Victor Fleischer, a professor at the University of Colorado Law School and long-time critic of private equity's tax treatment, seems to have ignited another row. This time the target of his ire is management fee conversion, the practice (relatively common in the US, although less so elsewhere) whereby private equity firms effectively waive their management fee in exchange for a priority allocation of future profits. In Fleischer's eyes, this is basically just a tax dodge so that it can be classed as carry rather than income, and thus be taxed at a lower rate.
As usual these days, the controversy is Romney-related: Fleischer's critique (which you can read HERE) was prompted by the disclosure of Bain Capital fund documents that show this practice was commonplace at Bain during and after Romney's time there. For example, Fleischer reports that Bain Capital Fund X LP had converted $338 million of fees as of the end of 2009 – which, he argues, equates to $67 million in missed taxes (based on a 20 percent tax rate differential). “Bottom line: Mitt Romney has not paid all the taxes required under law,” he concludes.
This last point is debatable, to say the least. Fleischer's legal opinion is based on his own (considerable) expertise and, he says, that of other tax specialists. Yet most of the lawyers we've spoken to this week insist that it's actually perfectly legal under the current rules; indeed, the US Internal Revenue Service has effectively approved it. So while it might be at the more aggressive end of the tax avoidance spectrum, that doesn't necessarily make it an illegal tax dodge. (Perhaps Fleischer is suggesting that the IRS isn't doing its job properly, but that's a different argument.)
Nonetheless – and leaving aside the equally dubious question of whether Romney should really be held accountable for the current tax arrangements of a firm he stopped running more than a decade ago – Fleischer has touched on an important point here.
Regardless of the legal rights and wrongs, arrangements like these clearly fail the 'sunshine test'. Should it come to broader public attention that firms are regularly manipulating fee income so it can be taxed as carry – and the current level of Romney-related scrutiny makes that far more likely – it would reflect very badly on the industry and do further damage to its image. What's more, it may be self-defeating; it's just the kind of thing that encourages politicians and regulators to clamp down harder on the industry's overall tax treatment, and it goes without saying that that's a battle nobody in private equity wants to fight.
There is one important caveat the critics should bear in mind, however. One of the reasons firms do this is because otherwise it can be difficult for them to fund their GP commitment. Over the last decade, LPs have continued to demand managers put more skin in the game, even as fund sizes have been getting bigger. Sometimes the GP won't be able to lay their hands on that sort of cash, especially if they haven't had the chance to accumulate wealth from previous funds (so at the moment, it's a particular issue for new firms and the more junior investment professionals at established firms – but it may become more widespread if the current crop of funds fail to pay out much carry). In which case, the only alternative in these situations is to borrow it – either from a bank, from the firm’s senior professionals or from the management fee. And there's a very good argument that the latter represents the most sensible alignment of interests.
On the other hand, this could further weaken the industry’s case for the current treatment of carried interest. We’ve argued before (see HERE and HERE) that it’s not justifiable to tax the share of the carry that derives from profits made on investor capital as capital gain rather than income – but it is justifiable for profits made on their own capital, i.e. the GP commitment. Where firms are also funding their GP commitment via the management fee (i.e. using investor capital), that exception arguably no longer applies.
To be clear: insofar as GPs are using these conversions as a way to avoid tax, this is a loophole that ought to be closed – and until it is, the industry's wider interest would be best served by firms choosing not to take advantage of it. But equally, it also needs to be recognised that managers – particularly in today's cash-constrained times – might have no other way of funding their share of the GP commitment. Just don’t be surprised if the ultimate outcome is that private equity ends up paying more tax, not less.