Private Equity's Boogeyman?

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Jon Foley of Reuters reports that Joe Biden is private equity’s tax boogeyman:

Private equity’s recipe for creating riches has two main ingredients: debt and tax perks. Joe Biden wants to turn the second one into a fond memory. If the Democrat becomes U.S. president after the election on Nov. 3, his tax plans could undermine buyout barons’ business model and pit shareholders, clients and employees against one another.

The Carry Trade

At the heart of Biden’s assault on companies like Blackstone and KKR is capital gains tax. The levy on profit from selling assets is currently lower than that applied to rich Americans’ income, and has been since 1990. Right now, the gap is up to 17 percentage points. Private equity managers love this arrangement, because they collect hefty rewards in the form of “carried interest,” a share of the returns made by their funds that tax authorities see as a capital gain.

For at least a decade, politicians have shied away from taxing this form of compensation, which looks like pay for performance, as income. Under Biden’s plan they wouldn’t have to make that call: for people who earn over $1 million a year, both capital gains and income would be taxed at the same rate of nearly 40%. Buyout firms’ star managers would lose out big time.

But it gets worse for them. A higher capital gains tax would also penalize big shareholders of companies they hope to buy and the executives they employ to run them, who are often paid in stock. Many entrepreneurs might be less willing to sell in the first place; those that do may demand higher prices.

The result could be less rain for the private equity rainmakers. Persuading their clients – pension firms, sovereign funds and so on – to pay more for the privilege of investing would be a tough sell. Right now, a typical buyout firm creams 20% off the profit from an investment. Assume that’s taxed at the 20% capital gains rate. If Biden gets his way, that rate would double, and the firm would need to raise its bounty to 26% of the investment profit to get the same after-tax amount. Maybe some blockbuster firms can wangle that; most can’t.

Move it or lose it

Some of those involved are already taking action, according to industry sources and advisers, looking into offloading investments before any tax change can kick in. The clock may already be ticking, since legislation passed even late in 2021 could conceivably be applied retroactively to the beginning of the year. A similar rush for the exit happened in December 1986, after President Ronald Reagan equalized the two tax rates, albeit at the relatively low level of 28%. Alternatively, some firms are considering moving from high-tax states like New York to low-tax states such as Florida, a shift which would help minimize their overall tax burden. Paul Singer’s Elliott Management is one of those, according to Bloomberg.

There’s an extra barb for Blackstone, KKR and Carlyle. As well as hiking capital gains tax, Biden also plans to increase the corporate income tax rate from 21% to 28%. Most private equity firms are partnerships, meaning they pass untaxed profit onto their owners, who are taxed on the income. But these three companies took advantage of President Donald Trump’s tax cuts that took effect in 2018 to turn into so-called C corporations – a change that meant they started paying income tax on their earnings. With the corporate tax rate at just 21%, there seemed little to lose. At a 28% rate it no longer seems so smart, although they surely anticipated that tax rates can rise as well as fall.

That further reduces buyout firms’ scope to reward their executives. A higher corporate tax rate means their earnings will be lower, putting downward pressure on their stock-market valuations. The pain for holders of their stock could be magnified because former Vice President Biden also wants to increase the tax on dividends to nearly 40%. It’s hardly compatible with fatter pay packages for staff.

In sum, shareholders, company founders, employees and investor clients could all find that private equity’s magic recipe loses its flavor if Biden prevails. It’s quite the reversal. Buyout moguls like Stephen Schwarzman have amplified their billions by taking advantage of the U.S. tax system. Just during Trump’s four-year term, Blackstone’s shares have generated double the returns of the S&P 500 Index, with rivals Carlyle and KKR close behind. Some loopholes, like the taxation of carried interest, have been open for too long. Biden could be the boogeyman who finally slams them shut.

Will Biden be private equity's boogeyman and slam shut lucrative tax loopholes?

As I stated in my comment on Friday, I'm not convinced Biden will beat Trump. It will be close, Trump can still win according to some experts, especially if he wins key battleground states like Florida and Pennsylvania.

But I must admit, after walking away from Leslie Stahl in a 60 Minutes interview and doubling down on his claims that rising US coronavirus cases are "Fake News Media Conspiracy" as hospitalizations rise, he's sounding more unhinged and totally out of touch with reality and hurting his credibility and chances of getting re-elected:

Sometimes I openly wonder whether President Trump really wants to be re-elected. 

So, if Biden wins, does that spell big trouble for private equity? Maybe, I'm not convinced of this either. Big private equity donors have donated millions to Biden's campaign so it will be interesting to see exactly what tax policy changes will actually materialize in a Biden administration.  

Remember the book I keep peddling on my blog, C. Wright Mills' classic The Power Elite. Read it a few times and you will understand all you need to understand about how democracies and capitalism actually work.

