The New Tycoons
Page 20
Alpha is where private equity made its bones and how it convinced pensions and endowments and others to pay the big fees that they’ve earned over the years. At the Tuck School of Business at Dartmouth, they say it even cleaner: “Alpha is a proxy for manager skill.”18
One of the lurking existential questions in private equity, especially as its largest practitioners expand beyond doing leveraged buyout deals into real estate, funds-of-funds, and capital markets, is whether alpha—those outsized returns that gave the industry its raison d’être, its right to charge more than any other type of manager, and its staying power for three decades—is still the top priority. “This will become a smaller, more concentrated business, mainly because the funders need to buy in bulk,” said Howard Newman, the founder of Pine Brook Partners and the former vice chairman of Warburg Pincus. “The big firms will get bigger, investors will look to smaller and specialized firms for alpha, and the super returns will go away except for the very best funds.”
Notes
1. Kevin Roose, “Decking the Halls, Carlyle Style,” New York Times Dealbook, December 15, 2011. http://dealbook.nytimes.com/2011/12/15/decking-the-halls-carlyle-style/
2. “Private Equity Principles, Version 2.0,” January 2011. http://ilpa.org/index.php?file=/wp-content/uploads/2011/01/ILPA-Private-Equity-Principles-version-2.pdf&ref=http://ilpa.org/principles-version-2-0/&t=1333650254
3. “Transaction and Monitoring Fees: On the Rebound?” Dechert LLP and Preqin, November 2011. www.preqin.com/docs/reports/Dechert_Preqin_Transaction_and_Monitoring_Fees.pdf
4. Ken Hackel, “How Dividends Can Destroy Value,” Forbes.com, December 13, 2010. www.forbes.com/sites/kenhackel/2010/12/13/how-dividends-can-destroy-value/3/
5. Michael Barbaro, “After a Romney Deal, Profits and Then Layoffs,” New York Times, November 12, 2011. www.nytimes.com/2011/11/13/us/politics/after-mitt-romney-deal-company-showed-profits-and-then-layoffs.html?_r=1&scp=1&sq=Dade%20Romney&st=cse
6. Andrew Ross Sorkin, “Romney’s Run Puts a Spotlight on Private Equity,” New York Times, December 12, 2011. http://dealbook.nytimes.com/2011/12/12/romneys-run-puts-spotlight-on-past-job-and-peers/
7. Dan Primack, “A Romney Talking Point That Should Stick,” Fortune.com, December 13, 2011. http://finance.fortune.cnn.com/2011/12/13/a-romney-talking-point-that-should-stick/
8. Anne-Sylvaine Chassany, “LBO Firms Leave Backers in Lurch in Secondary Buyouts,” Bloomberg News, October 5, 2010.
9. Ibid.
10. Jason Kelly and Jonathan Keehner, “Pension Plans’ Private-Equity Cash Depleted as Profits Shrink,” Bloomberg News, August 20, 2009.
11. Devin Banerjee, “Carlyle Said to Return Record $15 Billion Ahead of Going Public,” Bloomberg News, December 27, 2011.
12. Jason Kelly and Jonathan Keehner, “Pension Plans’ Private-Equity Cash Depleted as Profits Shrink.”
13. Oliver Gottshalg, “Why More Than 25% of Funds Claim Top Quartile Performance,” Buyout Research Program Research Brief, February 2, 2009.
14. Robert S. Harris, Tim Jenkinson, and Steven N. Kaplan, “Private Equity Performance: What Do We Know?” (February 10, 2012). Fama-Miller Working Paper; Chicago Booth Research Paper No. 11-44; Darden Business School Working Paper No. 1932316. Available at SSRN: http://ssrn.com/abstract=1932316 or http://dx.doi.org/10.2139/ssrn.1932316
15. “AIM Program Performance Overview,” CalPERS website. www.calpers.ca.gov/index.jsp?bc=/investments/assets/equities/aim/private-equity-review/overview.xml
16. “Oregon Public Employees Retirement Fund Alternative Equity Portfolio.” www.ost.state.or.us/FactsAndFigures/PERS/AlternativeEquity/FOIA%20Q3%202011.pdf
17. Private Equity Growth Capital Council website. www.pegcc.org/education/pe-by-the-numbers/
18. “Private Equity Glossary.” Website of the Center for Private Equity and Entrepreneurship, Tuck School of Business at Dartmouth. http://mba.tuck.dartmouth.edu/pecenter/resources/glossary.html
Chapter 10
The Taxman Cometh
As Occupy Wall Street reached a fever pitch in early November 2011, I went downtown to check it out for myself, having seen spin-off protests in both central Phoenix and outside the U.S. Post Office in Chapel Hill, North Carolina.
