I was surprised by the overly simplistic op-ed by Mankiw a couple of days ago — for Mankiw, it’s all substitution effect, no income effect.  Here’s Matt Bodie (SLU) with a snarkier take:

Two years ago, Greg Mankiw threatened to stop working if Obama was elected, basically on the theory that his tax rates would go up and his incentives would thereby go down.  It was one of those “Going Galt” threats that looks ridiculous in retrospect.  Mankiw, of course, is still a professor at Harvard.  But he has stopped working in one respect — hes recycled that old blog post into an op-ed for the New York Times.  A few thoughts:

First, if youre looking for reasons why the print media continues to lose importance and market share, compare this and this.  The New York Times essentially ran a two-year-old blog post in its Sunday edition.  I cant even really blame Mankiw for this — where are the editors?  In fact, I think Mankiws op-ed is an elaborate inside joke on his part.  ”Two years ago, I threatened to stop working.  And I made good on that threat!  Of course, if people want to pay me for not working, Im happy to accept it, even with higher taxes.

via PrawfsBlawg: Greg Mankiw is threatening to stop working again.

This Bloomberg story, among others, reports that fund managers are trying to realize portfolio company exits before year-end tax increases.  For funds in which the investors are tax-exempt, however — most PE fund investors are tax-exempt pension funds and endowments — the GP’s tax planning may violate the GP’s fiduciary duty to its partners in the fund.

The GP’s responsibility to the fund is to maximize the exit valuation and after-tax return to the investors.  Accelerating the exit to avoid additional taxes to the GP is hard to justify.  Fund managers may be accepting lower returns, in other words, to avoid getting hit with higher personal taxes.

To use a simple example, assume that a portfolio company was purchased for $100 and could be sold for $200 in December or $210 next spring.  Further assume that the GP’s tax rate will increase from 15% to 30% at year-end, and that the LPs are tax-exempt.  Clearly the LPs would want the company to be sold next spring, as that’s an extra $10 (or $8 after carry) in their pockets.  The GP, however, would get $17 (20 carry less 3 tax) in December, or $15.40 next spring (22 carry less 6.6 tax).  Thus the rush for the exits.

Of course, it would be hard to prove, in any particular case, that the sale was tax-motivated.  There should be some interesting empirical studies to come.

Tax Driver

Private-equity firms may do more deals in the remainder of the year as they race to sell assets ahead of possible tax changes in the U.S., according to Jeffrey Raich, managing director and co-founder of Moelis & Co. The rate on carried interest, or the share of profits that fund executives earn as part of their compensation, is slated to rise to 20 percent in 2011 from 15 percent currently.“You are seeing a lot of seller deals based on concerns about increases in capital-gains tax rates and potential legislation around carried interest have driven private-equity firms to sell portfolio companies this year,” Raich said. New York-based Moelis advised Connecticut-based buyout firm Littlejohn & Co. on the $890 million sale of Van Houtte Inc. coffee to Green Mountain Coffee Roasters Inc. this month.

via M&A Snaps Back as BHP, Intel Drive Busiest Quarter in 2 Years – Bloomberg.

A mention from the President probably helps the chances of the tax extenders bill in which carried interest reform is embedded.  As always, though, in would be useful to know what the Senators from Maine are thinking.

But Obama held his ground, saying the majority of Americans likely believe he has been too soft on Wall Street. His case in point: the White House has not been able to end the practice of taxing some hedge fund and private equity fees as capital gains rather than income. So-called “carried interest” is taxed at 15% rather than the 36% tax rate that hits the highest income tax bracket.

“The notion that maybe you should be taxed more like your secretary when your pulling home $1 billion a year isn’t me being extremist or anti-business,” the president said.

via Obama Raises Prospects of New Economic Team – Washington Wire – WSJ.

The tax extenders bill, with carried interest reform, is back.  I haven’t looked at the new bill yet, but I suspect there are not a lot of changes from June.

