What happens in private equity stays in private

This is a relatively link-free post, sorry. I’m waiting for a break in the rain to bolt to the laundry. Or to do the laundry, whichever is the common usage in your country.

Movement on both sides of the Atlantic. In yesterday’s Financial Times, the leading opinion piece discussed taxation (or effective lack thereof) of many private equity gains.

The fair way to tax private equity

The United States, even in its present mood of economic discontent, is less given than most countries to outbursts of animosity against the working rich. But strength of feeling on the subject is driven by the fact that the tax treatment of these managers, as compared to the treatment of other very highly paid individuals, really is anomalous. Take the anger and disgust away, and disinterested considerations of efficiency and fairness urgently demand a change.

To tax carried interest as ordinary income when granted would require an options-based valuation, which is not straightforward. Another complicated remedy would be to treat carried interest as an interest-free loan from the fund’s investors, and then collect tax in two parts: on the interest forgone, taxed as ordinary income, and on the subsequent capital gain, taxed at the lower rate required by current law. The simplest approach, and most likely the best, would be to set the question of deferral aside, and tax carried interest as ordinary income on realisation. To emphasise, this would not be to single out private equity or hedge fund managers as deserving of a new or specially punitive regime. It is a matter of even-handedly applying the logic of the present code.

For another day are bigger questions of whether it ever makes sense to tax capital gains at a lower rate than ordinary income (the policy that gave rise to this problem in the first place) and, in the American case, whether the tax system as a whole should be made more progressive. The case for reform on both points is strong, in fact. But the carried interest anomaly can be dealt with promptly, and should be.

They get to use ‘fair’, since it’s an opinion piece – although the suggestion to treat carried interest, which is basically income, as income, counts as fair in my book. Sorry, Dave.

The key, amongst the rough, is that private equity should not be taxed punatively for the money it makes. That Equity chiefs can admit to paying less tax than their cleaners is certainly an indication that something needs repairing, but the fact that some such chiefs are taking home more than USD1bn in salaries should not make them special targets. Just properly-targeted targets. Heh.

This is a legitimate issue, though, for once. It is not merely a straw-man employed by Wall Street Journal wankers to insist we’re all commies. Talk of a Private Equity Tax Rate is, unfortunately, being heard (whether it is being heard in earnest, or is from inception that straw man, I do not know. Frankly, either is a needless waste of time). Private Equity should not face a specific higher tax rate. Income should be properly identified, and taxed appropriate to society’s wishes. As long as the income is earned legally, its source should not warrant special attention. I’d sooner see New York City slumlords taxed to hell and gone before Private Equity, anyway.

In the UK, meanwhile, which is closer to actual action, little action, in fact, has resulted from all those entertaining committee meetings (i.e., the meetings were entertaining. They were meetings of the Treasury Select Committee on Private Equity, not the Entertainment Committee, or anything. Come on, that was hilarious). From – where else – the Guardian:

Private equity firms yesterday escaped the threat of tighter regulation and demands for closer scrutiny of pay and fees after a review rejected imposing public company-style rules on the industry.

In a consultation document, Sir David proposed a code of conduct that he said would greatly increase the supply of information to employees, customers and other stakeholders of the firms private equity acquired.

The code should be voluntary, he said, though he hoped some 200 large private equity buyout firms based in London would adopt it. He expects to produce a final report in October ahead of a review by the Treasury of allegations that private equity firms have been abusing tax rules to enrich their senior executives and investors. A further review of the industry will be completed by the Treasury select committee in the autumn.

Unions are not happy:

Unions said they were disappointed with Sir David’s report and it would fail to alleviate the fears of workers at private equity-owned companies. The GMB and other unions have accused private equity firms of profiteering at the expense of workers and the taxpayer through unfair tax breaks, asset-stripping techniques and anti-labour practices.

The TUC’s general secretary, Brendan Barber, said: “It will do little to reassure the staff of private equity takeover targets that the quest for short-term returns will not continue to threaten their jobs, pensions and working conditions.”

Personally, I don’t see that Public Company Rules would have done much to protect workers anyway, but this a game, and whatever keeps one’s opponent on their back foot would be welcomed. The secrecy surrounding the industry – who’s in, who’s making money and how much, the little details about financing and leveraged buy-outs that would land football clubs in a lower division, for example, is an issue that I had hoped the committee would manage. At the moment they have kicked this one for touch (Americans: they ‘punted’).

A later review, mentioned in the article, keeps the fire somewhat lit, but I won’t hold my breath. I would say that Private Equity can call this one a win. Moreso if it means greater room to maneouvre with the US Congress, when it comes time over this side (assuming Congress ever gets anything done again).

Looking the code of conduct over, it is essentially the equivalent of what is required of public companies, but it isn’t required. Just politely suggested. Mind you, given Private Equity’s fascination with not being villainised, they ought to, and most likely will, go in for at least some of the recommendations.

This, by the by, did not touch on the matter of tax paid on income earned via carried interest. So legislation shutting that opportunity down is probably – should be – on the cards, both in the UK and the US. And anywhere else it is employed.

Private equity to pay higher price for done deals

Keeping with the costs of doing the business of Private Equity. You will recall I mentioned the Wesfarmers’ buy-out of Coles Group (the reassuringly old-fashioned one). I commented at the time that two other groups, headlining Blackstone and the Carlyle Group, had failed to find lenders for their bids for the Coles Group. Well:

Private equity firms can now be in no doubt that they are going to have to pay more to fund the debt for buy-out deals they have already sealed.

This week alone has seen two of the biggest deals on either side of the Atlantic – buy-outs of Alliance Boots and Chrysler – forced to increase the premium, or interest rates, on loans they are trying to sell. Bankers in a flurry other deals have had to act likewise.

This means it is going to cost the US carmaker, which is being bought from DaimlerChrysler by Cerberus, the private equity group, an extra $20m annually to service this debt, plus whatever it has to give away in discounts, which could be another $20m up front.

On the same day it also emerged something similar was going on at Alliance Boots, the record UK leveraged buy-out, which is seeking some £9bn worth of loans from investors.

The changes are likely to cost anywhere between an extra £15m and £31m annually, according to investors’ expectations, plus some more in terms of fees.

However, it is not yet certain that even this will be enough to get the buyers in. One London-based investor said he thought the Boots loan had little chance of getting the commitments it wants from investors by a tentative deadline on Friday.

It goes on to other deals, similarly afflicted (it’s worth the read). Couple that with the news that financial offerings are becoming less popular with ordinary investors (another ripple in the pond from that sub-prime skipping stone), and a picture forms, thank you Mr. Squiggle (Brits: think Rolf Harris. Americans, I don’t know. I’ll ask my wife), of a market that is coming to remember that debt has risk attached.

If only the re-awakening would extend to casinos and bloody pokies (Brits: fruit machines. Americans: slot machines), I’d be ecstatic. Not just regular ecstatic. Just-been-told-Joss-Whedon-got-the-cast-back-together-for-5-more-seasons-of-Firefly ecstatic. And if you don’t get that reference, you’re God’s problem.


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