Wait and see

While President Barack Obama was elected on the back of a campaign of Hope and Change, now that he has taken up residence in the White House, private equity players are cautiously waiting to see what his version of change will mean for the industry in 2009. But while many managers and tax lawyers are reportedly planning for the worst, they may be unnecessarily jumping the gun.

Of the changes to tax law that Obama has proposed during the campaign, the one that has caused private equity and hedge fund executives the most sleepless nights is his pledge to revive a failed 2007 bill that would increase the capital gains tax on carried interest from the current 15 percent to the ordinary income rate of 35 percent or more. Since carried interest represents the lion's share of a general partner's compensation, with management fees already taxed at the ordinary income rates, such an increase represents a substantial potential hit to their wallets.

Obam's previous focus on carried interest as a possible target for tax increases, coupled with the Democratic Party's new majority in the Senate and existing majority in the House, raises the likelihood that some version of the 2007 legislation will be reintroduced. According to a December report by Bloomberg, many tax lawyers are counting on such a scenario and advising their clients to start restructuring their partnerships in order to circumvent the higher taxes.

David Winter, a partner at Hogan & Hartson, says that some fund sponsors have inserted into their partnership agreements – with the consent of their investors – a provision that if there if there is a tax law change that would adversely impact the sponsors, then changes to the agreements would be negotiated in good faith in order to alleviate some of the damage.

“My clients that have elected to address this issue in their partnership agreements have done so in a way that basically puts everyone on notice that if the legislation becomes law, the parties will work to see if they can revise the sponsor/ investor relationship in a way that has no adverse affect on the investors, but protects the sponsor from this ordinary income rule,” said Winter.

Legal loopholes
One of the measures that some lawyers have advised for sidestepping the expected higher taxes is to move the fund or the entity through which the fund sponsor invests offshore to the Cayman Islands or some other tax haven that would make them eligible for lower rates.

Another set of possible structural solutions involves strategies that have the effect of increasing a GP's capital share of the fund. Recent legislative proposals have defined ordinary income as any income which the GP receives as a share of profits in excess of its share of the capital (i.e. carried interest).

In response to this, some fund formation attorneys recommend upping GP capital contributions through loan facilities. Under one such proposal, the fund sponsor would borrow enough money from investors to put in 20 percent of the fund capital, which could result in the fund sponsor having a true 20 percent equity stake in the partnership and therefore getting the capital gains rate on its full carried interest. There's a risk, though, if the fund does poorly, in which case the fund sponsor would be on the hook for 20 percent of fund losses.

Alternatively, participants in the fund could form their capital commitments in part with debt and in part with equity. Under this scenario, in a $100 million fund where the fund sponsor is committing $1 million, the investors would fund $95 million as loans to the partnership and then have the investors contribute their remaining $4 million as equity, with the fund sponsor adding $1 million in equity itself. The result would still be a $100 million fund, but as a result of the loans, the fund sponsor now has a 20 percent equity stake and thus escapes the effects of early versions of the proposed legislation.

However, Winter says that a bill proposed last year in the House of Representatives and sponsored by Rep. Charles Rangel included provisions to prevent the use of these three loopholes. Winter says it is likely that any final legislation will include provisions that target these loopholes and other loopholes brought to the attention of Congress. However, he said that there may be opportunities for considering variations on these structures, and other structures, once the legislation is finalised.

Not every change to the tax code is potentially bad news for private equity. As part of Obam's recent stimulus proposal, companies would be able to carry back their net operating losses five years instead of the current two, thereby increasing the amount of past taxes that would qualify for a rebate. For instance, a company that recorded losses in 2008 and 2009 would get refunds for the years 2003 to 2007 if they were profitable during that period.

While not specifically geared toward private equity, the measure would still benefit an industry that is seeing lower returns following some record-breaking years. In particular, Peter Daub, a partner at Baker & McKenzie, says extra cash coming in that wasn't previously expected could increase the stock price and valuation of portfolio companies.

Political sacrifice
In any case, nothing is set in stone until a bill arrives on Obam's desk, and that may not happen as quickly as many in the industry expect, especially as some influential Democrats including New York Sen. Charles Schumer have benefitted from private equity donations in the past. Obama himself even outpaced presidential rival John McCain in the amount of campaign contributions coming from private equity firms and hedge funds.

Although Darryll Jones, a professor of law at Stetson University, believes that the carried intrest tax increase will eventually get done, Obama may sacrifice it in the near term not only in the interest of starting his term with more bipartisan support, but also because of the smaller carried interest returns that managers are seeing in the recession.

“It's not illegitimate to consider political alliances, and the whole tax code is sort of a political compromise,” Jones said. “I would keep that in my pocket as something to deal away, because the hedge funds are losing money, people are taking money out of them, and so a tax increase is not going to raise a lot of money even if he does change it.”

As such, while the huge fundraising numbers of 2006 and 2007 put a political bulls eye on private equity's back, the lower returns of 2009 will likely make the industry less of a priority for Congress. “If the General Accounting Office can't say that reforming the carried interest will generate let's say $500 billion a year in tax revenue then it's not worth fighting about, and I don't think they are going to be able to say that,” Jones says.

Since it is difficult to predict what the final legislation will look like, Winter says that managers should for now, if they choose to do anything at all, just include in their fund documentation the concept that the relevant parties will come back to the table if and when a bill goes through and see what can be done.

“As far as specifically restructuring the fund today, in a way that might be costly and doesn't achieve its intended objectives absent a change in the law, I'm not sure that's the right way to go,” he said. “For example, you could create arrangements where the fund sponsor borrows significant money from the investors, takes on a substantial amount of additional risk if the fund does poorly, and then the final legislation applies the ordinary income rule to the structure in any event. That's a disaster for the fund sponsor because it has taken on extra risk without deriving the intended benefit.”

Tax lawyers who are telling managers to restructure their partnerships may wind up doing more harm than good for their clients for at least 2009. “More conservative tax advisors are telling their clients to do something now, but I think that more aggressive advice might be to just hold your cards and wait and see, because I don't see this carried interest change as something that is bound to happen in the next two years,” he said. “I don't think it's necessary for the fund managers to incur a whole bunch of transaction costs restructuring their partnerships unless they know the law is definitely going to change.”