Private equity having tough time knocking tax rise

NEW YORK (Reuters) - Private equity gurus are having a hard time making a case against raising taxes on the industry's bread and butter.

A lack of support from pension funds, coupled with a study showing buyout firms can earn even more money from fees than from selling on restructured assets, has undermined the buyout industry's fight against a proposed tax increase.

Pending legislation would raise taxes on "carried interest" -- profits on the sale of assets -- at private investment funds to 35 percent from 15 percent.

Lobbyists say President George W. Bush would likely veto any carried interest bill, given that it could raise taxes on thousands of firms. But just how deep a hike would cut into private equity profits has come into question lately, indicating carried interest would remain on the front burner should Democrats win the White House in the 2008 election.

Pension funds -- private equity's biggest investors -- have been largely silent on the issue, a sign that pension managers feel the tax rise would not hurt investment returns. They are also under pressure from unions to support the hike.

A recent study on fees isn't helping private equity's cause either. Leveraged buyout funds can expect to collect $10.35 in management fees for every $100 they manage, while $5.41 comes from carried interest, according to two professors at the Wharton School of the University of Pennsylvania.

Buyout firms routinely charge companies "deal fees" just for doing transactions, and "monitoring" fees for running the businesses.

The lack of support from pension funds is an especially tough blow to buyout firms. The firms often defend their riches by saying private equity's success helps support the pensions of firefighters, police officers, teachers.

True, buyout returns help keep pensions well funded, but they're only a small part of a pension fund's portfolio.

"It will not impact us in any material way," said Terren Magid, executive director of the Public Employees Retirement Fund of Indiana, referring to the carried interest bill. About 2 percent of the $17 billion fund is in private equity.

Private equity firms buy and sell companies by borrowing most of the money, using cash raised from institutional investors such as pension funds, and college endowments.

While the carried interest bill would impact both hedge funds and private equity, the focus of the legislation has centered on the riches created by the buyout industry.

With more than $700 billion of deals in the last year, on more than $400 billion raised from investors, the industry has taken over several big-name companies, including Hilton Hotels and HCA, and created high-profile billionaires in the process.

Buyout firms typically charge a 2 percent management fee on funds they invest, so a 50-person firm with $10 billion would share $200 million. While some of that pays for expenses, a lot ends up in managers' pockets. The management fee is subject to a 35 percent ordinary income tax.

But buyout firms also keep 20 percent of the profit they earn from the sale of a company -- money taxed at the 15 percent capital gains rate. The carried interest bill, if it passes, would bump that tax rate up to 35 percent.

LOOP HOLE OR FAIR TREATMENT?

Opponents of the carried interest bill say the private equity business is structured in such a way that supports the capital gains rate.

"The tax treatment of this ownership structure is well settled by case law and administrative rulings of the Internal Revenue Service. It is anything but a loophole," Carlyle Group CYL.UL Managing Director Bruce Rosenblum told Congress in July.

He said there is a clear distinction between owners who take entrepreneurial risks to grow businesses over time and employees who are paid based on their performance.

But some in the industry question just how entrepreneurial buyout investing is.

"No aspect of my income ... would cause me to lose money," said Leo Hindery, a managing partner of buyout firm Intermedia Partners, speaking at The Deal's "Convergence 2.0" conference in New York on Monday. That's because private equity involves investing other people's money, he said. Warnings of firms going belly up or overseas should taxes go up are overblown, he said, echoing what other buyout executives have said.

Raising the carried interest tax rate is seen by some lawmakers as one way to help pay for reducing the alternative minimum tax, seen as urgent since the AMT is expected to hammer more than 20 million taxpayers this year. Originally designed to make sure wealthy taxpayers paid their fair share, the AMT is increasingly hitting the middle-income brackets.

How much the government would make by taxing carried interest at the ordinary income rate is unclear. Estimates put the potential take at $3 billion to $10 billion a year. Costs of fixing the AMT range from $50 billion to $800 billion.

Democrats have adopted a pay-as-you-go budgeting rule since winning control of Congress last November. So measures that promise to bring in sizable revenue tend to get more attention than modest revenue raisers, a pattern likely to play a role in deciding the fate of carried interest taxation proposals.

(Additional reporting by Kevin Drawbaugh in Washington)