Tax: a private equiteer’s second best friend
Before you ask (and you shouldn’t need to ask), a private equiteer’s first best friend is carry. Coming in a distant second, a very distant second, a private equiteer’s next best friend is tax.
Here are the reasons:
- The typical private equity investment is highly geared, ipso facto, it has high interest expenses. Those high interest expenses provide a tax shield, which means private equity investees often don’t pay a cent of tax. And not paying tax while receiving the benefit of others paying tax is a private equiteer-friendly concept.
- Tax gives private equiteers a bargainning chip. All of a sudden, they can justify paying a lower price because of the tax implications. They can refuse to grant management options because of the tax implications. They can make a case for their preferred legal structure because of the tax implications. They can gear the business up to its eyeballs because of the tax implications. They can justify just about anything because no sane person understands the Internal Revenue Code (or whatever applicable tax code) in enough detail to debate it.
- Lastly, a private equiteer’s heartfelt campaign to have the vendor pay less tax creates an alignment of interest. “I want you to pay less tax because it increases the value of the transaction for you, it helps us both create a better business for your employees, and… no one likes the tax man (chuckle, chuckle).” How could you turn down a line like that? You’d love it if you were a vendor, wouldn’t you?. Now that we’re best buddies with a common enemy, I proceed to show why I should pay you less for the business, why the strike price on your options should be higher (so they don’t incur tax) and why the business should be geared at 6 x EBITDA.
So, to recap, private equiteers love tax because they don’t have to pay it and still get the benefit, it creates a bargaining chip, and it helps to show alignment with vendors. I’d be a billionaire if I was paid a million dollars every time I heard a private equiteer raise the strike price on management options citing tax implications. My advice, just give it to people straight; they tend to value that.
Tax is my second best friend since (in addition to the above) carried interest proceeds are structured as capital rather than income in nature, and hence the capital gains tax payable is less than the income tax payable – making the post tax proceeds better. Clearly this is dependendent upon the jurisidiction, and clearly it is under siege.
My 3rd best friend is co-investment rights, who else gets to invest their own money into companies they can due diligence to death, direct strategy, hire/fire/rewaqrd/punish managemnt backed upon by large doses of OPM?
My 4th best friend is management fees.
Shibumi
28 Aug 09 at 08:09
After these recent posts this week, if I were a member of the US Congress, I might start to think that the PE industry is awash in easy money ripe for the plucking!
Maybe enough to fund Medicare, Medicaid and Social Security indefinitely as well as plenty left over to pay for healthcare reform, the wars in Iraq and Afghanistan…and, well..hell, why not Iran too!
Now might not be the best time to talk too much about abundant inflows of cash and enhancement of wealth that may not be seen by some to be the result of sweat.
David Jung
28 Aug 09 at 11:47
Shibumi: thanks for the note. With your co-investment rights, do you still have to pay your firm a management fee? Just curious.
David: good point, but I’m all for bringing some transparency and honesty to the industry. It probably sounds very socialist of me, but I would likely support better health care in the US at the expense of financial engineers in PE. Of course, whether the government would use the money efficiently is another argument entirely.
The Private Equiteer
31 Aug 09 at 00:06
Beyond increasing transparency and honesty within the industry, which is understandable, I think that the industry’s customary practices often leave significant Investee value “unharvested”.
In my experience, I have seen that this results from a failure to adequately identify value-add opportunities within business practices (i.e., as a targeted objective beyond the comfortable realm of financial re-engineering), especially with regard to the emphasis on economic modeling the transaction’s value proposition (i.e., vs. “architecting the enhanced enterprise”)during due diligence.
Maybe, the PE industry could benefit from a bit of the “External Eye” as well.
David Jung
31 Aug 09 at 11:07
I’ve been involved in taxes for longer then I care to acknowledge, both on the private side (all my working life-time!!) and from a legal point of view since passing the bar and pursuing tax law. I’ve put up a lot of advice and corrected a lot of wrongs, and I must say that what you’ve posted makes complete sense. Please uphold the good work – the more individuals know the better they’ll be equipped to deal with the tax man, and that’s what it’s all about.
Tax Guy
23 Nov 09 at 03:53
Wow, thanks for the feedback, very much appreciated.
The Private Equiteer
23 Nov 09 at 06:46