June 19, 2015
Consider: PitchBook data tracks 300 public pension funds that are currently invested in private equity (PE) funds, many with investments in multiple funds. Public pension funds—the deferred income of public sector workers whose services are paid for by taxpayers—are the largest source of equity committed to private equity funds. An analysis of PitchBook’s data on limited partners (LPs) finds a combined capital commitment of $425.7 billion to U.S. private equity funds from pension funds, sovereign wealth funds and government agencies over the years 2004 to 2014. Public pension funds accounted for $407.6 billion of this total. As can be seen in the figure, public sources provided between 20 and 37 percent of total capital committed to U.S. PE funds over this period.
Taxpayers underwrite private equity in other ways as well. Best known perhaps is the carried interest loophole in the tax code, which lets the general partners (GPs) of private equity funds pay the lower capital gains tax rate on a big chunk of their incomes—so-called carried interest. Carried interest paid to GPs of PE funds is typically 20 percent of the funds’ profits despite GPs having put up only one to two percent of the fund’s capital.
Private equity has found other ways as well to reduce the taxes it pays at the expense of ordinary taxpayers. As I previously discussed, GPs of private equity funds often use the alchemy of ‘management fee waivers’ to transform management fees, which are taxable as ordinary income, into capital gains taxed at a lower rate. The Treasury plans to issue guidance shortly to make sure that private equity firms understand that, in most circumstances, this is not allowable.
Yet another practice of private equity firms is to disguise dividends paid to them by their portfolio companies as monitoring fees. Dividends are part of the portfolio company’s income, and as such are taxable. In contrast, monitoring fees are an expense that reduces the taxes paid by the portfolio companies. Contracts for monitoring services often do not specify a minimum number of hours or what services will be provided. That is, the contracts lack the necessary ‘compensatory intent’ for these fees to be deducted as expenses by portfolio companies. The payments from the portfolio companies to their PE firm owners simply disguise what are actually dividends as monitoring fees. This is an abusive practice that reduces the taxes that portfolio companies pay.
And of course, private equity funds load the companies they acquire with lots of debt using so-called leveraged loans and mortgaging the company’s assets. They turn the 70% equity, 30% debt capital structure of publicly traded companies on its head and reap the tax advantages of debt financing. The use of very high levels of debt reduces the taxes paid by PE-owned companies since there are no limits to the tax deductibility of interest payments on this debt.
Some PE funds receive subsidies from state economic development programs interested in job creation and growth, but these subsidies don’t always work as intended. In one recently reported case, a PE firm used a Maine investment program to obtain millions of dollars at taxpayer expense but did not create jobs or value for the state.
One has to wonder just how well the nearly 2,000 private equity firms operating in the U.S. would do without taxpayer and government funding. Which leads us to the question posed at the outset: are private equity firms government-sponsored enterprises? Just asking.