A tale of private equity... and equity

It is funny how the media has the power to inform and misinform people. The current spotlight on the Blackstone IPO and KKR’s loud intentions of going public added some steroid-powder to the cake. Uncle Sam decided to show up at this party and brought in heavy-weight party crashers, like Sen. Hilary Clinton, and Sen. Baucus & Grassley who are trying to pass a bill raising the capital gains taxes. Everybody wants a piece of this big cake, but very few actually have an idea of this thing actually is going to digest. Very few journalists, bloggers, readers, and apparently and unfortunately — congressmen — actually have a clear idea of what’s going on.

The IPO of Blackstone, one of the largest buyout shops in the Private Equity industry, startled a lot of people. The size of the transaction, the tax treatment, the nature of the business, its financials, the way it conducts business and a lot more was disclosed when the firm filed the S1 — the initial filing at the SEC. As the S1 is a never ending document (it actually has 291 pages), very few actually bother to read it. But the worse thing is, you don’t need to read Blackstone’s S1 to understand why the current tide on the subject is misguided (unfortunately for Sen. Clinton’s intern team).

Maybe we need to step back to have a perspective of the subject. The private equity value chain is taxed at four levels: the investor level, the fund level, the portfolio of investments level and the fund manager level. The law for limited partnerships in the US (which 80% of the PE firms use) generally allows a “flow-through” (also know as “pass-through”, but the first is the official IRS terminology) tax exemption — meaning that the investment vehicles are not taxed themselves, and the general partners are taxed on their income and on the profits they accrue from the transactions made through their portfolio.

Sen. Clinton recently said in a speech: “It offends our values as a nation when an investment manager making $50 million can pay a lower tax rate on her earned income than a teacher making $50,000 pays on her income”.

Now let’s do something that both politics and buzz words prevents us of doing: thinking. Every fund manager pays taxes. And they pay A. Income taxes according to their tax bracket, just like any other mortal in the country and B. Capital Gains taxes, derived from the sale of the assets in their portfolio.

As the real median male worker income in the US is $40.798 (the female’s average income is 63% of that, so the global average will be necessarily lower), an average US worker will pay an income tax rate between 15% and 25%. Relatively, fund managers pay more income taxes than the average American, considering their average salary. Their tax bracket will be somewhere between 33 and 35%. On the top of that, the absolute tax value that fund managers pay to the IRS is much higher, because they their salary is bigger. So nobody pays less taxes on income. Hillary, strike one. But it is understandable why everybody’ jumpy on this. A fund’s manager total income is not only formed by the salary he receives for managing the investments of the firm.

The center of attention here is the tax on the fund manager’s (also know as “general partners") share of profits. A GP income is formed by his salary, also know as a “management fee” (generally a 1% to 2% of the total capital under management) and his/her share on the profits of the funds, which generally is 20%. Competent fund managers add value to their portfolio of companies and exit the investment at higher valuations, therefore earning big profits. Therefore, we can expect that the larger part of the income of a fund manager derives from the profits of the portfolio. And this is the piece of the pie that Uncle Sam is trying to bite: the capital gains tax.

Currently, the IRS says that long term transactions, or transactions which the investor has held the investment for more than a year, are subject to a capital gains tax bracket of 15%. This tax applies to any purchase/trade of security or asset, like a company’s stock or a house. As Private equity firms generally are “stay in” an investment for an average of 4 – 6 years, they fall under this tax-bracket. Taxing a particular industry itself is an instrument of public policy that must be severally scrutinized in order to understand the economic impacts it will pose.

Therefore, what is the difference of an average worker that builds equity, buys a house and after 5 years sell it at a reasonable profit and a fund manager of a private equity firm? Aren’t they performing basically the same economic transaction? The point is that creating a specific capital tax for this industry can harm the US economy in ways that very few people are aware of.

One definition can help us through here. When I say “private equity” I refer to all stages of the private investment private companies. Early stage investing, which generally consists of seed capital and financing for start-ups are generally called “Venture Capital”. Later stages of the firm development are called “Private Equity/Buyout”, and “Mezzanine” to mention a few. A capital gains tax would hurt all the phases of financing the development of a business, because investment firms would have lower economic incentives to invest. Therefore, financing for businesses star-ups, SMEs and companies seeking capital to prepare for an IPO would be reduced to a unknown extent.

A tax on the carried interest is a tax on the industry that brought many of the technological and competitive edge that the United States bears today. Microsoft, Apple, Google, Fedex, America Online, Intel, Palm computing, Costco, just to name a few — all those firms relied on private equity capital at one or more stages of their lives.

In a nutshell, the private equity industry channels a massive amount of resources to business opportunities, and seeks efficiency on their investments so they can extract more value. But, they take their share of the profits. And this is where they are being heavily scrutinized — because all of a sudden the media is aware of their profits. I wonder why nobody looks at their benefits. The private equity industry has been active in the United States since the 1960’s and helped finance technology, improved access to new services, fostered medical innovations and provided better returns to institutional investors, many of them pension funds, that I you and all of us rely on.

Taxing the carried interest can drive those companies to other markets — where they will promote efficiency. Good for them, bad for the United States because A. it will have a reduced pool of capital to finance its private sector, and B. In an almost Tarantino-style vendetta, the US will have to compete with firms more capitalized and more efficient in the near future. Let’s not forget that PE-backed companies that went public are more profitable and productive than the average listed company. Hillary, strike two.

If all the information on the economic benefits of the private equity industry and the nature of its taxation is public, why the media has been treating it that way? Do we need an always need a scapegoat? I remember when it was Bill Gates, now it is Steve Scharwman. Or does it just boil down to politics, and congressmen are so desperately for a home run that they will hit whoever is on the spotlight just to swing the bat? If it is a matter of jumping on the profits, the government will never need an argument to do so. But please, don’t embarrass us trying to shove us some bed-time history about the big bad wolf that lived in Wall Street. We live in a modern and well informed society, we know our rights and we know duties. Any other argument or reasoning that brings up the little red cap plot will definitely be strike three.