Big decisions are always being made in the background to favor the Power Elite, and the private equity industry is definitely run by elites. 

Why do you think the Fed increased its balance sheet by $3 trillion and then decided to buy junk bond ETFs? To save the economy? No, it was to directly bail out elite hedge funds and private equity funds.

Ray Dalio conveniently omits stating this outright in his latest 'shocking' warning on capitalism but I have no issue pointing it out because it's the truth.

And here's the kicker folks, nothing is going to change, something the late great comic genius George Carlin brilliantly pointed out in his famous skit on the American Dream. 

Anyway, getting back to private equity, we are at the top of the cycle and the industry is preparing for a big downturn.

How do I know? Check out these tweets:

The shift into alternative energy is a call on Biden but whenever you read private equity is looking to expand to retail investors, you know the top is near. 

Edward Siedle is right to be very critical of this push into 401(k)s but even he misses the bigger point.

Last week, I discussed how Ontario Teachers’ Pension Plan and Lightyear Capital agreed to acquire wealth management firm Allworth Financial from Parthenon Capital.

I learned that several years ago, Ontario Teachers' Private Capital did a detailed attribution analysis on all their private equity deals and here's how they ranked them by profitability from worst to best:

  • Fund investments were the worst because carry and management fees ate up most of the returns
  • Minority syndication (a lower form of co-investments where you get a some slice of a deal, say 5%) were second worst because these deals are typically done in bad vintage years when deal activity is high and GPs are looking to unload investments.
  • Teachers' purely direct deals were the second most profitable deals but they weren't plentiful.
  • And the most profitable deals by far were jointly sponsored co-investments (50/50) where Teachers' and their partners sourced and underwrote deals jointly, reducing fee drag. For example, Teachers' deals in Dematic (with AEA Investors) and CPG International (with Ares), both returned roughly 8x the money. These are phenomenal deals.

What is critical to understand is Ontario Teachers', just like CPP Investments, has a specialized PE staff doing jointly sponsored co-investments which is where they get their best bang for their pension buck.

And as was explained to me, not all co-investments are profitable, especially not minority co-investments which are considered direct deals but are really nothing more than syndication where GPs unload small stakes to smaller LPs who can't do jointly sponsored co-investments (and sometimes to larger LPs).

Now, think about it. If Ontario Teachers', CPP Investments and other large Canadian pensions are finding their PE fund investments aren't as profitable as jointly-sponsored co-investments, then why do they continue to invest in PE funds?

Answer: to gain access to large co-investments to reduce fee drag.

The critical point I'm trying to make here is after you account for carry and management fees, private equity funds have less than stellar returns.

And unlike big Canadian pensions, Joe and Jane 401(k) are not gaining access to large co-investments to reduce those big fees. Capiche?

Of course, maybe I'm very jaded when it comes to PE moving into retail. Mark Wiseman seems to be in favor of it:


Still, even Mark has noted that PE managers are turning to specialist borrowing facilities to ensure their highly leveraged strategies can survive the pandemic, but there are growing concerns that the use of these complex financing deals poses new threats to investors:

What else? it is is worth noting Blackstone just raised $8 billion for a long-term private equity fund. This tells me they see this as the top of the market, want to lock in money for longer and reduce fees to their main LP investors:

The firm’s second core private equity fund will be more than 70% larger than its first, which closed in 2016. Investments will focus on essential business services and companies with compelling intellectual property or content, Joe Baratta, Blackstone’s global head of private equity, said in an interview. The group’s previous long-term fund made investments that included music-rights company SESAC Holdings and Servpro Industries, a provider of cleaning and emergency restoration services.

“These are businesses that have really clear and transparent operating models,” Baratta said. “Here we’re deploying capital for a decade plus. That’s attractive and more cost efficient for large investors.”

Blackstone, the world’s largest alternative-asset manager, has remained a fundraising machine even amid the uncertainty caused by the Covid-19 pandemic. It brought in $47.6 billion during the first half of the year, after a record $134.4 billion haul for all of 2019. The private equity industry bills itself as a safe custodian of investor cash in volatile times, pointing to its strength in the wake of the 2008 financial crisis.

Managers were stung by hefty losses early this year but their performance has largely rebounded along with the broader market. All Blackstone segments posted gains in the second quarter, led by a 12.8% advance for private equity funds. The New York-based firm is scheduled to report third-quarter results Wednesday.

Again, investors prefer these long-term private equity funds because they get better fee arrangements (but they allocate more to the fund) and better alignment of interests (as these long-term funds avoid the typical churning of investments where PE funds sell portfolio companies to each other every three years to raise another fund).

