Private equity tax a thorny issue for pensions

NEW YORK (Reuters) - The debate over raising taxes on private equity firms has put pension fund managers in a tight spot.

On one hand, the managers have reaped big investment returns from many private equity firms, which has helped keep retirement coffers well funded.

On the other hand, the managers face a fierce protest from unions that represent pension workers who believe private equity dealmaking should be reined in, and that the firms should pay higher taxes.

The pressure on pension funds to side with the workers revealed itself on Wednesday, when Reuters reported that a trade group representing more than 500 U.S. pension funds had withdrawn its opposition to two pending tax bills aimed at raising taxes on buyout firms.

The trade group, the National Conference on Public Employee Retirement Systems (NCPERS), said last month in a letter to the leaders of the Senate Finance Committee that raising the taxes would hurt pension funds and public employees.

But on Tuesday, NCPERS asked the lawmakers -- committee Chairman Max Baucus, a Montana Democrat, and the panel's senior Republican, Chuck Grassley of Iowa -- to disregard that letter.

The follow-up letter did not entirely explain why the group had changed its stance. But sources close to the matter said pressure from unions led to the reversal.

The complexity of the issue is reflected in the response of California Public Employee Retirement System (CalPERS) spokesman Clark McKinley when asked where the largest U.S. pension fund stands on the matter.

"We are not taking a position," he said.

TAX BENEFIT OR LOOPHOLE

From its inception in 1990, CalPERS' Alternative Investment Management Program, which invests in private equity funds, has generated $11 billion for CalPERS.

For example, the KKR Millennium Fund, which CalPERs allocated $150 million to in 2002, gave CalPERS a net internal rate of return of 37.9 percent on its investment.

But if Kohlberg Kravis Roberts & Co. goes ahead with an initial public offering, a bill proposed by Baucus and Grassley would increase the firm's federal tax bill to 35 percent from 15 percent.

How much the hike would end up pinching KKR's returns is under debate, but private equity representatives say it would be significant.

Even more significant, the representatives say, is proposed legislation that would increase the taxes buyout firms pay on profits -- known as carried interest -- to 35 percent from the current 15 percent.

Passage of this bill could impact returns at small market buyout shops as well as big firms such as the Blackstone Group (BX.N), whose fourth fund gave CalPERS a net internal rate of return of 55.2 percent on $200 million invested, according to CalPERS' Web site.

But the Service Employees International Union (SEIU), which represents 1.8 million workers, believes the issues of job losses and unfair tax treatment trump the pension return factor.

CalPERS invests the pension money of 90,000 California state employees who are members of SEIU Local 1000 and whose pensions have benefited from private equity returns.

Yet the SEIU is waging an aggressive campaign against the private equity industry, taking aim at the billionaires the industry has minted in the last few years.

Asked to name a recent takeover that involved job cuts of SEIU employees, union spokesman Andrew McDonald could not name one.

But job cuts are typically a standard step that private equity firms take immediately after buyouts to improve profits. Whether private equity buyers add or subtract jobs in the long term is subject to debate.

The SEIU is also pushing for better compensation and insurance for workers who remain after buyouts.

The AFL-CIO, a federation of 55 U.S. and international unions whose members benefit from private equity returns through their pensions, is campaigning hard in favor of the carried interest bill.

"We're not in favor of the bill because we think private equity is a bad thing," said AFL-CIO spokesman Daniel Pedrotty. "What we're saying is that this is a tax loophole that should be closed, and closing it will not affect our pension returns."

Proponents of the legislation say the higher tax rate will produce greater revenue for the federal government.

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