Despite the ire being aimed broadly at Wall Street and corporate America, private equity has never been directly in the crosshairs of the protests. Schwarzman’s residence was picketed in mid-October 2011 when a throng of protesters marched on various apartment buildings known to house billionaires. His Park Avenue place, the sprawling apartment once owned by John D. Rockefeller, Jr., was on the route. Still, private equity remains largely ignored, to the genuine surprise of some in the industry, who’ve seen unions and other political action groups occasionally protest takeovers and companies, from Carlyle’s Manor Care to Bain and KKR’s Toys “R” Us.
As I walked around Zuccotti Park—the protesters referred to it by its former name, Liberty Park—and marveled at the mini-tent city that would capture the nation’s attention for nearly two months, I spotted the first evidence of private equity creeping into the conversation. There, printed on orange cardboard, were the words, “Carried Interest Loophole,” with a circle-and-slash symbol in fluorescent marker around it. This admittedly less catchy sign (another read, “No Bulls, No Bears, Just Pigs”) explained exactly why private equity was avoiding the negative press: the complexity. It would take a Republican candidate from a private-equity firm and the more digestible and volatile issues of class warfare to garner national headlines. The porcine insults were then directed mostly at the leaders of the big-name banks, from Bank of America to Goldman Sachs. Those institutions, vilified in the public imagination as well as on Capitol Hill, bore the vast brunt of the criticism about causing the financial crisis.
Within weeks of my Occupy visit, private equity was very much back in the national conversation, perhaps on a level where it never had been before, thanks to Mitt Romney. In early 2012, the tax question that had lingered in the background for five years became a defining issue for Romney and, by extension, the industry he helped create. As we’ve seen, carried interest is the portion of the private-equity equation that creates the extraordinary wealth for the industry’s practitioners. Normally, any discussion of taxes leaves most of us desperate for a change in subject. In this case, the private-equity tax question became a touchstone for a broader debate about income inequality and class, viewed in the hothouse of a presidential election year. How the question is ultimately answered touches on some of the basic economics of how the private-equity money flows back to its most successful players.
The question dates back decades, to the earliest days of the industry. The so-called “2 and 20 structure” of a typical fund gives, by most accounts, a clear incentive for managers to deliver profits to their investors. The 2 percent annual fee pays the bills, and most established managers charge less than 2 percent since they have more substantial cash flow from previous successful funds. The 20 percent, carried interest, is the real money. That buys the second and third houses and the jets and means you have the coin to get your name on a building at your alma mater or a symphony hall somewhere.
Most institutional investors, for the most part, seem okay with this, as long as they’re getting the returns they were promised and so long as the managers get rich on the carry and not from the management fee or other assorted fees. This was an area where Texas’s Steve LeBlanc and others in the ILPA principles movement directed some of their fire.
Here’s the catch on the tax side and what the protesters, and others including the Obama administration, characterize as a loophole: Carried interest is considered investment income and therefore taxed at a capital gains rate, which in 2012 stood at 15 percent, versus the top ordinary income rate of about 35 percent. For years, this practice was noted by some in Washington, and there were half-hearted efforts to change it. Then Victor Fleischer, a young law professor who blogs, wrote a paper. He later told a reporter he hoped it would
help him secure tenure at the University of Illinois College of Law, where he was teaching at the time.1 Now he’s at the University of Colorado, and he was hailed by Politico in 2007 as the then-36-year-old “this season’s academic It Boy.”2
Fleischer wrote a refreshingly straightforward paper that started making the rounds of key offices on Capitol Hill in early 2007. The introduction to the 59-page article, eventually published in the New York University Law Review, says it all: “This quirk in the tax law allows some of the richest workers in the country to pay tax on their labor income at a low rate. Changes in the investment world. . . suggest that reconsideration of the partnership profits puzzle is overdue.” He goes even further, asserting he will prove “that the status quo is an untenable position as a matter of tax policy.”3
Fleischer’s paper was exceptionally well timed because in 2007, the year of megadeals, mega-birthday parties, and Blackstone’s IPO, political will coalesced, and suddenly Washington was primed to take up the issue. Politicians saw an easy target—the ultra-rich getting away with something that could be remedied. The New York Times editorial page, citing Fleischer, eventually called on Congress to act.
