Have you been scratching your head, wondering why public companies, which drove US economic growth for decades, are rapidly being taken private — a seemingly backward step? I haven’t seen any really compelling explanation of this, but I’m beginning to think that a lot of it comes down to taxes.
An editorial in the New York Times today cites a paper by Victor Fleischer in which, over the course of 51 densely-argued pages, he shows that private-equity principals get taxed at ridiculously low rates for no good reason. Here’s the tax dodge: if you’re running a private-equity fund, then most of the money you invest belongs to your investors, or limited partners. You do personally have some “skin in the game”, however — usually somewhere between 1% and 5% of the total amount in the fund.
Now because you have made an investment in the fund, most of your individual profits can be structured as being capital gains on that investment, rather than income. Let’s say you own 1% of the fund, but receive (as is standard) 20% of its profits. Thanks to your 1% stake, that entire 20% profit share — and often some if not all of your 2% management fee as well — is taxed at the 15% capital gains tax rate.
And that’s not all: You also get to defer your taxes until the fund is wound up, another benefit potentially worth millions.
What this means in practice is that private-equity billionaires like Blackstone’s Stephen Schwarzman essentially have a 15% tax rate, because all their income is treated as capital gains.
Of course, that isn’t enough for Schwarzman, who’s also trying to structure the Blackstone IPO in such a way as the company itself also manages to avoid paying any corporate income taxes. The trick is to have Blackstone not run any businesses itself, but simply own subsidiaries which have so much debt that interest payments wipe out all their profits. Those interest payments then go to Blackstone, which in turn can claim that it’s passively deriving its income from interest, and that therefore it’s just a “partnership with passive investments” which has minimal tax liabilities.
Private-equity shops have managed to get away with these shenanigans thus far mainly because they’ve been pretty good at flying under the radar. But it increasingly seems as though Blackstone and Schwarzman have stuck their necks too far above the parapet. And if Congress wakes up and changes the tax treatment on them, that will impact not only Schwarzman but all other private-equity principals too, as well as principals at venture-capital funds. Predicts venture capitalist Fred Wilson:
The capital bases of the very best venture capital firms are increasingly made of of the general partners’ own capital. They continue to invest third party capital as well. If the economics of managing third party capital gets much worse, I bet we’ll see the best firms move to investing only their own capital.
Which might be true, but is no reason not to make the change.