TOPICS > Economy

Congress Eyes Higher Tax Rates for Private Equity Firms

June 22, 2007 at 6:15 PM EDT

JEFFREY BROWN: Today’s public offering by the Blackstone Group, setting the market value of the company at some $38 billion, is just the latest big splash for an industry that has quickly become a major player in American finance. So-called private equity firms typically buy companies using large amounts of borrowed money, then resell them at a profit.

They’ve been fantastically successful in recent years, earning vast sums for their executives, including Stephen Schwartzman of Blackstone, and for their investors. But they’ve also come under increasing fire from a growing number of lawmakers, who worry about a lack of oversight and believe these companies should pay higher taxes.

We look at the situation now with Douglas Lowenstein, president of the Private Equity Council, an industry trade and lobbying group; and Dan Pedrotty, who works on investment and corporate governance issues for the AFL-CIO.

And welcome to both of you.

Douglas Lowenstein, first, remind us a little bit, tell us a little bit more about how these companies operate and how they make their money.

DOUGLAS LOWENSTEIN, President, Private Equity Council: Sure. Well, private equity is really a form of ownership. We essentially have two forms of ownership in this country: private ownership, which, in fact, represents the vast majority of companies in the United States; and public ownership, companies that are traded on public stock exchanges.

What private equity firms do is organize funds. They raise money from investors, typically pension funds and university endowments…

JEFFREY BROWN: So large investors.

DOUGLAS LOWENSTEIN: Large investors, typically, high net worth individuals are part of that. And they deploy those funds by acquiring companies who might be public companies who are underperforming companies that might have been struggling and not succeeding. They might acquire divisions of other companies, where the parent company has decided that it’s not a good fit and they can’t really give it the attention it deserves is. Or they might even acquire family-owned businesses, where the family owners are ready to liquidate their investment.

The private equity firm comes in, invests in those companies, typically operate them, own them for three to five years, with the goal of growing them, increasing their value, because the entire business model is predicated on buying the company at one price and hopefully selling it down the road at a profit.

And the economic model is essentially that the private equity firms generate their money by selling these businesses at a profit: 80 percent of the return when they make a sale goes to the investors; 20 percent goes back to the private equity funds.

'Even out the tax code'

JEFFREY BROWN: Now, Dan Pedrotty, before we look at specific tax proposals that are being put out there, the general principle, why do some lawmakers -- and you yourself -- think that these companies should be taxed at higher rates?

DAN PEDROTTY, AFL-CIO: Sure, Jeff. We feel like these firms shouldn't be able to take advantage of a tax loophole -- in fact, a subsidy -- to a handful of public private equity firms that would, essentially, enable them a competitive advantage over other firms in the capital markets.

We feel like, especially at a time of unprecedented needs that our nation is facing in Iraq, relocating homeless residents of New Orleans after Katrina, that we should even out the tax code and make it more fair and equitable.

One other problem here that we note, firms like Blackstone, when they go public, are trying to game the system and have it both ways, in that when they make the case that they should have a lower tax rate for their limited partnership, that they engage in passive activities. But when they go to the Securities and Exchange Commission and say that they're not an investment company, they make the opposite argument, that they're an active manager.

JEFFREY BROWN: I'm sorry, you say game the system. Just to be clear, what they're doing is legal in the -- they're loopholes, you call them.

DAN PEDROTTY: They're loopholes that need to be closed, we think. And by going public, by seeking investment and dollars from mom-and-pop investors, we think that they should abide by the same set of rules that other companies, other corporations do. That's on the corporate side. I think there's also an emerging move in Congress to address the carry on the individual side.

Paying at corporate income rate

JEFFREY BROWN: OK, so let's look at the first one, on the corporate side. This is a bipartisan effort in the Senate, from Senators Baucus and Grassley, that says that, when these companies go public, they should pay at the corporate income rate, as opposed to the lower 15 percent rate. Now, why, Douglas Lowenstein, is that a bad idea, I guess would you think?

DOUGLAS LOWENSTEIN: Well, I think there are several issues here. One is it's not accurate that no other corporations operate this way. There are -- Congress, in fact, in the '80s made a series of exemptions from the partnership tax rules that permit companies in certain forms, particularly in the energy and gas industry, to trade as these so-called publicly traded partnerships. So this is not unique to private equity.

We believe private equity firms qualify under those rules to issue shares as publicly traded partnerships, and qualify for the benefits thereto. The problem with changing the law as it's been proposed is that you'll essentially deny private equity firms access to the capital markets and single them out amongst all other corporations, so to say, "We're going to treat you differently, in terms of your ability to access capital," and we don't think that's fair.

JEFFREY BROWN: And would a lot of this activity dry up as a result?

