Whitney Tilson of T2 Partners has just released a statement to ValueWalk stating why he is angry about the recent private equity tax scandal.

private equity

The New York Attorney General is  is looking into whether/how some f is whether and how some firms convert certain management fees into investments that are eligible for more-favorable tax treatment private equity firms convert some of their management fees into investments, in order to be eligible for lower taxes. According to the latest from the Wall Street Journal, the scandal involves big private equity firms like Bain Capita, Apollo Global Management LLC (NYSE:APO). and KKR & Co. L.P. (NYSE:KKR) formerly employed the practice from 2007-2009. Some big private equity firms which did not use the practice; The Blackstone Group L.P. (NYSE:BX), and Carlyle Group LP (NASDAQ:CG).

Below are some of his comments:

If I understand this correctly, I am STUNNED by the audacity of these private equity firms and managers (and their tax advisors) (are any hedge funds doing this? I’ve never heard of this). I know a little about a management fee – I’ve been earning one for nearly 14 years. It’s revenue, from which expenses of managing the fund are paid – staff, rent, etc. – and what’s left over is INCOME (and taxed as such).

What appears to be happening here is that the managers of these large private equity funds get MASSIVELY more management fees than required to manage their funds, but didn’t want to pay income taxes on this income, so they instead “channeled” the management fees as investments into their funds, so that any gains would be taxed at the much lower capital gains rates.

It strikes me as blindingly obvious that this is NOT okay – it doesn’t come close to passing the straight face test, and I don’t care what they’ve pay some high-priced tax attorney to say. It doesn’t matter whether the money, once in the fund, is at risk or not – the point is that the profits from the management fee should have been taxed as income BEFORE it went into the fund! To see how obvious this is, imagine for a moment that a shoe salesman’s $50,000 salary was $10,000 more than what he needed to live on in a particular year, so he decided to “channel” $10,000 to his Fidelity mutual fund account, where the money was at risk. Does ANYONE think that, in doing so, he can avoid paying payroll and income taxes on that $10,000?! What could the IRS be thinking, allowing this for so long!?

If the Private Equity firms want to FORGIVE their management fee, fine – but if their investors are required to pay it, then it’s revenue to the firm and whatever is left over after expenses is INCOME, and channeling it into their funds doesn’t change this. (Let’s put aside for a moment that ALL of what their investors are required to pay, whether management fees or the (usually much larger) promote (aka performance allocation), is revenue and, after expenses, should be taxed as the income that it is.)

 

If managers want to channel management fee income into their funds, fine, but here’s how it should work: the managers should pay income tax on the profits from the management fee and then, if they wish, they can invest the proceeds into their funds.