Battle Over Carried Interest Intensifies

After starting out a few months ago as a murmur emanating from Washington, D.C., the debate over the tax treatment of private equity partnerships has escalated into a full-fledged conflict that has finally awakened mid-market buyout shops.

Legislators from both houses of Congress have introduced bills that would treat carried interest profit as ordinary income rather than capital gains, a move that would raise the tax rate for the most lucrative part of buyout pro compensation from 15 percent to 35 percent. At the same time, members of the House of Representatives have sponsored a bill that would tax publicly traded partnerships like corporations, subjecting them to a much higher tax rate. The so-called “Blackstone Bill” was introduced days before The Blackstone Group listed itself on the New York Stock Exchange in a wildly oversubscribed issue. The bill would provide a five-year phase-in for Blackstone and Fortress Investment Group, which earlier this year became one of the first American private equity firms to go public. If approved, the legislation would force publicly traded partnerships to pay the corporate tax rate on profit, and it would disallow a partnership structure in which earnings flow through the partnership to individual partners who then pay income tax on the money.

All of this has taken place against a backdrop of growing criticism of the buyout market, both here and in the United Kingdom. For example, the Service Employees International Union, the nation’s largest organized labor group, has stepped up its “Behind the Buyouts” campaign. Last month, the union announced a full summer program to broadcast complaints that LBO firms rake in profits at the expense of portfolio company workers.

Mid-market buyout firms, which once paid only passing attention to the implications of the industry’s increasingly public profile, have found themselves pulled closer to the fray. True, the battle has thus far snared only the biggest-name buyout firms, at least in terms of publicity. But all LBO fund managers earn income from carried interest, so what’s tax law for The Carlyle Group is also tax law for lesser-known mid-market shops. Some mid-market pros have said they’re content to ride on the coattails of the Private Equity Council, the trade group founded in late 2006 by a handful of the biggest firms.But Kilpatrick Stockton, an Atlanta law firm that represents buyout shops, has sensed a disconnect between the brand-name LBO firms and their smaller mid-market brethren. The Atlanta firm is beginning to put together a lobbying group geared toward the smaller players. “Mid-market guys have been reluctant to step up,” said Lynn Fowler, a partner at the firm. “But I think it would be a mistake to sit idly by. I think everyone realizes the time is now.”

Indeed, in comments posted to industry blog, mid-market general partners have expressed their frustration with the recent turn of events. One recently complained of “Blackstone billionaires” who drew legislators’ attention to private equity, while another said he “shouldn’t be penalized for the few that hit the headlines.” (Thomson Financial, publisher of Buyouts, operates Buyouts also conducted its own online own survey of the industry, finding, among other things, that 62 percent of respondents oppose the tax-law change.

Given the intensity of the debate and the high financial stakes, the mega-firms have responded by kicking their nascent lobbying group, the Private Equity Council, into high gear, and by stocking up on their own warehouses of lobbyists and policy shapers.

In the last two weeks, the Private Equity Council hired its fourth lobbying firm, while Bain Capital, Blackstone, Kohlberg Kravis Roberts & Co., and TPG have all retained their own K Street firms. Industry leaders have also aligned themselves with the U.S. Chamber of Commerce to oppose the taxation measures, forming a group dubbed the Coalition for the Freedom of American Investors and Retirees.

But if the hiring of lobbyists is any indication, the buyout business would rather wage combat out of the harsh light of public scrutiny. That’s going to be increasingly hard since Democratic lawmakers, the SEIU and their allies relish a big public fight.

“The big question right now for the industry is whether this will play out in the public square or in the halls of Congress,” said James Post, a professor of corporate governance, strategy and policy at the Boston University School of Management. “There are lots of interests that would like to keep this public. It seems unlikely that private equity will win this in the public square.”

The success of the industry in the carried interest battle will likely hinge on how effectively they can frame the issue, Post said. Much as they’ve tried to do so far, industry players will make the case that they take significant financial risk not just to reward themselves but also the university endowments, public pension funds and charitable foundations that provide the investment capital. At the same time, they create value in portfolio companies, boosting job creation and economic expansion.

On the flip side, politicians can beat a loud populist drum, arguing that private equity professionals earn tens of millions of dollars and throw lavish birthday parties for themselves, all on the backs of fired workers and off-shored production.

The SEIU, which represents janitors and health-care workers, has so far led the charge on this theme. At the end of June, the union organized a prayer vigil in Chicago outside the venue where ServiceMaster Co. shareholders voted to approve a buyout by Clayton, Dubilier & Rice. The groups, including ministries and environmental organizations, have called on ServiceMaster’s extermination unit to cease using what they consider to be dangerous pesticides. The day before the shareholder vote, the SEIU organized a press conference next to the New York Stock Exchange, where leaders from LBO firms and investment banks attended a conference on deal-making.

Later this summer, the SEIU plans to hold a series of town halls for college students to attempt to connect student lending practices with the pending buyout of lender Sallie Mae by J.C. Flowers & Co. The union is also putting the finishing touches on a report that will examine the workings of Bain Capital, although the SEIU is vague about what it expects to uncover aside from the fact that the firm charges a 30 percent carried interest.

“We’re going to work in all sorts of different ways to tell the story of private equity,” said Stephen Lerner, the organizer of the SEIU campaign.

All of this gnashing of teeth comes at a time when historically favorable market conditions are beginning to turn into a noticeable headwind. Buyout firms have had to significantly alter—and even withdraw—debt offerings following resistance from investors who eagerly gobbled up the same kind of high-risk bonds just weeks before. Even Blackstone’s stock, which rose by 20 percent on the first day of trading, is now hovering below its initial price.