Private Equity From Two Sides

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

The Levellers (an old Label . look it up)

A number of factors are coming together as this is written, to create a combustible atmosphere for private equity . including particularly buyouts and hedge funds but potentially dragging venture capital funds into the mix as well. Witness the decibel level of media criticism, fueled in part by reports of the perfectly extraordinary amounts of money the principals of buyout funds took home last year. And factor in a Democratic Congress, the members of which are concerned with typical Democratic issues . including the widening gap between the rich and the middle class/poor in this country. The lower tier may be holding its own if one looks at historical levels of poverty versus affluence; but the absolutely spectacular upwards spike in compensation (ordinary income and capital gains) to private equity and hedge fund managers necessarily widens the gap to extraordinary levels. Accordingly, there are three (at least) clouds on the horizon as plaintiffs and Congress take up the challenge.

  • First, there is a proposal in the Congress to tax carried interest profits (gains) for managers of buyout funds at ordinary income versus capital gains rates. As articulated to me by corridor commandoes on Capital Hill, it is unclear how far this proposal will travel. Parenthetically, if the Treasury and the Congress elect to tax carried interest profits at ordinary income rates, it can be confidently predicted that the managers will try to navigate around the change (or at least attempt to do so) by adopting a system which has long been in effect at certain financial institutions like XYZ Bank vis-…-vis the managers of the private equity funds capitalized by the institution. The managers are (or at least were in the old days) styled as 'friends of XYZ Bank' (I believe that was the nomenclature used). As each position was acquired by the fund . a private label fund as it were . the bank lent (indeed now loans, as far as I know) sufficient capital to the managers to co-invest in accordance with that percentage which otherwise would have been their share had the carried interest been in effect. The loan is recourse to the manager only to the extent required so it is not deemed to be compensation to the manager in question.[1] Upon a liquidity event, the loan is, of course, repaid. If the investment is a bust and the loan is repayable, XYZ Bank can forgive the loan and 'gross up' the payment (and accompanying tax). More likely is the scenario in which the cumulative results from the fund's activities are significant plus, so that the loans called by reason of a portfolio company's failure can be repaid from the abundant profits which the fund has made over the years, on the basis of its winners.
  • Next is the litigation involving Silverlake and Texas Pacific Group in the buyout of Sabre and Travelocity. In settlement of a shareholder lawsuit, the buyout fund entered into an agreement with plaintiffs (and plaintiffs presumably represent a class that includes all the public shareholders of the target) to share with the public shareholders the "resale profit" if the purchase yields in turn a profit of more than 10% on the funds' investment within six months of the buyout. The exact metrics, to quote an article by Paul Ziobro in The Dow Jones Wire are:

"If Sabre sells at least 60% of its voting securities, at least 60% of Travelocity, or at least 60% of its other businesses for cash or other marketable securities, it will pay the class members of the McBride suit an amount equal to 25% of the resale profit."

I am quoted in the piece, as follows:

"People are going to be alarmed that this sets a precedent" . "If these shareholders get it, why aren't others getting it?"

". the settlement may allow public shareholders in future public-to-private buyouts to push for more concessions to ensure they aren't being fleeced by PE firms .

Thus, if you look at the glass as half empty, the settlement may be just the thin edge of the wedge . public shareholders looking for what amounts to an earn out (a/k/a "dummy insurance") in going private transactions, which will tend to capture profits from the buyout firm in, say, the first five years . vs. the first six months.[2]

  • The final cloud has to do with a report from Dan Primack, on Private Equity Week Wire (Thursday, March 29, 2007). Primack reports that the powerful Service Employees International Union has focused in on Blackstone's proposed IPO. Steven Lerner, an assistant to Andy Stern, the SEI president, is quoted by Primack as follows:

"Lerner says that Blackstone has made much of its fortune on the backs of company employees, and that its IPO should not just be used to continue consolidating wealth for the privileged few. Instead, it should partially be a mechanism for kicking some cash down the employment food chain.

"After all, Lerner points out that Blackstone execs are going to make a fortune on fees and carried interest from the Equity Office deal. But what abut the janitors who literally clean those assets? Do they get a cut? Even a tiny one?"

As Jimmy Durante liked to say, "Everybody wants to get into da' act."

