Buyout bosses lose another layer of their mystique

September 5, 2012

By Richard Beales
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

U.S. Republican presidential hopeful Mitt Romney’s background at Bain Capital has directed a spotlight onto the unusually low tax rates paid by buyout firm executives. But a New York probe into a complex technique used by private equity firms to pay less tax on fee income may take more sheen off the industry. Even if legal, it’s yet more evidence of financial engineering.

New York Attorney General Eric Schneiderman’s latest enquiries target a practice, employed at Bain and elsewhere, that has been questioned for years by academic lawyers.* Alternative investment firms generally charge investors a flat management fee, say 2 percent of assets, and take a typical 20 percent of fund gains. In private equity and venture capital this latter component, known as carried interest, has attracted controversy because it is taxable at the capital gains rate – currently 15 percent – rather than the much higher 35 percent and higher levy that applies to ordinary income. That is, however, legally clear. What the Democrat Schneiderman is now targeting are efforts to turn the management fee, as well, into a form of carried interest.

This requires a fund manager to “waive” the fee. Investors then hand over the cash in other ways, for example by stumping up for capital the manager was supposed to invest. A convoluted set of legal arrangements can leave all parties with essentially the same cash flows. The wrinkle is that fund managers are on the hook for fund performance. As long as profit is sufficient – and that can mean in a few specific periods, not over a fund’s life – they keep what they would have got as management fees, pay less than half the tax, and pay it later.

Some big buyout firms, like listed Blackstone Group , have never used this approach. Kohlberg Kravis Roberts, for instance, used to on occasion but hasn’t since it went public. Across the industry, firms go both ways. On the one hand, they’re entitled to minimize their tax bills, and law firms have blessed versions of the fee waiver structure. On the other, it can be legally aggressive, for instance when managers can elect to waive fees rather than having the treatment hardwired. And it’s complex to explain to other investors.

Either way, the technique is designed primarily to reduce taxes for fund managers rather than to benefit investors like pension funds. Action from Schneiderman or, probably more appropriately, the Internal Revenue Service could yet define clearly what’s permitted. In the meantime, it’s a distraction. But for firms that did it, so was all the effort to arbitrage the tax system in the first place. It makes the industry’s more noble claims of investing savvy and management mojo a bit less convincing.

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