the industry grows, and while hard to argue with the logic fuelling the tax debate – that it’s unfair to treat carried interest as capital gains considering it isn’t technically the GP’s capital being risked – they certainly intend to, if push comes to shove.

David Rubenstein, Carlyle Group co-founder, has said: “I think Congress is now looking for revenue because they’ve got some holes to fill and private equity – because it’s gotten so much publicity – is an attractive source of potential revenue.”

Speaking last month at the 10th annual Milken Institute Global Conference in Los Angeles, Rubenstein likened any change in private equity partnership taxation, which would apply to all types of partnerships, to the Alternative Minimum Tax act.

The act was meant to tax a couple hundred wealthy families and now affects ten of millions of middle class Americans. “I think you’ll have the law of unintended consequences, and you’ll probably have people doing things that aren’t really that desirable,” Rubenstein said.

To help shape the debate, he said, the industry must do a better job of explaining itself and highlighting the fact that public pension funds are primary beneficiaries of private equity investments.

But positive PR isn’t the only avenue for avoiding a higher tax rate, according to a report published this week by La Jolla Economics. The Southern California-based economic consulting firm contends GPs can protect their carry by following The Blackstone Group’s lead and floating the management company:

“Under new accounting standard SFAS 159, private equity firms can calculate an option value for the future carry it might generate on any deal that is booked upfront. So by going public they can cash out at the 15 percent tax rate as opposed to 35 percent,” the think tank said.

The downside, it added, is the option value is updated and adjusted at an exit, which could result in a loss to the IPO’s investors.

The argument may factor in significantly as the industry grapples with how to best unlock the franchise values of management companies, create permanent capital, and attract and retain talent.

But for how long a public offering’s tax advantages will last is the more salient question. The Internal Revenue Service and US Treasury have reportedly just launched an associated inquiry.