Friday FeedBack

The rain is falling, the beloved Red Sox are cruising and I’m running late due to a poorly-timed TV appearance this morning. In other words, it’s time for some Friday Feedback.

First up are two comments related to yesterday’s discussion of buyout-backed IPOs. Tom writes: “I haven’t done the empirical analysis, but it seems to me that more recent sponsor-backed IPOs (VC or PE) would tend to under-perform non-sponsor backed IPOs in the near term (6-12 months), as a result of sponsors seeking liquidity post180 day lock-up expiration. This additional stock supply — as well as short investors recognizing the opportunity– drives down the price.”

Jman adds: “This seems a bit misleading. If what we’re searching for here is the returns of LBO-backed IPOs to public investors, the returns are overstated since Thomson calculates these returns using the offer price as a baseline. If you use the closing price at the end of the first trading day, the returns aren’t quite as impressive.”

*** Moving on to the carried interest tax issue, including some comments made by former Labor Secretary Bob Reich during a recent radio program we were on together:

Zachary: “The idea that the work of the GP should justify capital gains tax treatment is exactly backwards. If the payment is made for the work of the GP, then it is compensation for services and is no different than the amount these same partners pay their maids and nannies for taking care of their house and children. Perhaps the maid should be allowed to put in 1% of the home’s value and then get capital gains treatment for the money received for cleaning it.”

Michelle: “I think it is clear that private equity GPs should pay regular income tax on their… ummm, income.It is outrageous to suggest they should pay capital gains tax on someone else’s capital gain (namely the LP).Once the GP charges the LP the fee, which happens to be a percentage of the cap gain, those dollars cease being capital gain and once transferred to the GP become good old, red-blooded income just like the rest of the folks in the US earn.I am as big a capitalist as anyone, but to be a pig is in no one’s best interest. The PE guys should thank their lucky stars they got away with a loophole as long as they did and happily pay their taxes.They, more than most, enjoy abundant gains that are made possible by the economic, legal, and market infrastructure that exists in this country.They should happily pay to maintain a system under which they have been so richly rewarded.”

Lawrence: “All participants in the debate are missing an important arithmetic effect of the tax code.Every income item creates a tax deduction for someone else. If carry is recharacterized as compensation income, then every limited partner will get a deduction for the expense paid. This will have no impact on tax-exempt investors, but every taxable investor in LBO funds will get a big deduction that is currently not available. If you assume that one-third of private equity investors are taxpayers, then the estimated incremental revenue is high by12% (one third of the lost revenue from a 35% tax deduction). In addition, to the extent that GP’s get paid more to offset the tax cost, that is really an indirect tax on tax-exempt organizations.”
Joe: “Is it just me, or has the financial world learned nothing from the cases against Milken and Quattrone? Oh sure, Quattrone won on appeal, but it didn’t come without cost and significant effort and damage to his reputation.And Milken has rebounded and is (perhaps) doing more good than he ever did on Wall Street. But the lesson is clear, ‘You make too much money and we will find something.’ Hubris has always gotten the attention of Washington, and various legal entities. I am reminded of Icarus.When people fly too high, bad things happen. It does not come down to a question of right or wrong, just the issue of making too much money and being arrogant about it (I am thinking multi-million $ birthday bashes for example).”

Tom: “Mathematically, carry is really a call option the GPs have to purchase a portion of the fund at a strike price equal to the LPs cost basis (plus fees in a full recovery fund). Therefore, the right way to tax it in harmony with other assets is to calculate a Black-Scholes value for the call option at the start of the fund and have that be income, everything else is truly a capital gain. (Yes it is true you have the problem of deciding on a volatility value but that hasn’t stopped GAAP from valuing options in other companies this way so why should a PE partnership be different).It is worth noting that I suspect trying to carve out any more onerous treatment for PE carry will simply cause funds to recast their partnership agreements in these call-option terms (which the LPs such be fine with since there is no economic effect) so no further increase to the treasury is likely.”

George: “Robert Reich proves Alan Abelson’s remark that economics is the only field where one can gain preeminence without ever being right.”

Mike: “Reich was a labor secretary and practically a socialist on many issues – nothing shocking there. I think there’s an et tu Brute aspect when a PE journalist espouses the same views.”

*** Finally, there Jim sent in the following yesterday: “Did you see that the Cow Bones publication led today with a story about how Curt Schilling is raising money for his video game company? They gave you no love at all, even though you broke that last month. Any thoughts?” Not really Jim. I think your email just about sums it up…