DOUGLAS LOWENSTEIN: Well, certainly you won't have companies -- I think it's highly unlikely that private equity firms will go public if the law is changed. I don't think private equity will cease to exist as a business. Obviously, we have companies operating today in private form, and that will continue.

JEFFREY BROWN: So the argument is they're acting like companies, they ought to pay the corporate rate?

DAN PEDROTTY: That's right, that's right. And Blackstone last year, I would note, just as the most current example, didn't pay a cent in federal income taxes. By their own measure and their prospectus, they paid 1.4 percent as an effective tax rate.

We think, again, as a publicly traded firm, they should abide by the same set of rules, the same tax structure, the same regulatory regime that other companies are faced with. And to take advantage of a loophole in the law, and in a sense, you know, rip off taxpayers by capitalizing on that, we think that needs to be addressed.

And I think you're seeing a growing movement in Congress, both on the House and Senate side, in a bipartisan fashion, to say, "All right, you're going to access the public markets, you need to do so in a fair and equitable way."

Fees earned considered income

JEFFREY BROWN: All right, now, a second proposal just came out of the House today. This is a little more complicated. It's called carried interests. But the idea is the partners and the firms earn fees on the deals they do, and the fees are currently considered capital gains and taxed at the 15 percent rate. So this would consider them as income?

DAN PEDROTTY: That's right.

JEFFREY BROWN: Now, why is that a good idea?

DAN PEDROTTY: We think that's a good idea, because, under the current regime, they're really trying to shove ordinary income into capital gains treatment. And what we're seeing is these individuals, these partners in these firms, are providing a service. It's essentially a fee that they're taking for the 20 percent.

And just as a fair and equitable manner, again, we don't think that someone like Steve Schwartzman should pay a lower tax than a firefighter does on his income. So I think there's an element of almost redistribution of income here in favor of the wealthy, and we think this balances it out by characterizing it and treating it in a different way.

JEFFREY BROWN: And what's the response?

DOUGLAS LOWENSTEIN: Well, I think there are several issues that we have with that. First of all, partnerships, which is what we're talking about, like private equity firms, operate this way and have operated this way for decades under federal tax law. This is not something unique to private equity. Small business partnerships, venture capital funds, real estate partnerships, oil and gas partnerships all operate the same way.

This isn't some sort of creative loophole that's been exploited by private equity; it's central to our partnership tax law. And that law says that people come together, and they pool capital and labor. And if you take risk, if you take entrepreneurial risk, try to build and grow something with that investment, we recognize that as something worthy of incentivizing and rewarding, if you succeed at it.

And that's exactly what's happening in the private equity structure, and it's quite worthy of capital gains treatment, as the current law provides.

Impact on capital markets

JEFFREY BROWN: I mean, you know that, in the political atmosphere, right, I mean, these are fantastic sums we're talking about. Steve Schwartzman today, his stake in this was worth $8 billion, I read. So do you expect -- do you see a political move here to try to go after the -- well, here's where the money is, and firms that do this kind of thing, hedge funds and so on?

DOUGLAS LOWENSTEIN: Sure. Well, obviously, as you refer to, there was a bill introduced in the House today that would change this particular tax treatment of carried interest for not only private equity, but venture capital, real estate partnerships, and a number of other partnerships. So clearly there are those in Congress who are concerned and see this as an opportunity to generate revenue. I think it's going to have quite a harmful effect on investment and growth.

And I think it's important to realize, because we tend to focus a great deal on Steve Schwartzman and these mass sums of money. And nobody is suggested that people in private equity aren't making a lot of money. But let's not lose sight of the fact that 80 percent of the profits generated by private equity firms when they succeed flow back to their investors.

Those are pension funds; those are union pension funds, including some represented by the AFL-CIO. They're foundations. They're university endowments. This is not some sort of a process where a handful of people are enriching themselves at the expense of everyone else out there. And that's, I think, an activity we don't want to discourage and disincentivize.

JEFFREY BROWN: He's got a point there. Some of that does go to your members' pension funds.

DAN PEDROTTY: It does go to our members' pension funds, but our members' pension funds also have the expectation that, when you go public, you abide by a certain regime, you abide by a certain transparency, you abide by corporate governance.

And what Blackstone and other firms are essentially saying is, "Give us all your money and trust us." And we think that there's got to be a more robust regulatory regime.

On the competitiveness issue, if I could just make a couple points, I think, first of all, you saw a recent report from Goldman Sachs that said that U.S. capital markets are the most competitive in the world. IPOs are up 28 percent. So the idea that the markets would suffer from some necessary safeguards, I think, is just fundamentally wrong.

In addition, I think, you know, I think what's best for our markets are a fair tax system, equitable tax base, and strong securities laws.

JEFFREY BROWN: OK. Dan Pedrotty and Douglas Lowenstein, thank you both very much.

DAN PEDROTTY: Thank you.