U.S. Senate Democrats on Thursday revived an effort to impose steeper taxes on private equity and other investment fund managers.

The legislation would raise about $14 billion over a decade by taxing most of a fund manager’s income at the higher ordinary income rates, now 35 percent, rather than the current 15 percent capital gains tax rate.

via US Senate Dems revive private equity tax proposal | Reuters.

I think it’s worth noting that in the UK, where private equity and buyout firms are already known as venture capital, the PE guys aren’t exactly loved.

When they were kings of the world in December 2006, eleven of the largest private equity firms banded together to form the Private Equity Council, a Washington-based trade group.

Nearly four years and millions of dollars in lobbying fees later, the council has — are you sitting down? — changed its name.

As of Tuesday, the group is now the Private Equity Growth Capital Council. If that sounds clunky, don’t worry. It looks like the group intends to refer to itself by the mellifluous acronym Pegcc.

via Peter Lattman, Private Equity Council Undergoes a Name Change – NYTimes.com.

I’m in NY for the fall semester as a Visiting Professor of Law at NYU.  I’m teaching Deals to a terrific and interesting set of students that includes 2Ls, 3Ls, Tax LLMs, International LLMs, Corporate LLMs – should be a fun semester.

Being in residence at NYU is just like NY generally – the quality and amount of intellectual stimulation is amazing, extraordinary, and overwhelming.

Between classes and workshops, I’m finishing a paper on the tax treatment of founders’ stock.  I should have a draft on SSRN in about a month.  I’ll also be editing my paper on regulatory arbitrage, which will be published by the Texas Law Review in December.

Nice story by Dan Primack on the so-called Enterprise Value Tax.

Interesting, except for one small problem: I cannot find any evidence that Sen. Baucus ever opposed the so-called Enterprise Value Tax. In fact, Baucus was a lead sponsor of the very bill that proposed EVT in the first place.”Its total bulls–t,” a private equity industry source said this afternoon. “I wish Baucus had been opposing this tax, but the very idea comes from his office.”

via The tax flip-flop that wasnt – The Term Sheet: Fortunes deals blog.

My father was born in Vienna in 1937, and is a refugee from Hitler.  Changing the tax rate on carried interest so that fund managers pay the same rate as everyone else on their labor income is, um, not the same thing as invading Poland.

“It’s a war,” Schwarzman said of the struggle with the administration over increasing taxes on private-equity firms. “It’s like when Hitler invaded Poland in 1939.”

via Schwarzman: Its a War Between Obama, Wall St. – Newsweek.

KKR is going public.  Here is the prospectus.

The timing is partly tax-driven.  Following the offering, the senior principals (Kravis et al) will be able to sell their shares to the public or redeem their shares with the newly-public holding company.  Under current law, Kravis will be taxed at long-term capital gains rates on the profit from this sale or redemption.  If Kravis sells $500 million to the public, he’d owe $75 million in income tax on the sale, less any tax basis he has in the shares (likely zero).

The pending carried interest legislation in Congress would change this result.  The idea behind the carried interest legislation is that carried interest represents, in part, a return on labor rather than a return on financial capital, and thus it should be taxed in part at ordinary rates.  The Senate’s latest version of the bill would tax 75% or 50% of carried interest at ordinary rates, thus shifting the tax rate on carried interest allocations from 15% to about 25% or 30%, depending on how long the underlying investment funds have held portfolio assets.

The so-called enterprise value tax. The carried interest legislation will also change the tax results when principals in the management company sell their shares to the public.  Normally, when you sell a partnership interest, Section 751 of the tax code provides for a mix of ordinary income and capital gain, depending on the nature of the underlying assets of the business.  The portion of the sales price attributable to inventory and other “hot assets” that would generate ordinary income in the short-run generates ordinary income; whatever is left generates capital gain.  For investment services management companies, most of the value of the business under current law generates capital gain, including the (large) portion of the value attributable to goodwill.  Proposed section 710 would tweak this result, recognizing that much of the value of the business (like current and future management contracts and carried interest allocations) partly represents a return on labor and human capital rather than financial capital.  The new legislation would treat the portion of the business attributable to goodwill and other intangibles as 50% ordinary income and 50% capital gain.

