Rolling the Dice: Carlyle filing discloses private equity IPO risks
Simpson Thacher & Bartlett’s Joshua Ford Bonnie shepherded the IPO for Carlyle, while Jennifer A. Bensch and Phyllis G. Korff of Skadden, Arps, Slate, Meagher & Flom represented the underwriters.
Carlyle’s prospectus embeds 52 pages of risk disclosures among the 495-page filing. Risks are broken down into five categories, those relating to: the company; its operations; its organizational structure; the common units and the offering itself; and U.S. taxation.
Whether couched in terms of regulatory risk or tax consequences, the idea that the Obama administration (as well as state tax authorities) could dramatically alter the capital gains regime pervades Carlyle’s prospectus. In one such statement, Carlyle discloses:
Although not enacted, the U.S. Congress has considered legislation that would have: (i) in some cases after a ten-year transition period, precluded us from qualifying as a partnership or required us to hold carried interest through taxable subsidiary corporations; and (ii) taxed certain income and gains at increased rates. If any similar legislation were to be enacted and apply to us, the after tax income and gain related to our business, as well as our distributions to you and the market price of our common units, could be reduced.
The disclosure notes that while the Senate did not pass the legislation, the House did; were the legislation ultimately enacted (in similar form), some of Carlyle’s investments could be considered investment services partnership interest (“ISPI”) and thus subject to taxation at the rate of ordinary income, rather than capital gains. An explanatory passage might hint at options presenting themselves to Carlyle’s management:
The House bill provided that, for taxable years beginning 10 years after the date of enactment, income derived with respect to an ISPI that is not a qualified capital interest and that is subject to the rules discussed above would not meet the qualifying income requirements under the publicly traded partnership rules. Therefore, if similar legislation is enacted, following such ten-year period, we would be precluded from qualifying as a partnership for U.S. federal income tax purposes or be required to hold all such ISPIs through corporations, possibly U.S. corporations. If we were taxed as a U.S. corporation or required to hold all ISPIs through corporations, our effective tax rate would increase significantly. The federal statutory rate for corporations is currently 35%. In addition, we could be subject to increased state and local taxes….
Implicit in this caveat is that unless precluded by statute, Carlyle could, like other companies, channel its revenue through tax-friendly jurisdictions. With interests on six continents already, the scenario is hardly far-fetched.
What’s more, the prospectus further cautions that although the above-described legislation failed, the Obama administration has signaled its intent to continue to pursue taxes on carried interest as a revenue source. Indeed, the feds are not alone. States, too, have shown an appetite for carry-interest revenues. The respective budget deficits’ red ink is blood in the water to circling legislators.
For Carlyle, the ripple effects of such legislation would extend beyond affecting the share price of the firm’s common units. According to the prospectus, the change could hamper the company’s ability to recruit and retain the type of seasoned professionals upon which Carlyle has come to rely.
Carlyle also warns of uncertainties surrounding implementation of the Dodd-Frank Act. The Act’s Financial Stability Oversight Council (FSOC) could saddle Carlyle with the designation of “systemically important”:
If we were designated as a systemically-important nonbank financial company…then we would become subject to heightened regulatory requirements that would impose additional administrative costs on our business and could limit our ability to grow.
The final Volcker Rule provisions of the Dodd-Frank Act also establish an additional layer of uncertainty as to how some of Carlyle’s investments might be treated. Carlyle warns that Dodd-Frank’s risk management provisions could materially hinder the company’s ability to retain personnel.
Tax and regulatory concerns are hardly the only issues confronting Carlyle’s would-be investors. The structure of the PE conglomerate could leave may disappoint the garden-variety investor accustomed to shareholder votes.
First, the limited partnership is advised by the general partner, Carlyle Group Management LLC. As Carlyle reports: “We intend to avail ourselves of the limited partnership exception from certain governance rules, which eliminates the requirements that we have a majority of independent directors on our board of directors and that we have a compensation committee and a nominating and corporate governance committee composed entirely of independent directors. In addition, we will not be required to hold annual meetings of our common unitholders.”
The common unitholders will likewise have no say in the board’s composition. By a unique arrangement, however, Mubadala Development Company, the high-powered Abu Dhabi-based investment vehicle, has the right to name one director to the board so long as Mubadala maintains a 7.5% interest in Carlyle.
Mubadala has another powerful input into Carlyle’s management: compensation. By arrangement with both Mubadala and the California Public Employees’ Retirement System (CalPERS), Carlyle fixes the compensation of its named executives to a scheme largely dominated not by salary, but by bonuses and opportunities for carry interest accretion. This limitation is considered to ensure that the interests of Carlyle’s senior management are aligned with the minority positions of Mubadala and CalPERS.
Carry interest, in addition to being a substantial concern with respect to tax consequences, will continue to make up a significant portion of Carlyle senior managers’ compensation.
In order to better align the interests of our senior Carlyle professionals and the other individuals who manage our carry funds with our own interests and with those of the investors in these funds, such individuals are allocated directly a portion of the carried interest in our carry funds. Prior to the reorganization, the level of such allocations vary by fund, but generally are at least 50% of the carried interests in the fund. As a result of the reorganization, the allocations to these individuals will be approximately 45% of all carried interest, on a blended average basis, earned in respect of investments made prior to the date of the reorganization and approximately 45% of any carried interest that we earn in respect of investments made from and after the date of the reorganization ….
Carlyle’s disclosures also reveal a partnership structure that is materially distinct from other common stock offerings. Carlyle is permitted to repurchase all outstanding common units “either if 10% or less of our common units are held by persons other than [Carlyle’s] general partner and its affiliates or if [the company is] required to register as an investment company under the 1940 Act.” Moreover, the structure provides what may be seen as a radical departure from fiduciary duties associated with public companies.
Carlyle expressly warns that its “partnership agreement” contains provisions that reduce and eliminate [the] general partner’s duties (including fiduciary duties) to the common unitholders. [The] partnership agreement also restricts the remedies available to common unitholders for actions taken that without those limitations might constitute breaches of duty (including fiduciary duties).
The company also discloses several material litigation matters, including a number from its liquidation of Carlyle Capital Corporation Limited (CCC). Suits have been filed in New York, Delaware, the District of Columbia, Guernsey, seeking damages of $1.0 billion. Carlyle also discloses two putative shareholder class actions filed in D.C., as well as a DOJ investigation into whether Carlyle may have violated antitrust laws. While Carlyle claims to be cooperating with the Justice Department, it rejects the other litigation as without merit.
Sophisticated investors are unlikely to be caught off guard by what is likely the most important element of Carlyle’s present structure: tax treatment. Assuming no changes to the U.S. tax code, Carlyle will continue to be treated as a partnership. This means that “common unitholders therefore will be required to take into account their allocable share of items of income, gain, loss and deduction of The Carlyle Group L.P. in computing their U.S. federal income tax liability.” While Carlyle “currently intend[s] to make annual distributions in an amount sufficient to cover the anticipated U.S. federal, state and local income tax liabilities of holders of common units in respect of their allocable share of [Carlyle’s] net taxable income, it is possible that such tax liabilities will exceed the cash distributions that holders of common units receive….”
The IPO market may be less-than-ideal, but that’s not stopping Carlyle. Already pressured to compete with the now-public Blackstone, Carlyle’s management may see its window of opportunity closing as revenue-hungry governments seal up every tax-leaking aperture they can find. In a perfect world, Carlyle might wait for a more advantageous IPO climate, but the getting right now might be as good as it’s going to get.
(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com. )