The Futurists

The Public Company Model is Busted

On the other side of the coin are two arguments, supporting the trend to buyouts of public companies, which run as follows:

One is expressed in a Blog by Larry Ribstein, a well known Professor at the University of Illinois Law School, who is discussing Marty Lipton's speech of February 7th. I cannot improve on Ribstein's prose so herewith follows (i) a link to the site why-is-the-public-corporation-in-eclipse where you can pick up the entire article; (ii) for those of you out of the reach of your Blackberry, an excerpt making Ribstein's major points, plus quoting extensively from Lipton's speech as follows:

Briefly, Lipton identifies alien forces that have besieged the modern corporation and are threatening the functionality of its key institution--the board of directors. Among other things, Lipton indicts:

--Activist investors who pressure the board to "manage for the short-term;"

--Experts who "reduce boardroom collegiality;"

--Powerful committees that function as "distinct fiefdoms;"

--Disruptive special investigation committees;

--Public pension funds that demand meetings with independent directors;

--Withhold-the-vote campaigns used to "embarrass compensation committee members;"

--The use of shareholder litigation as "a type of extortion;"

--"Media critics and governance watchdogs [who] simplify scandals and assume that all directors are at fault when something goes wrong;"

--Burdensome director screening that that discourages service by qualified candidates; and

--Governance watchdogs who "justify their existence and satisfy political motivations by finding new governance practices to propose each year."

Lipton concludes by "embracing Professor (Michael) Jensen's 1989 article [The Eclipse of the Public Corporation] less for the reasons he espoused in 1989 and more as the solution to the problems created by rampant, unrestrained and unregulated shareholder activism."

I sympathize with Lipton's litany of woe. I've discussed and criticized a lot of what bothers him on my blog over the years. Moreover, I think he's correctly identified where all this is headed--the end of the publicly held corporation.

Herewith also a link to the full text of Lipton's speech, Shareholder Activism and the 'Eclipse of the Public Corporation', noted yesterday, which is required reading, in my view, for professionals in this business including (I hope) policy makers.

The gist of all this commentary, taken together with the so-called Paulson Report, the Bloomberg/Schumer Report and other returns from precincts in this country, is that the post-Enron pendulum has swung way too far. The country is in need of (i) serious tort reform to level the playing field and take away the power of creative and predatory plaintiffs' lawyers to impose a tax on public companies in this country when and as any hiccup appears in their financial performance; and (ii) a new model to square away executive compensation so that the "activists" Lipton (rightly in my view) deplores will not be empowered to use CEO salary and benefits to help them initiate and pursue guerilla warfare against public companies . looking to create enough turmoil in the market place from which the activists a/k/a privateers can profit one way or another.[3]

What Would We Do Without Private Equity?

A second look at the future has to do with the effect on private equity if indeed the Congress and the Courts start beating up on what they perceived to be excess profits. Again, let me quote Paul Ziobro, this time in The Private Equity Analyst, as he focuses on threatened tax increases on the carried interest profits:

"When you tax something more, you're going to reduce the activity," said Matthew Rhodes-Kropf, a professor at Columbia Business School with a specialty in private equity, "In general, it's going to be harder to be in the industry."[4]

Of course, a typical policy maker, a Congressman, for example, might take the view that the diminution of activities by private equity funds is solidly in the "who cares" department. The obscene (allegedly) annual take home pay is riling the natives, particularly in the Red States . and those natives vote in Congressional and Presidential elections. The problem, however, I see is the principle of unintended consequences; one of the most threatening problems facing the natives, meaning taxpayers in every State, Red or Blue, is that public (and private) employee benefit plans are in many (if not most) cases hopelessly underwater; and in order to pay, in particular, the general retirement and healthcare benefits for the increasing cohort of retired public employees, the States are going to have to either cut benefits and/or impose extraordinary penalties on taxpayers who are not the beneficiaries of those liberal compensation schemes, i.e., lucky enough to retire on a lush (relatively) state or a city pension and/or health care plan. There is one hope, short of the basis tax increases, to fund the ballooning deficits . the investment performance of the pension funds, compounding their investment results at a rate which will enable them to catch up to their actuarial liabilities. It is not going to happen, however, if fancy returns are not available . and fancy returns these days appear to be available in one, and only one, sector of our economy . private equity. These are the returns that will (the pols hope and pray) bail out the delinquent funds. Shoot down the funds and you may kill the geese laying the golden eggs.