If Kravis holds on to his KKR shares and sells them after the effective date of the carried interest legislation (currently slated for the end of 2010), then his tax rate on the sale would be 25% or 30%, because of the way that proposed section 710 would treat the disposition of an investment services partnership interest.  Instead of paying $75 million in income taxes, he might pay $150 million.  So Kravis alone has tens of millions of dollars at stake to push for a public offering this summer so he has time to dump as many shares as possible before the end of the year.

What KKR Shareholders Should Know. The first thing KKR shareholders should know is that the timing of the US IPO is partly driven by tax reasons — the insiders’ desire to avoid their personal income tax liability.

The second thing KKR shareholders should know is that they will be funding most of Kravis’s tax bill.  Through a tax receivable agreement between the public holding company and the senior principals, when the principals sell shares, which generates goodwill (a tax asset) in the hands of a taxable subsidiary of the holding company, 85% of the tax benefit will flow back to the principals.  The beauty of this arrangement is the tax arbitrage:  while Kravis pays tax on the increase at the 15% long-term capital gains rate, the goodwill is amortized over 15 years at the 35% ordinary income rate.  If Kravis sells for $500 million, generating $75 million in income tax liability, and $250 million is attributed to goodwill, the $250 million would generate a tax benefit of about $6 million a year for 15 years, which has a present value of about $58 million, of which Kravis would receive 85%, or about $50 million.  Kravis’s $75 million tax liability will be effectively 2/3 funded by KKR public shareholders.

Pricing the Tax Receivable Agreement. In theory, this projected liability under the tax receivable agreement — which effectively increases the tax liability of the KKR public company by removing a tax asset — should be priced into the offering.  But it’s not at all clear that it will be.  The whole point of the tax receivable agreement is that investors are not good at pricing in the value of this tax asset; since the market doesn’t value the tax asset nearly as highly as Kravis, he’ll just enter into a contract with the KKR public company so that he retains the benefit of it.  The public company has nobody at the negotiating table; the shareholders’ only recourse is to pay less for KKR shares.

Policy concerns. From a policy perspective, four things bother me.  First, as I wrote about in my article on the Blackstone IPO, these publicly-traded partnerships should really be taxed as corporations.  The only reason that they are not is that, under current law, carried interest is treated as investment income rather than service income.

Second, even after the carried interest legislation passes, the lobbying efforts of the PE industry have secured a ten-year (!) transition relief that will allow them to continue to be taxed as if they were privately-held partnerships rather than publicly-traded partnership.  There’s no policy rationale for a transition rule that exempts not only existing PTPs but future PTPs (like KKR) for 10 years.

Third, the goodwill tax arbitrage is good for the insiders and bad for public shareholders.

Fourth, the motivation and tax treatment of the selling shareholders highlights a broader problem underlying Section 751.  Section 751 was not designed with global financial services firms in mind; it allows easy conversion of labor income into capital gain.  As the US has fewer firms with hard assets like factories, inventory, and equipment and more firms with intangible assets, we’ll need to revise the tax code to maintain fair and equitable treatment.  Your tax rate shouldn’t depend on whether you happen to work for a partnership or a corporation.

References:

1. Victor Fleischer, Taxing Blackstone, Tax Law Review (2008)
2. David Cay Johnston, Tax Loopholes Sweeten a Deal for Blackstone, New York Times, July 13, 2007.

KKR Structure

The new structure is similar to Blackstone and Fortress.  It’s designed to avoid the corporate tax that normally applies to publicly-traded entities; the strategy depends on carried interest being treated as investment income rather than labor income.