It also allows Blackstone to cement its position as the world's largest alternative-asset manager and sends a message to new competitors that they remain the kings of alternatives and will not be outdone by new entrants in the space, like BlackRock's long term private capital which hasn't gained traction among institutional investors (it might ultimately gain more traction with high net worth individuals and retail).

Remember, the name of the game for Blackstone and BlackRock is asset gathering. BlackRock is the king of public markets but fees have been significantly compressed there over the last decade(s) so they shifted their attention to private equity in an attempt to gain a foothold in lucrative private markets where fees remain juicy (but coming down there too).

Blackstone is a fundraising machine and tends to raise the most assets when a big crisis occurs (so its investors can capitalize).

While Blackstone is raising assets like crazy, one of its largest competitors is running into big trouble.

Over the weekend, Bloomberg published an article on how Apollo's investors are revolting given its founder's ties to convicted sex offender Jeffrey Epstein:

It keeps getting worse for Leon Black.

Over the past week, Black’s giant investment firm, Apollo Global Management Inc., has confronted one question after another about his decades-long relationship with convicted sex offender Jeffrey Epstein.

First, his own board ordered an external review prompted by Black himself. Then a Pennsylvania pension fund paused new investments -- and the state of Connecticut has done the same. One major consultant -- a gatekeeper to $160 billion of investor commitments -- has urged clients to hold off, and another is considering taking similar action.

Clients who for years enjoyed some of the best returns on Wall Street are reconsidering their ties to Apollo amid renewed scrutiny over Epstein, spurred by a New York Times report earlier this month and given fresh attention from an unsealed deposition of Epstein associate Ghislaine Maxwell.

Investors distancing themselves from the firm show how serious the issue has become for Black and his general partners. Some clients aren’t convinced that the review, which will be handled by law firm Dechert LLP, will be enough to clear Black’s name, according to people familiar with the matter.

A freeze in new money could hurt Apollo at a time when it’s trying to raise $20 billion for several new funds. The pandemic-spurred turmoil in the credit markets is a prime investing opportunity for the firm, which is known for buying struggling businesses. Apollo is seeking to take advantage of market dislocations as well as invest in private debt, people with knowledge of the matter said in April.

Black’s growing troubles reflect the changing politics of the investing world, where major funds have become more sensitive to environmental, social and governance matters. The new focus means that even the prospect of lucrative returns may not be enough of a lure in the midst of a scandal.

“While performance is always going to be an important factor, increasingly it’s not the only factor,” said Gerald O’Hara, an analyst at Jefferies Financial Group Inc. “In some respects, there’s some willingness to sacrifice performance for a company that’s run with good governance, good ethics.”

Investment adviser Aksia told clients not to give new money to Apollo, Bloomberg reported Friday, while Connecticut said it is halting new investments with the firm. Earlier in the week, the Pennsylvania Public School Employees’ Retirement System said it would stop making additional investments in Apollo for now, and consultant Cambridge Associates is considering not recommending the firm to its pension and endowment clients.

While Black faced pressure in the immediate aftermath of Epstein’s arrest last year, investor angst was rekindled by a New York Times report that he had wired at least $50 million to Epstein after his 2008 conviction for soliciting prostitution from a teenage girl. The article didn’t accuse Black of breaking the law. Apollo shares have fallen about 12% since the story was published on Oct. 12.

“We are firmly committed to transparency,” Apollo said Friday in a statement, noting that Black has been communicating regularly with investors. “Although Apollo never did business with Jeffrey Epstein, Leon has requested an independent, outside review regarding his previous professional relationship with Mr. Epstein.”

In a letter to Apollo’s limited partners this month, Black said he deeply regretted having had any involvement with Epstein. Black said he had turned to him for matters such as taxes, estate planning and philanthropy, and that nothing in the Times’ report was inconsistent with an earlier description of their ties.

It will be tough for investors to cut ties completely with Apollo as private equity funds typically lock up capital for years -- a trade-off many are willing to make with the promise of high-flying returns. And unless the inquiry unearths something more damning, clients may ultimately decide to look the other way, said three investors who asked not to be identified.

It’s particularly unappealing for clients to pull away given the firm’s stellar returns. Apollo’s flagship private equity fund, which opened to investors in 2001, has delivered annual gains of 44%, Bloomberg reported in January.

But even yield-starved investors looking to pump more money into private equity may choose to go elsewhere in future, as rivals flood the market with new offerings.

“It’s a very competitive race for capital and one thing that we continue to see in fundraising is it is in many ways more similar to a political process than a capital-raising process,” said Sarah Sandstrom, partner at Campbell Lutyens, which helps private equity firms raise money. “You are telling your story, creating relationships with investors.”

I'll tell you what every major institutional investor is thinking right now: "Please God, don't let any photos of Leon Black hanging around Jeffrey Epstein's pedophile island surface, we're cooked!"

