What role did the government play in setting the price for JP Morgan Chase’s acquisition of Bear Stearns? The big story in today’s Wall Street Journal indicates that regulators may have misled lawmakers on this question.
A lot of you probably think that urge on Capitol Hill to raise taxes on private equity companies that go public has been dampened by recent market turmoil, threats of recession, and the discovery of at least three ways of avoiding the tax. But that’s because you don’t know much about Capitol Hill.
On the Letters to the Editor page of today’s Wall Street Journal, Republican Senate finance head Charles Grassley reminds us that Capitol Hill operates on a very different planet from Wall Street. The tax won’t raise more revenue for the government? That’s not the issue. The tax may hurt the economy may depleting it of a last-resort, go-private option for troubled companies? Doesn’t bother the lawmakers. It will hurt the markets by draining at least some takeover premiums from companies with damaged stock prices? That’s just Wall Street, not Main Street. It throws a dagger at the heart of another kind of public capital formation at a time when public capital markets are under assault from regulatory burdens left-over from the business scandal outrage of the first years of the decade? They don’t care.
So what’s on the mind of the top Republican finance lawmaker? Well, it seems that it’s nothing more than a drive to tax companies because they go public, unless they are oil and gas partnerships.
[Excerpts from Grassley’s letter after the jump.]
Letters to the Editor (seventh letter) [Wall Street Journal]
Lawmakers supporting the bill on Capitol Hill to raise taxes on private equity firms going public claim that it’s a basic matter of tax fairness. The bill’s sponsors, Democratic Senator Max Baucus and Republican Senator Chuck Grassley, have argued that private equity companies should not be allowed to access the public capital markets without having to pay the 35% corporate income tax. But the notion that private equity firms enjoy an unfair tax advantage may actually depend on a misunderstanding of how they make money and how they pay taxes.
Most private equity firms are organized as partnerships so that they can take advantage of a provision of the tax law that exempts certain kinds of partnerships from the corporate tax. Like most parts of the tax code, these provisions are written in a convoluted loophole-within-loophole style way that would have string theory physicists scratching their heads. So don’t get too worried about the details.*
One of the reasons the partnership structure is so important for private equity firms is that they make so much of their money from owning and selling operating companies—like, say, Chrysler—that are already subject to corporate taxation. If the private equity partnerships were taxed at the corporate rate, they’d effectively be taxed twice—once at the op-co level, and once at the partnership level. To make things worse, they’d really be taxes three times, since distributions to partners are subject to capital gains taxes. It seems a bit extreme to tax the same revenue stream over and over again.
Today’s Wall Street Journal editorial page, however, says that this is exactly what the Blackstone Bill would do. “Under the Baucus-Grassley proposal, Blackstone’s investment income would be taxed first at a 35% corporate tax rate on, say, American Widget Company when it earned the profits; taxed again when those profits are passed on to Blackstone at another 35% corporate income tax rate; and then taxed a third time at a 15% capital gains tax when Blackstone distributes its earnings to partners and shareholders,” the Journal says.
The Blackstone Tax [Wall Street Journal]
* If you must know, one provision says all partnerships get taxed with the corporate rate. Another provision creates a list of about fifteen different types of entities that are exempt from this treatment. Private equity partnerships fall under the exception for entities deriving income from “passive type income”—which is income from capital gains. This means that the law treats them as “pass-through” partnerships, so that the taxes don’t hit the partnerships themselves but only the owners of the partnerships. Because of this the managers of the partnerships typically pay capital gains taxes, rather than ordinary income taxes, on the profits of the firm.
No Small Time Steve Schwarzmans
By John Carney
How The Blackstone Bill Could Cut Ordinary Investors Off From Private Equity Profits
Over the past few years, the business of private equity has made a tremendous amount of money for a small number of people and institutions. And, if the top lawmakers on the Senate Finance Committee get their way, the number of people who participate in the profits of private equity isn’t likely to grow by very much.
One little noted effect of the move afoot on Capitol Hill to treat private equity and hedge funds as corporations after they go private will be to prevent ordinary investors from participating in what has been one of the biggest sources of wealth on Wall Street in recent years. The “Blackstone Bill” introduced by Senate finance committee head Baucus-Grassley would force private equity firms going public to pay the corporate tax—a huge expense that may chill the desire of firms to go sell equity to the general public.
“The little guy is going to be permanently shut-out,” one expert in corporate taxes told DealBreaker.
Until some private equity firms recently began offering funds that are publicly traded, most the prosperity of private equity over the past few years had been enjoyed exclusively by wealthy individuals and institutions that invest in the funds of the firms, and the partners who own them. The decision to go public would have let ordinary investors into this exclusive club.
