New York to investigate PE firms over tax abuse

Many of the largest US private equity firms have reportedly been caught up in a probe over management fee conversions, which can reduce the tax they pay by up to 20 percent.

TPG Capital, Kohlberg Kravis Roberts and Bain Capital are among a dozen or so private equity firms that are reportedly being investigated by New York attorney general Eric Schneiderman – a Democrat appointed by President Barack Obama – over a controversial tax strategy.

According to various media outlets, the firms were subpoenaed in July by the attorney general’s Taxpayer Protection Bureau, which wants them to hand over documents showing whether or not they have previously employed a management fee waiver.

This involves effectively giving up fees in exchange for a priority allocation of future profits – one benefit of which is that the proceeds are taxed at the federal capital gains tax rate of 15 percent (like carried interest) rather than the ordinary income rate, which currently can be as high as 35 percent.

Some tax experts believe that this is perfectly legal, arguing that since GPs are effectively converting fees into carry, which could decrease or lose all of its value, they should be entitled to the lower capital gains rate.

Other managers use it as a way to raise the necessary capital for their GP commitment, as we pointed out in last week's Friday Letter.

The practice is widely used in the industry; a 2009 Dow Jones survey quoted by the New York Times (where this story first appeared on Sunday) showed that 40 percent of the 35 firms who participated used at least some of the firm’s fees to make investments in their funds.

Notable absentees from the list include The Carlyle Group and The Blackstone Group, whose regulatory filings state that they do not divert management fees into their funds.

The practice of management fee waivers was highlighted last month after hundreds of pages of Bain Capital’s financial documents were made available online, as part of the ongoing scrutiny of Presidential candidate Mitt Romney's tax affairs. The documents suggested that Bain had converted at least $1 billion in fees in this manner, potentially saving more than $200 million in federal taxes.

These subpoenas apparently pre-date the release of Bain’s financial documents by several weeks, so they do not seem to be directly related. But any investigation could further damage the industry's reputation as it continues to struggle with the additional scrutiny prompted by Romney's White House bid.


Read PEI's view on the management fee waiver row HERE