is the income tax preference for private equity justified? …I don’t think so

simplified preliminaries

Private equity investors raise money from institutional investors.  Those funds become the equity portion of highly debt-leveraged capital cocktails used to purchase underperforming companies.  Once in control of a target company, private equity typically tries to streamline operations.  It cuts overhead (including marketing and R&D) and staff, with the intention of selling the made-over and hopefully more profitable project firm, as a whole or in pieces, within five-seven years. 

Private equity is paid in two ways:  through recurring management fees for its projects, and through a share of the profits when the project company is sold.  Applied to private equity, carried interest refers to the practice of having the private equity managers’ compensation structured, either mostly or entirely, as equity–ownership interests in projects.  As a result, although the compensation sounds a lot like what hedge funds charge, it is taxed as long-term capital gains rather than ordinary income.   This “tax shelter” feature of private equity was highlighted in last year’s presidential campaign, which showed that Mitt Romney’s paid Federal income tax at about a third of the normal salary rate.

most investment professionals pay normal income tax

Last year, Representative Sander Levin of Michigan introduced a bill to close the tax loophole that private equity uses.  Mr. Levin has been quoted as saying that it isn’t fair for investment professionals to pay taxes at a lower rate than workers in other industries.  I agree.  I should point out, though, that Mr. Levin is wrong about one thing.  The income of the vast majority of investment professionals–private equity being the only notable exception–is already taxed as ordinary income.

is there reason for a tax preference for private equity managers?

Do private equity managers perform an important economic and social function that would not be accomplished if their compensation were taxed at normal rates?

The two potentially positive arguments that I can see are :

1.  that private equity managers are an essential part of the “creative destruction” that continually reinvigorates the US economy.  They take idle capital out of the hands of those who use it badly and put  those corporate assets into the hands of people who can employ it more effectively.  Sounds good.  But I haven’t read a single study of the private equity industry that shows conclusively that private equity makes the companies they acquire very much better.  Yes, barnacles get scraped off the bottoms.  But researchers I’ve read conclude that any supernormal returns generated by private equity projects come from the debt-heavy (read: very risky) financial structure they fashion in their project companies.

2.  that they provide counterbidders to trade buyers ( i.e., industrial companies) who would otherwise capture M&A targets too cheaply.  That’s probably true.  But this doesn’t man any extra social good is created.  This is more an issue of into whose pockets the purchase premium goes–the buyers’ or the sellers’.  Private equity tilts the field toward the sellers–who, by the way, happen to be the guys who have spawned and tolerated the inefficient entity.

lobbying legislators has been the key to preserving carried interest (no surprise here)

Heavy lobbying by the private equity industry, both in the US and in Europe, has protected the carried interest tax avoidance device so far.  Not for long, though, in my opinion.  Mitt Romney, a key figure in private equity a generation ago,  became a public illustration of how private equity mega-millionaires use the carried interest loophole to make their tax bills from Uncle Sam all but disappear.  It didn’t help, either, that Mr. Romney was inarticulate and disorganized during the campaign–and completely blown away organizationally and in the use of technology by Mr. Obama.  And Mr. Romney was supposed to be the cream of the private equity crop.  

private equity zombies–very hard to kill

what they are

The Wall Street Journal has been writing recently about private equity “zombie” funds.  These are funds that whose managers refuse to liquidate and return the proceeds to the original investors, even though the typical 8-10-year fund life has already passed.

A given private equity investment is supposed to last around five years.  That gives the managers time to make operating improvements and locate a buyer to sell the now-polished-up company to.  Add a year or so to that, so the managers to find enough good investments to use all the fund’s capital.  Add another, in case recession makes buyers temporarily wary.  That’s how you get to 8-10 years of life for the total fund.

In theory, private equity managers have no interest in keeping client money.  True, they get a recurring yearly management fee of around 1% of the assets under management (based, incidentally, on their own estimate of asset value–another bone of contention).  But their big payoff comes from their “carried interest,”  the 20% or so of the capital gains generated by each project that clients cede to them.  Private equity managers only collect this when the project is sold and proceeds returned to the clients.

The details, including the “sell by” date, are all spelled out in the private equity contracts.

How, then, can “zombies” arise?

The combination of two circumstances keeps them lurching around:

–failed investments, ones with no capital gains possibility, and

–clauses in the early private equity contracts that gave the managers (unlimited) extra time to find a buyer.  The intention was good–to not force the private equity managers to sell at a bad time.  In most cases, however, there was no other provision giving clients a course of action if they disagreed with the managers’ assessment.

