All Eyes On Washington In Early 2010

Private equity professionals will be paying close attention to Washington D.C. early this year as Congress debates several pieces of legislation that could demand more transparency from buyout shops and boost taxes on carried interest.

That most buyout firms will have to register as investment advisers with the U.S. Securities and Exchange Commission starting in 2011 appeared likely as we went to press. However, it looks like they’ll get at least a short reprieve on the question of whether they’ll have to pay regular income taxes on carried interest, rather than the lower capital gains rate as they have in the past.

As part of a regulatory overhaul of the financial industry, the U.S. House of Representatives passed on Dec. 11 the Wall Street Reform and Consumer Protection Act of 2009. The reform act would require buyout firms with $150 million or more under management to register as investment advisors with the SEC. As registered advisors they would be subject to regular examinations, and have to provide reports related to their assets under management, their use of leverage, counter-party credit risk exposures, trading and investment positions and trading practices. Venture capital firms would be exempt from registration requirements.

Needless to say, the bill would have little to any impact on large firms already registered as investment advisers and that already have the in-house administrative ability to handle such reporting. But many smaller firms would at a minimum have to find another $150,000 or so to hire a compliance officer, or outsource the job to companies that provide fund administration services, said William Kelly, a partner at Nixon Peabody LLP. The proposed legislation would give the SEC leeway to tailor its reporting requirements based on how much risk individual firms represented—potentially good news for small shops.

The Senate isn’t as far along on crafting regulatory overhaul legislation, but any final legislation will most likely look like the House bill, Kelly said. For one thing, the House bill is more in line with the Obama Administration’s proposal, which called for buyout firms to register if they manage $30 million or more. Secondly, the House bill is more comprehensive than different proposals being floated in the Senate. The House Bill, crafted by the Financial Services Committee under Barney Frank of Massachusetts, is 387 pages long.

One wildcard is that the Senate process will likely be run by Sen. Chris Dodd, the chairman of the Senate Committee on Banking, Housing, and Urban Affairs** who represents Connecticut, the nexus of the hedge fund community and home to several buyout shops. Dodd’s version of the bill would exempt both buyout and venture capital firms from registration, although buyout firms would face some reporting requirements, according to a source tracking private-equity legislation. “I don’t think it’s at all clear that it will move quickly,” Kelly said. “Also, Dodd has control of process, and he happens to be the Senator from private equity-ville.”

When and if the bill passes, firms would likely have to register one year after the date on which it becomes law.

Meantime, it doesn’t look like Congress is going to pass legislation proposed by the House in early December requiring buyout shops and other managers of investments-related limited partnerships to treat carried interest as regular income instead of capital gains. A provision to do so passed the House as part of a tax extenders bill designed to revive certain business-related tax credits that had expired at the end of 2008, according to our source tracking legislation. The carried-interest tax provision, estimated to generate more than $20 billion over 10 years, would help pay for the tax credits.

But, according to our source, the Senate may not pass a tax extenders bill. And even if it does, the Senate Finance Committee in crafting the language appears to have little appetite for taxing carried interest as regular income. “They don’t want to impose an investment tax when the economy is still recovering,” our source said. “It is virtually certain that carried interest [legislation] will not pass the Senate.” It was also the Senate that rejected similar tax proposals, much to the industry’s relief, twice before in 2007 and 2008.

The buyout industry isn’t out of the woods yet. The proposal to tax carried interest as regular income could well crop up early this year as part of a comprehensive tax reform bill sought by New York Democratic representative Charlie Rangel, chairman of the House Ways and Means Committee. The bill could also include a related proposal, present in the House tax extenders bill, to tax publicly traded partnerships and limited liability companies as corporations (with a 10-year grandfather clause for those already publicly traded). “That might be harder to defend against, because it would be a huge bill, and this would be one small provision,” our source following Congress said.

The industry has to decide just how hard it wants to fight any unfavorable tax provisions written into the comprehensive tax reform bill. It could simply sit back and hope the legislation remains too distasteful overall to pass; it could fight to keep the tax proposal out of the legislation; or it could try to hammer out a compromise, although that would help ensure that the legislation actually passes. Looking beyond 2010, buyout firms can hope for republicans, generally more sympathetic to their causes, to pick up seats in Congress in the mid-term elections. That, in turn, would help ensure that carried interest continues to be viewed as capital gains in the eyes of the Internal Revenue Service.

SIDEBAR: Other Regulatory Issues To Watch

Buyout professionals should keep a close eye on at least two other regulatory developments in 2010:

* The House tax extenders legislation includes a provision that would require buyout firms managing off-shore vehicles to comply with rules intended to ensure that U.S. investors pay their income tax. The so-called “Foreign Account Tax Compliance Act of 2009” would generally require buyout firms managing off-shore vehicles to provide a variety of financial information about its U.S. investors to the IRS. (Buyout firms can avoid new reporting obligations provided they agree to file Form 1099 for all of their investors as if they were individuals.) Failure to comply could subject the firm to a 30 percent withholding tax. If enacted, the legislation would “impose significant compliance burdens on private equity and hedge funds,” according to Weil, Gotshal & Manges LLP.

* Buyout firms may eventually have to produce consolidated financial statements for their portfolio companies, an exercise that buyout shops believe would be a colossal waste of effort and virtually useless to investors. The Financial Accounting Standards Board and the International Accounting Standards Board, with encouragement from the Securities and Exchange Commission, are working to bring U.S. accounting standards, which exempt private-equity firms from consolidation requirements, closer to the IASB standard, which does not carve out an exemption.

** An earlier version of this story incorrectly stated that Sen. Chris Dodd was the chaiman of the Senate Finance Commitee.