[1] An informative Morrison Foerster update indicates ways the Treasury might try to change the tax regime, one or more of which might checkmate the "creative" gambits outlined in the text, viz:

Having noted that no decision has been made to change the treatment of the taxation of carried interests, it is nevertheless interesting that commentators have suggested several possible approaches to recharacterize a portion of the capital gain attributable to a carried interest. One approach is to treat the GP as having received a loan from the limited partners in an amount equal to the carried interest with the GP then investing that amount in the partnership. Under Section 7872 of the Internal Revenue Code ("Code"), the deemed below market (interest free) loan would be deemed to be forgiven over time. This would create cancellation of indebtedness income to the GP, taxable as ordinary income over the life of the deemed loan. This treatment also finds support under Section 467 of the Code, which applies to prepaid or deferred rent under certain rental agreements. Other proposals recharacterizing a portion of the gain would be based on an asset composition and size test applied to the partnership. Thus, funds whose income consists of substantially all capital gains and which meet an assets or income threshold would have a portion of the income attributable to a carried interest recharacterized as ordinary income. Still other proposals would provide for a longer term holding period for the gains from the sale of the securities to qualify as capital gain in the hands of the GP. Finally, rules similar to those which apply to futures contracts under Section 1256 of the Code could be developed in which 40 percent of the gain is short-term capital gain and 60 percent is long-term gain. Since these rules would be arbitrary and inconsistent with basic partnership tax principles in a situation where no abuse of those principles is present, this would not be a preferred approach.

Morrison Foerster Legal Updates & News, Humphreys, Cudd & Feldman, "The Current Debate About the Federal Income Tax Treatment of 'Carried' Interests - Status and Possible Approaches" (Apr. 2007).

[2] The 'half full' view is that the suggested 'dummy insurance' . 25% on 'short swing' profits . will become industry standard . the price one pays to escape relentless criticism in The New York Times.

[3] To buttress this point, see the Sunday, NYT, January 29, 2006, report:

"Over and over again throughout the week [in Davos, at the World Economic Forum], chief executives of some of the world's largest companies repeatedly lamented the costs of being public, and some acknowledged that in this new era of megabillion-dollar buyouts, they would actually prefer to be taken private if possible.

"But it may not be for the reasons you think. While everyone here complains about what they say are the onerous costs of complying with the Sarbanes-Oxley Act or dealing with pesky shareholders, it is much more than that.

"There is a feeling among some managers that being public hinders the fundamentals of their business, from the quality of boards to decision-making and recruiting talent.

"Do I want a board of people who are owners that want to make the business better, or a group that acts like scared regulators?" said one top executive of a major Fortune 100 company. "I'd much rather have a strong businessperson on my board than a Harvard professor who is an expert in corporate governance who only wants to talk about process." (Emphasis added.)

"Crist¢bal I. Conde, chief executive of SunGard Data Systems, said that after a consortium of investment firms took his company private, one of his great surprises was how helpful it was to have a board made up of owners with immense resources at their disposal - like a team of analysts to help each director. Others spoke of the freedom at private companies from having to meet quarterly earnings expectations.

"Then there is the issue of recruiting. Private companies can pay executives more without having to face the wrath of shareholders or the public. One executive at a public company, referring to Stephen A. Schwarzman, chief executive of the Blackstone Group, said, "If I were paid what Steve Schwarzman would pay me if he owned my company and it was still public, someone would find a way to put me in jail."

[4] Ziobro, "The Tax Man Cometh, And Carry Could Suffer," 4 Private Equity Analyst (April 2007).

[5] See a statement, quoted in Primack, PEWeek Wire (Apr. 25, 2007) by Dug Lowenstein: "Private Equity Council chief Doug Lowenstein . in response to the SEIU report . criticized the union for not also noting that "the largest investors in private equity are public employee pension funds, foundations, and universities who have flocked to the sector because top PE firms have generated returns more than triple the S&P 500."

Joseph W. Bartlett, Special Counsel,

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