The result is hundreds of failed private equity funds that refuse to liquidate, because managers want to continue collecting an annual fee.  They claim they’re looking for buyers, but…  The WSJ thinks that what we’re seeing now is just the tip of the iceberg.

two lessons

1.  Buy in haste, repent at leisure.  In the early days of any new investment fad, buyers rush headlong to be one of the first owners of the new thing.  They rarely look carefully.  If they are alerted about possible pitfalls, like no recourse if the private equity manager refuses to give back remaining money, they ignore the warnings.

2.  In desperate times, almost no one remains honest.  I’m an optimist.  I have great faith in human nature.  But in “zombie” circumstances, this is always a foolish bet.  At the very least, a professional with an obligation to protect clients’ assets shouldn’t rely on the kindness of strangers.

why not let sleeping dogs lie?

Institutional investors appear to be making a big push now to get their dud private equity investments resolved, even by selling them for half nothing (assuming they can find a buyer at all).


Two reasons:

–for taxable investors, an investment loss has an important tax value.  The present value of the loss deteriorates over time, so the sooner it’s used, the more it’s worth.

–keeping a dud investment on your balance sheet makes you look like an idiot.  Well, when you bought the thing, you were an idiot.  That’s the way it is.

But there’s invariably someone on your board of directors who will ask about it at every meeting.  Prospective clients may even make little gasping sounds if they recognize it on your list of holdings.  The black eye you’ve given yourself will only fully disappear when the investment is sold.  This is especially important if you see more of these coming down the track.


what is a carried interest?

Mitt Romney’s taxes

Mitt Romney’s partial disclosure of his tax situation has reopened debate on the issue of how private equity managers and some hedge funds use carried interest as a device to shelter their earnings from tax.

Since Mr. Romney left the private equity business a decade ago, it seems to me that he isn’t currently using carried interest as a tax shelter.  In all likelihood, it’s some combination of itemized deductions, like charitable contributions or state and local taxes paid, and the favorable treatment of long-term gains on investments that’s producing his low tax rate.  But he was a prominent figure in the private equity community, so the press–and his political opponents–have made the connection anyway.

Powerful lobbying efforts by the private equity industry have defeated repeated attempts to close the tax loophole it uses to lower its executives’ tax burden.

I wrote about this topic in mid-2010.  But I haven’t read anything, wither in the current discussion or in the past, that explains exactly what a carried interest is.  Hence this post.

carried interest

A carried interest is a participation in an investment venture where the holder gets a share of the cash generated by the project (profits or cash flow) without having to contribute anything to the venture’s costs.  The holder of such an interest is “carried” in the sense that the other venture participants pick up the burden of his share of project expenses.

Carried interests aren’t just a private equity phenomenon.  They’re very common in the mining industry, which is where I first encountered them thirty years ago.  But they also occur in lots of other industries, particularly those where highly specialized experience or skills, or possession of crucial physical resources are key to a project’s success.  In the extractive industries, holders of mineral rights may be carried.  The fund raisers or organizers of any sort of projects may be carried, as well.  So, too, famous actors or holders of key intellectual property.

variations on the theme

As with everything in practical economic life, there are myriad variations on this basic idea.  For example,

–a party may not be carried for the entire life of the project, but only up to a certain point–say, when cash flow turns positive.

–the other parties may be entitled to recover the “extra” costs they’ve paid to subsidize the carried interest before the carried interest receives a dime (there are also lots of variations on the cost recovery theme), or

–the carried interest may only be paid if the project exceeds specified return criteria.

In plain-vanilla projects, the carried interest receives a portion of the recurring revenue that the venture generates.  This is ordinary income and taxed as such.  The private equity case is different.

private equity and carried interest

Private equity raises equity money from institutions or wealthy individuals, arranges financing of, say, 3x -5x that amount, and uses the assembled war chest to make acquisitions.  It targets mostly badly run companies.  It spruces them up and resells them a few years later.  There’s no conclusive evidence that this process adds any economic value, although it certainly sets the process of “creative destruction” in motion in the affected company–but that’s another issue.

Private equity companies appear to me to act as a blend of business consultants and managers of a highly concentrated (and extremely highly leveraged) equity portfolio.  What’s really unique about them is their pay structure.

Private equity charges its clients a recurring management fee of, say, 2% of the assets under management plus a large performance bonus if the turnaround projects they select are successful.  This bonus is structured as a carried interest (an equity holding) in each individual project.  Because the projects last several years and result in an equity sale, the bonus payments are capital gains, not ordinary income.  This means the private equity executives’ tax bill is much less than half what it would be if the payments were income.

my thoughts

You’ve got to admit that turning investment management income into capital gains is a clever trick.  Should the loophole be closed?  When I first wrote about this I thought so.  I still do.  But I’d prefer to see more comprehensive tax reform that achieves this result rather than specific legislation that targets the private equity industry.  I also find it somewhat disturbing that private equity political contributions and lobbying allow them to “own” this issue in Congress, despite the fact that private equity’s taxation is clearly different from other investment managers’, from management consultants’ and from corporate executives’ for basically the same activities.

what is a roll-up?


