CandidCapital

Part 1 of this review of how private equity managers are rewarded covered fee income and carried interests. Today we cover the impact of tax, especially taper relief for capital gains and the impact of leverage.

Taxation 1: Carried Interests

Now for an attempt to explain why the taxation of PE transactions has occasioned wailing and gnashing of teeth. (Some of you may remember the riposte of the fire-and-brimstone preacher to the elderly parishioner who protested that she has lost all of hers: 'Teeth will be provided.')

It is not just investments by PE funds that are leveraged; investments into PE funds themselves generally comprise a small amount of equity (<1%) and a large amount of debt. The limited partners or external investors (pension funds, high net worth individuals, banks) will be repaid their debt before profits are distributed on the capital commitment.

It is normal for the management team - the partners in the PE firm - to provide 1%-3% of the funds under management themselves to reinforce the alignment of interest between the external investors and the managers. (The rule of thumb is the same as for a management team in MBO: enough of your own money to concentrate the mind, but not so much as to distract you from doing the job.) The managers in many cases will borrow to make the investment.

PE managers and their advisers over the years have skilfully played the tax rules to minimise the amount of capital gains tax they have to pay. As a result, the carried interest of fund managers is treated as a capital gain (not income) and benefits from low rates of tax because of taper relief.

The House of Commons Treasury Committee report (page 37) explains clearly how the rules work:

Business assets taper relief was introduced in 1998 as part of the reforms to Capital Gains Tax (CGT). In its original form, it reduced the CGT payable on business assets that were held for at least 10 years from 40% to 10%. In 2000, the period after which the maximum taper relief applied was reduced to five years, and it was reduced again in 2002 to two years. The original intention was to reward long-term investment, with a view to promoting enterprise and the venture capital industry. This was before the increase in the size of the largest private equity transactions. […]

Because the private equity partners also work in the companies which they own, their ownership of stakes in those companies is treated as a business asset and receives the most generous form of taper relief. Such relief was originally intended to support business start-ups and venture capital which were seen as high-risk ventures, whereas it is difficult to argue that the takeover of a large established company poses an equivalent risk to the new owners.

The Committee identified the following issue arising out of the tax treatment of carried interests:

The question is, therefore, whether the reward is disproportionate to the risk, and whether the carried interest should be regarded as a capital gain or a reward for services, reflecting in the latter case the fact that it is not directly a return on the capital invested.

And it is a fair question. I’ve struggled to find an analogy and the best I can do is this. Imagine you worked for an oil company that regularly sends managers for 2-year postings to countries such as Nigeria or the Sudan. To ensure a sufficient flow of suitable candidates, these postings attract a 30% hardship allowance. Over time, the allowance is extended to ‘grey’ zones – Alaska, say. Then as profits rise over the cycle and a few astute managers negotiate skillfully with the company, the allowance is extended to postings such as Texas; after all, both Texas and Alaska are part of the same country.

It isn’t long before even the guys at head office are receiving a hardship allowance for working in Mayfair. And that is what happened with Private Equity. Perhaps it’s not surprising the engineers working in Uzbekistan (i.e. venture investors) are looking uneasily over their shoulders in case their allowances become collateral damage when a new broom sweeps away lotus eating at HQ.

And a new broom is distinct possibility. The taxation of PE funds structured as limited partnerships has been governed by a Memorandum of Understanding with the Inland Revenue since 1987 (revised 2003): within given parameters, capital gains treatment would continue to apply to profit shares earned by the general partners, who will be treated as if they had paid fair value for the right to the carried interest.

The Treasury Committee has asked what is now HM Revenue & Customs to explain the rules including (p38):

'•setting out the rationale behind the production of the Memorandum of Understanding in 1987 and the update to it in 2003;
• explaining the extent to which the Memorandum is used by the private equity industry;
• assessing whether the context in which the Memorandum is currently being used conforms with the original rationale; and
• stating whether the override provisions of the Memorandum have been exercised and what internal guidance on the exercise of the override has been prepared.’

Watch this space. There is an outside chance that the tax regime may finally be tweaked to benefit high-risk, early-stage venture capital. But there is also a risk of the venture baby being thrown out with the private equity bath water (or asses’ milk, as it is in many instances). A similar review is being undertaken by the United States Congress.

