Public-pension LPs could get dinged by provision in tax plan

Public pensions are lobbying House and Senate leaders to halt a proposed change to the tax code that could make their private equity investments more expensive.

Both the House and Senate in recent weeks approved bills to slash the corporate tax rate while eliminating certain deductions. One of the revenue-raising proposals the House approved would require public pensions to pay taxes on unrelated business taxable income, a common type of earning PE funds generate.

The Senate’s version of the bill did not include this provision.

House and Senate leaders before year-end are expected to agree on a joint version of tax reform, which would likely deliver President Donald Trump and congressional Republicans their first major legislative accomplishment since they assumed control of both branches of government in 2016.

Public-pension LPs, led by organizations like the National Conference on Public Employee Retirement Systems and Institutional Limited Partners Association, are lobbying to keep the UBTI provision out of the conference version of tax reform.

“We, along with a number of other folks, other plans, have been meeting with House leadership and the tax-writing committees in both the House and the Senate,” said Hank Kim, executive director and counsel at NCPERS. “And we’ve expressed our concerns and expressed our positions, and hopefully when they go to conference, it’ll be out of the final bill.”

Officials from several state pensions were in Washington last week to pitch their case to Senate leaders, Washington State Investment Board spokesman Chris Phillips told Buyouts.

“Our main concern is that it not unwittingly get carried over from the House bill,” Phillips said. “We’re really pushing it as a fiscal issue rather than a political effort.”

UBTI

Portfolio companies sometimes generate income that’s unrelated to a sale or exit, which is characterized as UBTI. As with most PE-related earnings, this income flows up from the companies through the partnership before it’s distributed to LPs.

For certain tax-exempt LPs like foundations and endowments, however, this UBTI is subject to a higher rate than the fund’s business-related income (i.e., exit proceeds).

In certain instances, PE firms will set up paper corporations to limit those LPs’ tax hit — known as blocker corporations — to act as tax buffers between the portfolio companies and more tax-sensitive LPs.

Those blocker corporations absorb UBTI before it’s distributed to LPs. The blocker corporation pays the taxes at the corporate rate, which is lower than the rate endowments and foundations would be taxed at if they received those distributions directly.

Until now, none of the above applied to tax-exempt state pensions. The House version of tax reform would eliminate public pensions’ exemption for this type of income, which could subject retirement systems to tax rates as high as 39.6 percent on UBTI.

The Senate’s version of the bill, which passed on Friday after last-minute negotiations, maintains the status quo for public pensions.

That could change, however, when the House and Senate negotiate a final version of the bill in conference over the coming weeks.

“It could mean that tens of thousands of [fund] structures, where the public pensions didn’t set up those [blocker corporation] structures, are impacted,” said Chris Hayes of the ILPA. “All of this creates an immediate drag on returns, because if you don’t get the blocker in place … you’re going to pay 39.6 percent.”

That doesn’t take into account the costs public pensions will incur when GPs restructure their limited partnerships to set up the blocker corporations, he said.

It’s difficult to fully gauge the section’s full impact, given the uncertainty around tax reform. Certain funds might offer public pension LPs a chance to restructure their agreements, though some LPs might not even go through with that process, said Rafael Kariyev of the law firm Debevoise & Plimpton.

“We’ll have to see whether funds actually offer to restructure,” he said. “Could they offer it? Yes. Would it be all that difficult? I suspect not.”

The point may be moot, however. Kariyev said he’s guessing the Senate will dictate the conference version of the bill — given the level of negotiation it took to obtain a simple majority. Hayes said he was relatively optimistic from his conversations with Senate officials.

“On the Senate side, our views have certainly been made apparent to the chairman and the [tax-writing] committee,” Hayes said. “We’re hopeful as we continue to raise the issue’s profile.”

Action Item: National Conference on Public Employee Retirement Systems: www.ncpers.org

The U.S. Capitol Building is seen shortly before sunset in Washington on May 17, 2017. Photo courtesy Reuters/Zach Gibson