The political establishment had another advantage. Private equity as an industry had barely paid attention to Washington for essentially all of its history, beyond personal relationships (read: donations to candidates) and occasional calls to testify before a subcommittee about a deal gone bad in a powerful member’s district. In part anticipating this fight and a broader need to engage more openly in public discussions, a handful of the largest firms had decided in 2006 to form an industry association, decades after their peers in real estate and venture capital had set up similar lobbying shops. In early 2007, the Private Equity Council opened its doors.
The group, and its members—comprising the founders of KKR, Carlyle, Blackstone, TPG, and those firms’ respective public affairs heads, among others—imagined they would spend the early days educating lawmakers about an industry that was already, at best, unknown, often mistrusted or misunderstood, and in some cases, loathed. Whatever honeymoon it had could be measured in weeks.
The argument that private-equity managers make, at least in public and through their lobbyists, is that the tax treatment—“founded on sound and settled tax policies”—is designed to encourage entrepreneurial activities and risk-taking. The group also points to the fact that real estate partnerships and venture capitalists enjoy the same tax benefits. Those other industries, both of which are well-represented in Washington, did in fact initially give the private equity industry cover and ultimately helped delay any action on carried interest by the Congress. The emergence of a vocal Republican faction that had literally sworn not to raise taxes also helped stave off any changes.
The bigger story around carried interest for private equity, though, may be what might be considered the political opportunity cost. The decision to make carried interest tax such a major issue right out of the gate meant that “Don’t you dare raise taxes on us billionaires” became the defining issue for an industry. It didn’t help that the initial make-up of the Private Equity Council was limited to a handful of the biggest firms run by the most visible titans of the industry, including Kravis, Bonderman, Rubenstein, and Schwarzman. The storyline was too easy: Wall Street firms, along with Washington’s most politically connected investors, are trying to keep a loophole open so they can pay less taxes than the average Joe.
And yet, the member firms were united in their opposition throughout. The movement to change the tax treatment struck at the heart of the business model. Their staunch defense dominated their Washington agenda, pushing any plans about broader initiatives to educate lawmakers to the fringes.
The Private Equity Council in March 2007 set about dealing with carried interest largely as a tax issue. The group sought out meetings with tax-focused staffers to make their case.
The story burst beyond the tax geeks on March 22, 2007, when Blackstone filed to go public on the New York Stock Exchange. The public started to get a sense of how much the firm was generating in profits and later, when the firm filed details of Schwarzman’s and Peterson’s compensation and the implied value of their stakes, it deepened still. Suddenly, carried interest wasn’t a nerdy tax question of abstractions. It was about these specific billionaires and their taxes.
Washington went a step further. Senator Max Baucus and Senator Chuck Grassley wrote a bill aimed squarely at taxing publicly traded partnerships, a move so clearly aimed at one firm that it became known as “the Blackstone bill.” While distinct from a bill in the House introduced by Representative Sander Levin to treat carried interest as ordinary income, the two pieces of legislation converged in the collective Beltway mind.
At the Private Equity Council, the staff and members realized that only a small handful of firms would go public, limiting the impact of the Blackstone bill. (In an only-in-Washington twist, the bill that unofficially bore its name had a grandfather clause that would have exempted Blackstone, effectively giving Steve Schwarzman’s firm a competitive advantage and reward for getting out first.)