But lawmakers on Capitol Hill seem intent on keeping that club exclusive, all in the name of tax fairness. Even if the tax change does not prevent the PE firms from going public (Alan Abelson of Barron’s thinks it won’t), it means that the companies the public can buy into will be far less profitable after taxes than the companies owned by the Steve Schwarzmans and Henry Kravises of the world.
Perils of Going Public [Barron’s]
The move to raise taxes on private equity firms going public is the bill the launched a thousand headlines. And ten-thousand blog posts. This afternoon we looked at the possibility of the bill getting enacted and answered the most fundamental question about the proposal. We’re going to send you away into the weekend with an extended write-offs section dedicated to private equity and taxes.
Private Equity, Meet Politics
Here’s the text of the bill [US Senate: pdf]
The official explanation from the finance committee says the bill is meant to address the ‘erosion of the tax base.’ [US Senate: pdf]
Holman Jenkins says the real purpose of the bill is to address the lack of political contributions coming into Washington, DC from private equity pooh-bahs. [Wall Street Journal]
And that explains why Blackstone gets the five-year break: because he’s playing the game the way the Senators and lobbying industry want him to. Membership has its privileges. [Ideoblog]
If Blackstone did buy themselves a break from the Senate, they did it on the cheap. Blackstone employees have only given $26,100 in campaign donations to members of the finance committee over the past 17 years. [Deal Journal]
Senator Grassley thinks that access to US capital markets should be contingent on paying the corporate tax. [Finance Committee Press Release: pdf]
Jenny Anderson and Andrew Ross Sorkin say the bill is going to be called The Blackstone Bill. Which is ironic, since the Blackstone Loophole may exempt Chez Schwarzman for five years. [New York Times]
Meanwhile, Blackstone itself is probably prohibited to publicly responding to any of this because it is in a pre-IPO quiet period. [Associated Press via Houston Chronicle]
Mary Gordon says Blackstone’s tax bill could double. [Associated Press via Forbes]
And, of course, the higher tax bill may chill the appetite for going public at other private equity firms. [DealBook]
DealBreaker Commenters notice the irony that taxing the public company at the corporate rate means private equity firms in which ordinary shareholders can invest face a bigger tax burden than private equity firms open only to wealthy investors. Sticking it to the little guy!
Details: Human Interest and Otherwise
Before news of the tax hit came yesterday, Schwarzman and other ‘stoners were pitching the company’s IPO to a standing-room-only crowd of about 600 investors at the Pierre Hotel. [Bloomberg]
When the news broke, Schwarzman was at the NYSE exchange getting an award from Yale. [Washington Post]
Schwarzman described the news of the bill as “a crisis.” [Wall Street Journal]
The Man Behind The Plan: Meet Victor Fleischer
The academic who is advising the Finance Committee on the tax treatment of private equity firms says the Blackstone IPO represents ‘2 and 20 on drugs.’[The Conglomerate]
And, yeah, he thinks the ‘carried interest’ capital gains break for fund managers should be brought to an end, too. [The Conglomerate]
But he also explains an even more twisted way that ordinary income tax could be avoided. [The Conglomerate]
Percy Walker says he doubts the changes will ever reach down to tag fund managers individually. [Percy Walker.com]
Felix Salmon thinks that’s wishful thinking. All the tax loopholes are going to be closed soon, even the ability to move funds off-shore. Especially if the Democrats take the White House. [Portfolio]
The deal team at the Wall Street Journal gets all ‘war correspondent’ on us. Broadsides. Shots across the bow. Private equity bracing for an attack. (Also, we count no less than seven Wall Street Journal reporters attached to this one story. Talk about sending in the cavalry.) [Wall Street Journal]
News from Around the World
British parliament rips into venture capitalists on why they pay 10% capital gains tax instead of income taxes on the earnings of their partnerships. [Epicurean Dealmaker]
The grandfather clause and other fun stuff
Steve Schwarzman became a grandfather of twins yesterday. [DealBook]
Suggested ring-tones for Schwarzman. [Deal Journal]
The gravity of Capitol Hill’s attack on private-equity going public is beginning to sink in. The proposed legislation would subject hedge funds and private equity groups—many of which are now structured as pass-through partnership for tax-purposes, allowing the partners to pay the 15% capital gains tax on distributions—to the 35% corporate tax rate if they go public. The bill has bipartisan support in the Senate and the support of key lawmakers in the House. Ominously, the White House has been decidedly quiet on the issue.
