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The Unspoken Risk In Private Equity: Part II

Most institutional investors, I imagine, are sympathetic to the plight of buyout professionals facing the prospect of paying higher taxes on carried interest. They recognize that a big reason so many bright people have migrated to private equity is that no where else (other than the hedge fund business, perhaps) can they get so wealthy from their investment talents.

But it’s not just buyout professionals that get a nice tax break from the business. For years institutional investors have taken advantage of a technique that allows them to avoid receiving what’s called unrelated business taxable income. UBTI is income generated by a tax-exempt organization through a trade or business that’s unrelated to what the organization itself does. Endowments, foundations and other tax-exempt limited partners must pay taxes on UBTI.

Most investment income generated by buyout firms is not UBTI. But buyout firms generate income in ways other than through profitable exits. Most, for example, charge their portfolio companies a variety of fees—transactions fees for work done to close an initial acquisition, investment banking fees for arranging a refinancing, monitoring fees for providing ongoing advice to managers. In forming new funds, limited partners have negotiated hard to get their fair share of these fees, since, they argue, buyout firms wouldn’t be able to generate them without their money. Today LPs typically take 50 percent, 75 percent, 80 percent or even 100 percent of these fees.

But tax-exempt LPs face a quandary. Since these fees would fall under the UBTI designation, they’d have to pay federal income taxes of as high as 35 percent. In addition, some would have to go to the expense of filing tax forms that they otherwise wouldn’t have to file. In certain cases, organizations could lose their tax-exempt status by accepting UBTI. So instead, buyout firms almost always agree to offset, or reduce the management fees that they charge LPs by the amount of the portfolio company fees that they agree to share.