The Blackstone bill also served to muddy the broader issues, and some members begin to question what the driving principles were. On carried interest, the venture capital industry especially argued that it should be carved out from carried interest, positioning itself as a growth engine versus the leveraged buyout firms. The real estate business negotiated an amendment in the House bill for similar treatment that was defeated, and talk of carve outs served to take steam out of the debate. During the election year of 2008, little happened, and as the credit crisis dominated the headlines and talk turned to massive bailouts and Lehman-sized bankruptcies, private equity inched further out of the spotlight.
With Obama’s arrival in early 2009, the industry assumed it was mostly a matter of when, not if treatment of carried interest would change. Talk began to bubble about cutting a deal, specifically a “blended” rate that would raise the taxes on some portion of carried interest, or peg a rate somewhere between capital gains and ordinary income. The debate over health care reform served to sideline the issue once again, and while there was some talk of using carried interest as a way to pay for Obama’s health plan, the architects of that legislation ultimately decided not to use any non-health care revenue as sources of money. Private equity coasted for the rest of 2009.
What appeared to be the final push came in the spring of 2010, when Baucus called representatives of the private equity real estate, hedge fund, and venture capital industries and said he was planning to use carried interest as a revenue generator that year. He and Levin negotiated a deal whereby 75 percent of carried interest would be treated as ordinary income, with the balance taxed as capital gains. What ultimately helped undo that effort–along with a growing anti-tax sentiment promoted by the Tea Party–was an element, shorthanded as the “enterprise tax,” that was designed to prevent private-equity executives from moving their carried interest into the firm itself and paying the lower rate when they eventually sold their interest in the firm (aka the enterprise). Private equity and its lobbyists, many of whom had resigned themselves to a higher carried interest rate, seized on this maneuver and used legislative jujitsu.
This would affect not only billionaire private-equity managers, but restaurant owners and other small businesses, they argued. Legislators listened and enough ultimately balked that the broad package that included carried interest and enterprise failed to pass.
The debate returned to the fore, and fiercely, in 2012, when Romney’s taxes became the big story. After weeks of resisting, despite near-constant attacks from his opponents, Romney released his 2010 and estimated 2011 tax returns in late January 2012. While political journalists set aside hours to comb through the returns to glean their impact on the campaign, so too folks who follow private equity tucked in for a rare look at a buyout maven’s finances. Some of the private-equity-related elements weren’t new. In separate financial disc
losure forms released the previous year, Romney laid out his investments, including the fact that he, his wife, or trusts managed on their behalf, had some financial interest in 31 different Bain-related funds. They also had investments in funds managed by Goldman Sachs, as well as Golden Gate Capital, a San Francisco-based manager of buyout and credit funds. Golden Gate’s better-known investments included jewelry retailer Zales and outdoor clothier Eddie Bauer.4
There was nothing especially controversial in Romney’s returns from a private-equity perspective, though it was a stark reminder of how much money can be generated from investments that are only available to a small number of participants. Beyond Bain, Romney had investments in vehicles open only to qualified investors. The day after the returns were released, Carlyle’s Rubenstein spoke at the World Economic Forum in Davos, where he was asked about Romney and taxes. “You change the law and they’ll pay the taxes,” Rubenstein said. “Romney said, and I’m not his defender, he’s paying whatever the law required. If you change the law, change the law, but don’t criticize him for paying the taxes that the law requires him to pay.”5
While Rubenstein’s logic is sound, private equity seems to have lost the argument. Long quiet about this issue, the industry’s biggest investors started making their opinions known in 2012, shifting the discussion. Joseph Dear, the chief investment officer of CalPERS, was blunt at a meeting of his $234 billion pension in February 2012. “General partners should recognize that tax treatment of their income has become indefensible,” Dear said. “The tax treatment is incomprehensible to ordinary taxpayers and citizens. . . . If people come to believe that private-equity general partners are reaping giant returns, while paying less in taxes than wage earners do, their support for those policies that enable private equity to work will be withdrawn.”6 Dear’s strong words have the benefit of being true, and they make an even larger point as to why private-equity managers should concede the point on taxes when given a chance. If the industry’s biggest investors won’t abide something, the entire private-equity system is at some level of danger. While paying a higher tax rate may dent the economics of individual men and women, in private equity, the possibility, however remote, that big investors will balk at future commitments over the tax rate is too great a risk to run.