Many in Washington doubt that George Bush, who has very rarely vetoed legislation not related to the war in Iraq, would defy leaders of his own party on Capitol Hill to reject legislation they had agree to pass. Support for Bush is already shaky among Capitol Hill Republicans—and Bush is expending a lot of his political capital to push for an immigration reform bill.
“I don’t think Bush wants to further alienate members of his own party by standing up for a tax loophole used to make the ultra-wealthy even wealthier,” a Senate staffer told DealBreaker.
Others agree. “Bush is against raising taxes but this wouldn’t necessarily be a tax hike. No rates get raised. It just applies a different tax treatment to very wealthy folks,” a source close the White House said.
Some hope that Bush’s ties to private equity might encourage the president to veto the legislation. The founder of Blackstone, Steve Schwarzman, has been a major backer of Bush. The two went to Yale, where George Bush was a member of the senior class of Skull & Bones that tapped Schwarzman for membership at the end of his junior year.
But Schwarzman’s lobbying on the issue of private equity taxation has already resulted in a tax-break for partnerships that filed for public offerings before the introduction of the legislation yesterday. The break comes in the form of a five-year moratorium on the new tax treatment and would give Blackstone a competitive advantage over other private equity firms looking at a public offering. Schwarzman may, in fact, be in favor of the legislation now, since it gives him a leg-up on his competitors.
That bit of regulatory arbitrage—or perhaps triage—no doubt looks like a bit of cruel irony to Blackstone’s competitors, many of whom have reportedly been exploring the possibility of going public themselves. In part, it was the news that Blackstone was going public that focused legislative attention on the wealth of private equity—and on it’s tax advantages. (Schwarzman’s extravagant birthday party at the Armory probably didn’t help either.) Many in the industry were happy to let Blackstone take the heat by stepping forward with the first private equity public offering. Now it looks like Blackstone has carved out for itself a nice—if temporary—exemption from the tax changes. Fortune favors the bold, as a well-known Florentine used to say.
Even with the phase-in for Blackstone, commentators are estimating that the bill could shave 15 percent to 20 percent of Blackstone’s valuation. Jenny Anderson and Andrew Ross Sorkin at the New York Times estimate that it could cost reduce the firm’s net earnings by “as much as $250 million” on annual basis. Lawmakers on Capitol Hill have singled out Blackstone as the inspiration for the proposed legislation. Mary Gordon for the Associated Press says that the change would double Blackstone’s tax burden.
Text of the Senate Bill [pdf]
Finance Committee Description of the Bill [pdf]
Press Release from Committee [pdf]
Tax Boost Sought For Buyout Firms Planning IPOs [Wall Street Journal]
Bill Would Raise Taxes on Public Equity Firms [New York Times]
Blackstone’s Tax Burden Could Double [Associated Press via Houston Chronicle]
Senators Max Baucus and Charles Grassley, chairman and ranking member of the Senate Finance Committee, introduced legislation today to raise taxes on private equity firms. And, in the process, they singled out the IPO of the Blackstone Group as raising troubling tax issues.
Senate finance committee makes its move. [Bloomberg] (And here.) [Reuters]
What’s behind the sudden interest in taxing private equity? Hint: It’s spelled M-O-N-E-Y. [Wall Street Journal]
The Blackstone IPO is tax and regulatory arbitrage [Ideoblog]
Vic Fleischer describes the bill as “pretty sensible.” [The Conglomerate]
Sometimes when one door closes, another opens. And sometimes just when you try to crawl out, they pull you back in.
So even if Brian Hunter is ready to open his own hedge fund shop, not everyone is moving on so quickly. (By the way, if you’ve got a copy of the Solengo prospectus, please send it our way! Your anonymity is guaranteed!) Specfically, a US Senate probe into the natural gas futures market has reportedly unleashed a tidal wave of information from all over the market about experiences with market manipulation and regulatory proposals.
After Amaranth’s trading woes came to light, there were lots of allegations of market manipulation floating around Wall Street. Mysterious firings of prominent traders from big banks, rumors of breached Chinese Walls and talk about a “hit on the kid” were passed back and forth like a dusty mirror in this guy’s dorm room.
Wall Street has moved on but now the mirror has been passed to Capitol Hill, according to Platts news service.
Platts, which has done some of the best reporting on the Amaranth collapse, writes that lots of people have been talking to lawmakers and their cronies about the energy trading biz.
The amount of information submitted unsolicited to the committee is “enormous and surprising,” the spokesman said, and came from a wide variety of
“Wall Street, hedge funds, big financial players,” were just some of the bodies communicating directly with the committee, the spokesman said, but he declined to name names.