Tax changes drive private equity’s great selloff

By Rob Cox
September 13, 2010

Are buyout barons becoming sellout barons? Private equity firms are on track this year to sell more assets than they buy for the first time ever. Buyout firm bosses say this reflects the need to realize cash for investors. That’s probably true to a point. But the prospect of tax hikes in the United States has also given the executives a rationale to sell now, even if it doesn’t much help their clients.

So far in 2010, private equity firms globally have sold $140 billion of assets from their portfolios, putting this year on a pace for the most disposals since 2007 and the second-biggest year in history, according to Thomson Reuters. Purchases this year stand at around $136 billion so far. Since at least 1994, sales have never exceeded purchases in a full year.

To some degree this follows from the recent boom and bust. Private equity firms went on a takeover rampage fueled by cheap debt in 2006 and 2007, making $1.1 trillion of purchases. At some point the firms need to exit those investments. And investors in their funds, known as limited partners, have been clamoring to extract cash and reduce future commitments. Last week the managers of the Harvard University endowment, for example, said they were reducing private equity exposure.

But it’s possible that something else is figuring in the great buyout selloff of 2010: self-interest. Private equity managers earn most of their money in two ways. They charge a management fee, generally around 1.5 percent of assets they oversee. And they take a cut, typically 20 percent, of any increase in the value of investments. This is known as the “carry” or “carried interest.” Up to now, those in the industry have paid income tax rates on management fees but lower capital gains rates on their slice of investment gains.

That is set to change in America, where many big buyout firms are headquartered. With elections due in November, it’s not clear when, or even certain whether, Congress might make the proposed changes law. But private equity executives have largely given up lobbying on the issue, instead focusing efforts on avoiding other tax hits such as one that might kick in when they sell their firms. If the industry is resigned to higher tax rates on carry, that could be changing its behavior.

Consider an imaginary buyout firm, BSD Partners, which acquired a fictional manufacturer of specialty widgets in 2006 for $2 billion. In that deal, BSD put up 25 percent of the purchase price in equity from one of its funds and borrowed the remainder. Now it has a chance to sell the business to industry leader Widget Worldwide, even though the company’s good prospects mean it could be worth more in just a few months’ time.

Suppose Widget Worldwide is offering BSD $2.5 billion for the business today. That’s not bad. Assuming the unit still carries $1.5 billion of debt, BSD’s original $500 million investment is now worth $1 billion. But if BSD holds on for six months and sells its widget firm after it unveils new products and beats sales targets, the business may be worth $2.6 billion. Investors in BSD’s funds might want to wait. Other things being equal, the value of their equity investment would rise by another $100 million, a 20 percent annualized return.

But the bosses at BSD are exposed to slightly different arithmetic. Sell today, and of the $500 million equity profit, $100 million goes to them as carry and $400 million goes to the limited partners. Tax the take of the firm and its employees at a 15 percent capital gains rate, and they take home around $85 million between them.

Now consider what happens if BSD waits for the higher price for its widget firm in early 2011, assuming the new taxes are in effect by then. The gain made by the firm’s fund jumps to $600 million, with $120 million kept as carry and $480 million going to outside investors. After taxes at a more income-like 35 percent, the BSD crew share only $78 million for their trouble — nearly 10 percent less. That’s an incentive for the buyout firm’s insiders to sell assets now, even though it could shortchange fund investors.

This is a hypothetical example. But it is a calculus that private equity barons must, rationally, be considering. And it may be one factor in the great sellout.

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