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.
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.
In addition to the relative poverty of journalists, we’ve long been obsessed with the cheapness of politics. Everyone rants about there being too much money in politics but we’re always surprised by how little there is. Take incoming Senate Banking Committee Chairman Christopher Dodd. Since 1989 Dodd has personally taken about $2.18 million in campaign donations from the investment industry, according to this item in DealBook. For the point of emphasis, the most powerful Democrat on the banking committee has been collecting less than $150 grand a year from the industry.
And yet the media and political watchdog groups are still concerned that this might create the appearance that Dodd is owned by the banks. We’re not saying this impossible. Just embarrassing. We knew that many of our politicians were whores. We just don’t like to be reminded that they sell their stuff so cheaply.
For Dodd, Wall Street Looms Large [DealBook]
Dodd Well-Positioned for White House Bid [Associated Press in Washington Post]
We’ve been pointing out for a long time that the really (potentially) explosive issue raised by former SEC investigator Gary Aguirre was not the now-officially dismissed suspicions on insider trading by Pequot Capital or illegal tipping by John Mack, but the still largely univestigated charges of favoritism at the SEC. Recall that Aguirre claimed he was fired from the SEC for trying to subpoena John Mack, who was then about to become the top man at Morgan Stanley. Now the mainstream media, for reasons of its own, has enjoyed playing up Mack’s connections to the Bush administration but a more relevant fact is probably his status as the head of a major Wall Street bank. This raises the fear that the SEC has been captured by the very industry its supposed to regulate. (By the way, even this might be too optimistic, since the words “been captured” imply that the regulatory agency was not created, owned and operated by the largest investment banks right from the start.)
In today’s Wall Street Journal, the Senate’s Finance Committee chairman Charles Grassley says that this is precisely the matter on which the committees investigation is focused.
Your Dec. 8 editorial “The Pequot ‘Scandal’” leaves the impression that Gary Aguirre and I are the only two people concerned about the way the SEC handled the Pequot investigation. In fact, Mr. Aguirre’s concerns have been echoed by both former and current SEC officials, who provided candid testimony to our committees.
The focus of the Senate investigation I’m conducting with Sen. Arlen Specter (R., Pa.) isn’t John Mack and Pequot; rather, it is whether the SEC retaliated against one of its lawyers and whether it wields an even hand in looking out for investors big and small. Our review is evidence-based, and so far the evidence suggests the Pequot investigation was fraught with problems, Mr. Aguirre’s termination is suspect, and the inspector general failed in his duty to conduct a thorough and independent inquiry.
Sen. Chuck Grassley (R., Iowa)
Committee on Finance
An SEC Investigation Fraught With Problems [Wall Street Journal]
That’s the gist of today’s Wall Street Journal editorial discussing the pressure coming for tighter regulations on hedge funds from, well, just about anywhere you look. There’s Senator Charles Grassley’s letter to regulators looking for suggestions on how to regulate hedge funds. (Our bet is that they’ll somehow come up with a couple!) And Connecticut’s Attorney General Richard Blumenthal’s mini-Spitzerism. And the noise from Germany about putting global regulations in place. (Look for more of this if Barney Frank gets control of the House Finance Committee.)
You see, a regulated industry is an industry whose players need to make campaign donations in order to influence lawmakers. It’s a pretty simple formula: regulate an industry and you instantly politicize it. Which is another way of saying that you monetize the industry for politicians.
But it’s not all about wringing donations from hedge fund managers. There’s also corporate managers who are tired of getting those pesky shareholder letters from hedge fund types, and worried they could lose their jobs as hedge funds buy up their shares. And those folks have lots of money to spend on campaign donations, as well. It’s a win-win if you’re a politician.
All the other talk—about “systemic risk” or pension funds or low-liquidity real estate millionaires—is just the sound of a policy in search of a rationale. And that policy, of course, is the enrichment of politicians. That’s always the policy.
Targeting Hedge Funds [Wall Street Journal]
The Aguirre-Mack-Samberg-Pequot-Heller-Credit Suisse-Morgan Stanley-SEC-GAO-Grassley Scandal Goes Meta And Picks Up Two New PlayersBy John Carney
The New York Sun thinks that the allegations made against Pequot Capital and Morgan Stanley chief John Mack have been getting a little too much ink from the New York Times. And they think they know why.
Mystified New Yorkers were left wondering what could possibly explain the Times’s fascination with this story. Some might say it’s Mr. Mack’s connection to Mr. Bush, but it could just as easily be Mr. Mack’s connection to Morgan Stanley. That is the bank that, earlier this year, withheld its proxy votes for members of the board of the New York Times Co. to protest the Sulzberger family’s preferential voting status. A Morgan Stanley analyst complained at the time that the Times was underperforming as a business in large part because of the ossified management perpetuated by the ruling family’s use of super-voting shares to control the Times despite a relatively puny stake in the Times company.
It’s a scandal about the scandal! And just insanely paranoid enough to possibly be true!
‘A Full Airing’ [New York Sun]
[Disclaimer: John Carney has written for the New York Sun and the Times, and he's friendly with a couple of the girls at both papers. Morgan Stanley was a client on several deals he worked on. He's never met John Mack or anyone named Sulzberger. George Bush won't return his phone calls.]