Roll-up is the name commonly used to describe the process of buying up and merging small participants in a highly fragmented industry.


The acquirer is most often a financial buyer, typically a private equity firm, rather than the operating management of a company in the industry in question.

The companies acquired are typically relatively small–and of sub-optimal size, in economic terms.

They are most often privately held, and owned by individuals who don’t have a sophisticated awareness of the value of their firms–either as stand-alone entities or as part of a larger combination.  As a result, purchase prices can be small single-digit multiples of yearly sales.


Industries in the US that have been rolled-up include:  radio stations, auto dealerships, funeral homes, independent radio and TV stations, billboards, taxi walkie-talkie radio systems (i.e., Nextel).

why do this?

The two basic aims of a roll-up are to achieve large size relative to other competitors in the industry, and to grow to economically optimal size in absolute terms.  Doing so allows the roll-up to:

–lower administrative overheads,

–cut capital spending by sharing plant and equipment,

–negotiate lower prices and/or better payment terms with suppliers,

–offer a wider array of services to customers,

–create and market a brand name–with the increase in unit profits that this will bring,

–have units mutually support each others’ sales efforts,

–focus competitive activity at firms outside the roll-up.

profit sources

I’ve already mentioned that:

–the target companies can usually be bought very cheaply, and

–economies of scale and simple improvements in general management can boost profitability a lot.

In addition:

–better access to credit can reduce borrowing costs,

–the target firms can be more highly leveraged financially (= more debt) as part of a larger unit, and

–the rolled-up company will likely be IPOed, allowing the private equity company to cash out at least several times its purchase price.

why an IPO?

Two reasons, other than extra profits  …one good reason, one bad:

–the private equity company is likely funding the roll-up with money from institutions or high net worth individuals.  These investors will expect their capital + profits to be returned after, say, five years.

firms that carry out roll-ups typically have little hands-on experience running businesses, and not much detailed knowledge of the rolled-up industry.  They’re good at basic general management and at creating a capital structure with a lot of debt in it to boost returns on equity.  I think they realize they’re better off exiting the roll-up before some crucial issue arises that requires industry knowledge to solve.


pension consultants and placement agents: the CalPERS report

the situation

Imagine you’re a global equity portfolio manager.  You have a top quartile record over virtually any period during the prior ten years.  In fact, there’s no one in the US, and only one in the EU, who can equal or better your numbers.  You have presentation skills polished by intense preparation by experts both inside and outside your firm, as well as your many hours of practice.

You visit a pension consultant in Connecticut.  You show him your numbers, make your presentation, and await his comments.

He has only two:

–your presentation skills are terrible.  Before he can recommend you to any clients, you must take a remedial course from his firm.  It costs $25,000.

–he’s not sure you know enough about foreign markets.  The only way he can gain the confidence he needs is if you subscribe to his firm’s international information service.  He shows you the latest copy.  It’s a worthless collection of news clippings–superficial, and weeks behind what your own information network provides.  It costs $50,000 a year.

Summary:  despite the fact your record is better than that of anyone he is currently recommending to clients (who are, incidentally, paying him large amounts of money to do manager searches for them), those clients will only hear your name if you agree to make an upfront payment (read: bribe) of $75,000 and agree to continuing payments of $50,000 a year.

We decline.

Welcome to the Realpolitik of pension consulting.

the CalPERS report

The consultant I’ve described lacks finesse.  It would be more common for a pension manager to agree buy analytic services from a consultant, who would examine the manager’s product offerings for their potential attractiveness to customers.  Paying the consultant to come to your offices and spend time digging through your products will not only give the consultant the knowledge of your products that might otherwise take five years of you visiting him to impart.  But it might engender a feeling of obligation as well.

The biggest weapon in the consultant’s arsenal, however, is his control over the types of products he will recommend that his client buy.  They will be all highly specialized, offering the maximum potential for the consultant to “add value” by applying asset allocation services to the individual pieces a given asset manager sells, thereby customizing a portfolio.

CalPERS wouldn’t see the sometimes seamy interaction between manager and pension consultant.  But that’s small potatoes compared with what the consultant earns by selling manager selection and asset allocation services.

None of this is mentioned in the just-released CalPERS investigative report on placement agents and consultant services.  In fact, the part about consultants is much like the amuse bouche in a five-course meal.  What the report says is this:

1.  Somehow, while it continued to pay pension consultants as neutral third-parties to find managers and monitor performance, CalPERS ended up hiring the same organizations as money managers, as well.  Talk about the fox guarding the chicken coop.

