Now that I’ve got you incensed (you did read yesterday’s blog, right?), let’s discuss a little of the mechanics of the private equity industry.  Which, even if your blood is not yet boiling, may cause you to need a trip to the emergency room when we are done.

Let’s explain…

Private equity sees a company that is chugging along- not the top of the heap- but capable of making a decent profit with better management and strategists.  You would think that would be what they plan to do…

But, no….

The private equity firm borrows millions to acquire the firm.  And, then transfers that debt to the balance sheet of the firm.  So, now, the acquired firm is highly leveraged.  That’s step 1 of the plan to “fix” the company.

Next, the ‘vultures’ find ways to cut costs- not in ways that promote the long-term viability of the firm, but to demonstrate short-term increases in profits. And, then the ‘vultures’ sell the firm- or take it public again.  And, they may even sell off divisions (yielding the private equity firms even more profits) before these final acts, harvesting profits for themselves.

That’s pretty heinous in my book.  (And, probably yours.)  But, that still doesn’t describe the full picture.

Nope.

The private equity firm charges the company a “management fee”  (in other words, the company pays a fee for the raping of its assets) of 2% of assets each and every year.

And, these ‘vultures’ also arrogate to themselves 20% of all future profits that the firm may generate.

As you can see, it become pretty difficult for those acquired firms- that are now leveraged to the hilt- to survive long term.  But, that’s not the problem of the private equity owner- it plans to dump the firm in 5 years or less from acquisition.

Also, now we get to the IRS tax wrinkle.  That 20% tax on future profits?    These firms call this “carried interest”.   (No- they didn’t invent this term.  It dates back to the Renaissance when ship captains were compensated by receiving that same slice of the profits from the cargo they carried from place to place.)

It wasn’t until 1993 that the IRS declared that  carried interest was to be taxed as capital gains and not current income.  Why is that important?  Because capital gains are taxed at 20%- while the marginal tax bracket for most of the executives of private equity/hedge funds is 37%- or higher (social security and medicare levies).   (This loophole is considered to cost the US Treasury at least $ 20 billion a year.)

OK, calm down.  I know your blood pressure is approaching 180 mm Hg.  But, there’s more to digest.

The firms have created another vehicle that allows them to convert their 2% asset management fee- and hide it as a bigger slice of future profits.  (Actually- no such thing exists.  This is simply a paper transaction.)  And, they term this tax dodge a “fee waiver”.  Basically, the 2% income (taxed at that 37%) has been laundered into a capital gain (taxed at 20%).

Fee waivers are now routine for Apollo Global Management, TPG Capital, KKR (Kohlberg Kravis Roberts)- and a slew of others.  (Only those hedge funds and private equity entities that converted to publicly traded firms don’t incorporate these fee waivers in their acquisition agreements.)

Note that this laundry chore is very lucrative.  A $ 1 million management fee would have been taxed at 37% or higher.  The fee waiver change means it’s a capital gain to be taxed at 20%.  So, the partner how gets the same money from the managed firm- but doesn’t have to send some $ 170K in income taxes to the Fed- that’s the savings realized by converting the current income to a capital gain.

(This concept was revealed to the IRS by a few whistle-blowers.  The three known whistle blowers were looking to collect millions in bounties as the IRS began overturning these arrangements.  Except the hedge funds/private equity entities launched a multimillion dollar lobbying campaign and stopped the IRS in its tracks.  Moreover, that fee waiver  got codified in the IRS regulations.)

Initially, TheDonald was going to whup this tax benefit down to zip.  Using the (at least) $ 20 billion in revenue to be collected by removing this loophole to cover the costs of the rest of his tax bill, the Tax Cut and Jobs Act of 2017.  But, that lobbying effort paid off.

The Treasury Department caved in and on 5 January 2021, one of the strongest provisions – giving the IRS to examine transactions between different entities controlled by the same firm- simply disappeared.

What was the result?  The top 5 (yes, just 5) publicly traded private equity firms reports net profits of $ 8.6 billion.  Paying their executives the paltry sum of $ 8.3 billion.

It’s time to redress these wrongs.