The who's who of major pension funds, sovereign wealth funds and endowment funds invest in Apollo because it's the best credit fund in the world (see a comment I wrote back in May on how IMCO took a big stake in Apollo's new fund). 

Black's ties to Epstein cast a shadow over what has thus far been an illustrious career. 

I don't know what to make of this but in a heightened "ME TOO" environment where investors are finally working to address sexual misconduct and protect the very few victims that do come forward, it’s obvious this culture will no longer be tolerated (see update at the end of this comment).

The fact that two gatekeepers are shunning the firm altogether (one is considering it) speaks volumes, everyone is edgy and nervous, especially if Ms. Maxwell makes any accusations implicating Black and others (she hasn't yet).

To put this into proper context, it's the equivalent of a nuclear bomb going off in the private equity industry. Well, maybe not that bad but it's bad.

I reckon a lot of investors are going to their PE teams right now and asking them bluntly: "What's our exposure to Apollo? Give it to me straight!".

Reputation risk is a huge risk for big public pensions and obviously, for Leon Black himself.

I don't get some of these powerful guys, how they get bamboozled by Epstein who has sleazeball written all over him is beyond me. I wouldn't have touched this guy with a ten foot pole if I was Black and other powerful people who fell for his charm. 

This is a lesson to all powerful and not so powerful people: choose the people you hang around with very carefully, it can come back to bite you in the rear end or worse, front end when you least expect it.

Alright folks, once again, please remember this blog is comments where I express my opinions. I certainly don't think I have a monopoly of wisdom, so if you have different opinions, feel free to share them.

Also, it's a good time to remind all of you, this blog runs on donations, so if you like the content (or hate it but still read it every day), please do the right thing and contribute to it using PayPal options at the top left-hand side under my picture. I thank all of you you show your appreciation by donating, it's greatly appreciated.

Tomorrow, I'm discussing the secular shift in real estate, and if you liked this comment, I guarantee you'll love that one!

Below, Nicolas Rabener, found and CEO of FactorResearch discusses why private equity provides the same economic exposure as public equities. Given this, private equity should not be considered as a diversifying strategy (h/t, Brett Friedman).

Rabener raises the same concerns and criticisms as many academics and these issues are very well known to institutional investors but he doesn't get it. 

In private equity, the approach matters, if you get it right (fund investments with top funds and jointly sponsored co-investments with them), you're definitely much better off over the long run than investing in public markets (all you PE critics and academics, take three hours to read CPP Investments' fiscal 2020 annual report).

Next, Apollo Global Management Llc. has announced an independent investigation into Leon Black’s ties to Jeffrey Epstein. The private equity giant now faces a possible investor revolt after more information emerged about its co-founder’s ties to Epstein. Bloomberg’s Dani Burger reports on “Bloomberg Markets: European Open.”

I agree with the reporters, that $50 million transferred to Jeffrey Epstein is at the core of this investigation and any way you slice it, it looks terrible for Black and his firm, raising a lot of suspicions. 

I hope they clear this matter up relatively quickly and I'm certain a lot of nervous pension fund managers reading this comment hope so too.

Lastly, Trump's chances of winning have plummeted to just 4% according to the latest polls but don't heed too much into these polls, there's no doubt in mind it will be a close race and Trump might still pull off a miracle if he wins Florida and Pennsylvania. Doubt it, especially after yesterday, but you never know.

If Biden wins, it looks like bad news for private equity but I wouldn't bet on it. The Power Elite are always ten steps ahead of everyone so don't count PE out just yet.

Update: Lindsey Walton, Head of Canada at Principle Responsible Investing (PRI) was kind enough to share this with me after reading my comment:

Hi Leo - sending a note to say I enjoy reading your blog insights and appreciate the work that you do. You seem like you are open to comments so I thought I would point out a paragraph that comes across perhaps not as you meant it to. In your blog emailed earlier today, you wrote "I don't know what to make of this but in a heightened "ME TOO" environment where investors need to guard against even the faintest appearance of supporting a potential sex offender, it's obvious some are adopting the strategy of shooting first and asking questions later." 

I worry that statement makes Me Too sound like an overreaction and may perpetuate the notion that false accusations are statistically a risk, which they of course are not. I would suggest rephrasing along these lines "In a heightened "ME TOO" environment where investors are finally working to address sexual misconduct and protect the very few victims that do come forward, it’s obvious this culture will no longer be tolerated". Thanks for reading my feedback and for always giving me the heads up on pension news!

I thank Lindsey for sharing her feedback and she's right, I didn't write that to minimize the Me Too movement in any way, that was the furthest thing from my mind. Sometimes I write my comments too quickly and I'm glad she pointed this out to me so I can edit it to say it in a better way.

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