CalPERS has finally worked out that, in addition to not being a sound action from a fiduciary standpoint, this is a no-win situation for it.  If the performance is outstanding (and my casual reading suggests it isn’t), there’s still the blatant conflict of interest.  If it’s poor, there isn’t even a pragmatic justification for the breach of prudent behavior.

2.  The big issue in the report, though, is placement agents.  These are well-connected individuals who sold their privileged access to CalPERS management for tens of millions of dollars in fees paid by third-party money managers, some of whom gained CalPERS as a client.  This appears to have happened predominantly in CalPERS alternative investment and real estate areas.

The report of the investigation, lead by law firm Steptoe and Johnson, LLP, is a carefully crafted document.

The authors point out that they received “universal and unlimited cooperation”  only from CalPERS and its current employees, less than that from others.   Some relevant people, notably former CalPERS CEO Fred Vuenrostro and former board member Alfred Villalobos, refused to cooperate entirely (understandably, perhaps, in the case of the named individuals because the report notes both are defending themselves against charges brought by the California Attorney General).

As I read it, the report makes several, not entirely consistent, points about the attempts of several of CalPERS key alternative investment managers to buy influence through Villalobos and Vuenrostro:

a.  CalPERS lost no money (not relevant from an economic point of view, but likely a key point under state securities laws)

b.  the main operational failure was on the part of the board of directors in not reining Villalobos and Vuenrostro in, and in some cases, aiding their influence-peddling efforts; the staff of CalPERS consistently resisted unwarranted pressure from Vuenrostro to select certain managers or not negotiate fees diligently

c.  nevertheless, the report also cites the case of the former head of CalPERS’ alternative asset arm, who appears to have accepted inappropriate favors from Apollo Global Management, while CalPERS was negotiating to buy a stake in Apollo

d.  in addition, many of the third-party managers who paid a total of $180 million to placement agents, Apollo Global Management, in particular, remain among CalPERS’ “most trusted external managers.”

e.  again, despite the contention that the staff of CalPERS acted entirely appropriately, the report also says that four alternative asset managers, Apollo, relational, Ares and CIM, “agreed to a total of $215 million in fee reductions for CalPERS.”

my thoughts

At least this behavior is out in the open.

To me, the conclusions in the placement agent part of the report don’t add up.  It may be, however, that CalPERS is so deeply entwined with the alternative asset managers who paid placement agents all that money and who overcharged the agency by close to a quarter billion dollars that it isn’t able to extricate itself.  So it has decided to make the best of a bad situation.  We’ll probably find out more as pending lawsuits wend their way through the legal system.

Skandia Life: we’ve made money on private equity

Who says insurance companies don’t have a good sense of humor?

the Skandia Life study

The Financial Times reported today that Skandia Life has done a proprietary study that “proves” its investments in private equity have made money for the company, even from purchases made during the wildest days of the middle of the last decade–when loans were flowing like water and everything not nailed down was being bid for at very high prices.

Despite this, Skandia concludes that its private equity investments earned it “between six and 14 per cent per year” better than publicly traded equities (which would likely have lost some money during the period).  The print newspaper article said the margin of outperformance was “between 0.8 and 1.5 per cent,” a set of figures that the FT apparently subsequently changed.  I don’t know which is correct.  (I’ve looked for the study on the internet but have been unable to find it.  So all I have to go on is the FT newspaper and website.)

the study’s assumptions

To get the Skandia results,  you have to make a number of (heroic) assumptions.  They include:

1.  that the private equity people who sold Skandia its deals worked for free.  That is, they collect no fees and have no carried interest.

2.  that estimates of the current values of the companies bought, which are made by the private equity firms doing the buying, are fair and accurate.  There was apparently a “third party” check on the figures,  presumably by the investment banks who were paid by the private equity firms to line up and help finance the deals.

3.  that the highly leveraged acquisitions of poorly-performing companies are no riskier than buying, say, a stock index ETF, so no adjustment to returns for”extra” risk needs to be made.

are they believable???

How likely are any of these suppositions?  In New York they say…”If you believe this, I have a bridge you might be interested in buying.”

The icing on this comedic cake is the answer to the question, “What financial professional could possibly have approved this study and endorsed its dubious results?”    …why, the guy in charge of giving Skandia Life’s money to private equity, that’s who.

In the thrust and parry of bureaucratic infighting in large companies, I can see why someone might call for a justification for making private equity investments at the top of the market to be made.  And I can see how a study like the FT writes about might have been the response.  What I don’t understand is why the authors would want it made public in any form.

On the other hand, maybe they didn’t.