A story of private equity GPs selling stakes for high sums, minting a new crop of billionaires, threatens to provoke political push-back against certain tax rules.
(An earlier version of this item appeared yesterday in Family Wealth Report, sister news service to this one.)
The way that private equity firms behave has come under the spotlight with reports that at least 60 firms have sold parts of their general partnerships at high valuations, making big, often tax-free gains and potentially drawing political ire.
A report by Forbes noted how the owner of the Detroit Pistons, Tom Gores, had earned a “ten-digit pay-out” from his Beverly Hills buyout firm, Platinum Equity. Gores reportedly paid 15 per cent of his stake in Platinum to another firm, Dyal Capital Partners, which will bring Gores $1.0 billion over four years, making Gores worth $5.6 billion after the transaction. The publication said that more than $20 billion is being raised for such deals.
What makes this story sensitive is that private equity carried interest is treated as capital gains, rather than income tax when fund managers pay their profit bonuses. The situation remained the same after 2017 tax changes. The publication said that the latest deals involving GPs also transform the 2 per cent management fee that private equity firms typically earn into capital gains. This can cut the maximum tax rate of 37 per cent to 23.8 per cent, possibly deferring that rate.
With family offices and other wealth management institutions being significant private equity participants – barely a week goes by without this publication being told how enthusiastic investors are – the story comes as a bit of a reality check.
“The underlying policy issue is how `carried interest' is taxed - while this `trade' is perfectly legal, this pattern will only bring more “bad press” and attention to this arcane tax issue. In an era of the `haves' and `have nots', one can predict this will not end well for the `haves', Jamie McLaughlin, of JH McLaughlin & Co, told Family Wealth Report.
The private equity industry has pulled in billions of client money during recent years, boosted by the allure of superior returns to listed equities in an era of very low interest rates. But that comes at a price of lower liquidity. In the past, use of significant debt amounts to finance buyouts proved a problem for private equity funds when credit markets froze in 2008. Unless investors hold a range of fund “vintages” (the inception date of a fund), they may find that they hold a highly cyclical asset class. Another policy issue is that if tax is a driver of private equity activity, it will fuel a backlash against buyouts, particularly if they involve job losses and negative headlines.
“Converting the GP management fee into capital gains is a clever and recent development that will apply to very few taxpayers – few of whom need/deserve another tax break” Thomas J Handler, partner at Chicago-based law firm Handler Thayer, told this publication.
“The carried interest is indeed the largest remaining `pig’ remaining in the Tax Code. Not only are income taxes avoided, but work/personal services are avoiding FICA, FUTA, SUTA, Social Security, Medicare and local payroll taxes as well,” Thayer said.
"Carried interests are incredibly difficult to tax; the previous attempts by the Treasury were so over-broad that nearly every conduit entity could be improperly punished; consequently, the last round of proposed regulations were highly criticized by absolutely everyone (including me). It will be very challenging to sharpen the pen here even if Congress or Treasury take this on,” he said.
Thayer argued that an even more important tax concern centres on estate tax. Private equity managers often transfer their GP interest or part of it into a Dynastic Trust for the benefit of grandchildren and future descendants, thus avoiding gift taxes by making the transfer before the fund has raised any money. Therefore they avoid estate taxes in perpetuity by using such a trust parked in a state/country that has repealed the Rule Against Perpetuities. Furthermore, the principals can retain “access” by using a family office/family holding company structure while safely keeping these assets out of their taxable estates, he said.
Michael Zeuner, managing partner at WE Family Offices, said an important question is how investors’ interests fit with those of GPs.
“While on the one hand these transactions appear to increase alignment as the general partners invest the proceeds into their funds, on the other does bringing a third party investor into the ownership structure of the fund change the general partner’s agenda with respect to delivering a return to those investors vs a return to their limited partners?”, he said.
“It’s important for families investing as limited partners in funds to understand during their diligence process if a fund they are investing in has sold a portion of its management fees to a third-party and, if so, what the implications of that sale are and how that might change the general partners alignment of interest with their limited partners,” Zeuner added.
(Editor's view: There is nothing necessarily wrong of course with a GP selling a stake in his or her firm to another and pocketing a profit. Welcome to capitalism, everyone. The point, however, is that if firms are able to exploit a large differential between the tax treatment of income and capital, that is on the face of it unfair, and that makes it politically radioactive.)