Battle over carried interest intensifies

If the hiring of lobbyists is any indication, the debate over the tax treatment of private equity partnerships has escalated into a full-fledged conflict that has awakened mid-market buyout shops.

In the last two weeks, the Private Equity Council hired its fourth lobbying firm, while Bain Capital, The Blackstone Group, Kohlberg Kravis Roberts & Co. and TPG have all retained their own Washington, D.C.-based 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.

At issue is the debate over the tax treatment of private equity partnerships. Legislators from both houses of the U.S. 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% to 35 percent.

At the same time, some members of the House of Representatives have sponsored a bill that would tax publicly traded partnerships, subjecting them to a much higher tax rate. The so-called “Blackstone Bill” was introduced days before Blackstone (NYSE: BX) went public at the end of June in a $4.1 billion IPO. The bill would provide a five-year phase-in for Blackstone and Fortress Investment Group (NYSE: FIG), which earlier this year became the first hedge fund firm nationwide 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, as it has announced a program to broadcast this summer complaints that LBO firms rake in profits at the expense of portfolio company workers.

Mid-market buyout firms, many of which once paid only passing attention to the implications of the industry’s increasingly public profile, have found themselves pulled closer to the fray. 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.

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 firm is beginning to put together a lobbying group geared toward the smaller players. “Mid-market guys have been reluctant to step up,” says 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.”

The law firm might be able to tap into growing resentment from mid-market general partners. One 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,” according to a recent survey on (Thomson Financial, publisher of PE Week, operates

“The big question right now for the industry is whether this will play out in the public square or in the halls of Congress,” says 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.”