Taxation 2: Domicile Rules

You will be relieved to know that this issue is relatively simple. As a general principle, if you are not domiciled in the UK, you are not subject to UK capital gains tax. A number of PE managers who, on any normal use of English are based in the UK and have been for many years, have been accused of making themselves non-domiciled for tax purposes.

The Treasury Committee has asked HM Revenue & Customs to crank up the review of the rules begun in 2003.

Taxation 3: Corporate Leverage and Irrelevance Theory

The final way in which debt can impact on the returns to PE managers is through the impact of the different tax treatment of debt and equity. This is a particularly complex subject studied by two Nobel prize winners, so I shall try to be as brief as I can while still including the essentials.

The splendidly-named irrelevance theory, which helped Franco Modigliani (1985) and Merton Miller (1990) win the Nobel Prize for economics, states that a firm’s financial structure—proportions of debt and equity, dividend policy—make no difference to its total value; financial structure only changes who benefits from how a corporation is funded. Therefore, neither managers nor owners should devote time to issues such as gearing or dividends; instead, they should simply maximise the value of their firm. However, irrelevance theory is only true in exceptional circumstances, because it is based on the following assumptions:
• No taxes exist
• No transaction costs exist
• Individuals and corporations borrow at the same rates

The point of the ‘M&M model’ is that it shows that if capital structure matters, it is precisely because one or more of the assumptions have been violated. In practice, an investor cannot adopt the detached view implicit in the irrelevance theory but must operate at a much more micro-level.

And one of the most important aspects that investors cannot ignore is taxation. Interest on debt is treated as a business expense and is therefore generally tax-deductible; dividends on profits are paid out of after-tax income. Hence the significant incentive to gear up a PE-funded company with as much debt as possible.

And here the fault may rest at least as much with government policy as with PE managers with an eye to the main chance. As the Treasury Committee put it (p39):

'Several witnesses indicated that increased use of debt instead of equity partly reflected the removal of dividend tax credits in 1997. Professor Jenkinson said that the removal of dividend tax credits “gave a spur towards more highly-leveraged structures”. Chris Gibson-Smith, Chairman of the London Stock Exchange, told us that “the removal of dividend tax credit effectively taxes profits in public companies twice”. And Jon Moulton of Alchemy told us that “debt became more favoured in the UK when the tax credits were taken off dividends”. The London Stock Exchange also noted the impact of stamp duty on the cost of equity, citing a study commissioned by itself and others which had estimated that stamp duty made the cost of equity of UK listed companies between 7% and 8.5% higher than it would otherwise be.'

It’s reassuring to be able to end this survey of tax and private equity on a note that does not reflect too badly on PE managers. And for the time being, the turmoil on international debt markets will likely slow down many of the most leveraged deals.

Summary

Blimp told me that he had a friend who, at the height of the dot.com boom, played a round of golf at Pebble Beach in California. Before setting off, greens fees had to be paid, buggies hired, balls bought, time slots booked, caddies paid….and as the man at the Pebble Beach office commented, ‘We sure know how to take your money off you here, guys.’

Something similar has been going on in private equity. So long as larger-MBO funds produced rates of return greater than quoted equities, investors did not ask whether the green fees were worth it – this was Pebble Beach, after all.

And the relatively risk-free, predictable world of private equity was able to wrap itself in the glory associated with the riskiness of venture capital. In so doing, it took on with a vengeance the capital gains tax relief aimed at venture investors, which may now as a consequence be at risk from a legislative review.

My criticisms of how PE managers have played the tax game are certainly not an argument in favour of taxation in general. Rather, they are about fairness and ensuring that the underlying purposes behind tax policies are met. As US Senator Chuck Grassley, a Republican from Iowa and hardly an egalitarian firebrand, put it:

‘It is not about whether alternative asset managers are good or bad for society. We’re not here to have a hearing on each industry, measure its value to society, and assign a tax rate accordingly. This hearing is about our responsibility to ensure that the tax code is operating fairly and consistently with the intent behind enacted policies. If it is not, then there is an unintended subsidy being provided to some, while others pay for it with higher taxes.’

15 August 07

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