The Unspoken Risk In Private Equity: Part I

Buyout firms and their investors love to point to the high risk-adjusted returns they generate—and justifiably so. But I suspect that few in the industry take tax risk into account when making their calculations. If they did so, returns wouldn’t look quite so handsome.

For years buyout firms and their investors have been rolling the dice with two strategies that help keep a lid on taxes. Tax attorneys say that both strategies, when structured right, are defensible, and that neither has been challenged by the Internal Revenue Service. But they also say the risk of a challenge exists. And no buyout firm worth its management fees will fail to understand one of the immutable principles of tax strategies: The greater the potential economic reward, the greater the risk of a successful challenge by the IRS.

One way buyout pros and their individual limited partners lower their taxes is for the management company to agree to waive a portion of its management fees in exchange for a profits interest of equivalent value to be paid later. The strategy has been around since at least the mid-1990s, tax attorneys say, and you find it deployed in at least half of all newly formed buyout funds.

Tax attorneys describe it as a “business deal” made between the LBO firm and its limited partners. The buyout partners agree to waive a small percentage of management fees—income on which they would have had to pay income taxes of as high as 35 percent. In exchange, they ask for an equivalent amount of money to be paid to them later out of partnership profits, which typically get taxed at the far lower federal long-term capital-gains rate of 15 percent. (Whether profits interests will continue to be taxed at the capital-gains rate is under debate in Congress.) Individual LPs also get a tax benefit. It is often not possible for them to deduct management fees as an expense on their tax returns. But they clearly don’t have to pay taxes on profits that go to another party. So in the end they come out ahead, tax-wise. LPs also like the fact that the technique gives buyout pros an extra incentive to get into the black on their partnership. Otherwise they’d never get all their management fees back.