Tuesday, May 8, 2007

“Who’s Afraid of the Big Bad Taxman…Blackstone?”

Apparently, the Blackstone Group has reason to worry. Last March, Blackstone, announced it was going public as a $40 billion tax-favored private equity partnership. It is impossible to tell for sure, given their hush-hush nature, but according to reports, Blackstone’s principals may have foreseen the taxman's arrival and decided to cash out early. Or so they thought. (For more on the tax implications of Blackstone's proposed partnership structure, see the posting “The Taxman Cometh…But Only for Some” and Victor Fleischer's blog.)

Indeed, conditions are looking a bit unfavorable for private equity firms. Newspapers, from the Wall Street Journal to the Financial Times, are reporting on a growing flurry of activity in the U.S. Senate around increasing the tax rate paid by private equity fund founders and partners on their 20% cut of the profits from their investment funds. If the Feds decide to tax carried interest as income rather than capital gains, partners could see their tax bill more than double.

Is this a good thing? The jury is still out, but the prospect of a change in the carried interest tax rate seems to have spurred other private equity firms to follow Blackstone’s lead. Last week, TPG announced it was considering selling a 20% stake in itself to pension fund investors. Are we surprised that TPG would react to Fed activity much in the same way Blackstone did a few months ago, and try to cash out before any higher tax rate hits?

Unfortunately, for private equity firms, Senate deliberations are bringing the tax-favored private equity partnership IPO escape-hatch into question. Buyer beware is the news of the day for investors. According to the Financial Times, the Blackstone “IPO prospectus warns potential investors of the possibility that its bid to be treated as a partnership could fail,” if the Feds decide to treat the partnership as a corporation and tax it accordingly.

Moreover, to complicate matters for private equity firms, the Senate has started to meet with financial experts, like Law Professor Victor Fleischer of the University of Colorado, who are concerned that private equity firms, like Blackstone, put investment banks, like Goldman Sachs and Morgan Stanley, at a competitive disadvantage. Professor Fleischer argues that the partnership structure gives private equity firms an unfair tax rate advantage over investment banks whose traditional corporate structure subjects them to a higher corporate tax rate.

TPG and Blackstone aside, an unjust tax code – one that favors one type of business over another – has the potential to undermine true competition. The fact that the Senate is conducting a thorough inquiry into tax policy affecting the private equity world can only be a positive thing for everyone.

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