General Discussion

kpete

(71,994 posts) Thu Aug 23, 2012, 06:59 PM Aug 2012

Bottom line: - "Mitt Romney has not paid all the taxes required under law.".

Romney’s Management Fee Conversions

in my opinion, and the opinion of many tax practitioners, the practices that were common in the private equity industry in the 2000s became very, very questionable, and it’s unlikely that they would have stood up in court.

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Management Fee Conversion. Current law on carried interest is already a sweetheart tax deal for private equity, but why not make it better? Private equity folks are not the type to walk past a twenty-dollar bill lying on the sidewalk. In the 2000s it became common for private equity fund managers to “convert” their management fees into carried interest. There are many variations on the theme, but here’s how many deals worked: each year, before the annual management fee comes due, the fund manager waives the management fee in exchange for a priority allocation of future profits. There is minimal economic risk involved; as long as the fund, at some point, has a profitable quarter, the managers get paid. (If the managers don’t foresee any future profits, they won’t waive the fees, and they will take cash instead.) In exchange for a minimal amount of economic risk, the tax benefit is enormous: the compensation is transformed from ordinary income (taxed at 35%) into capital gain (taxed at 15%). Because the management fees for a large private equity fund can be ten or twenty million per year, the tax dodge can literally save millions in taxes every year.

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Fund VII. Gawker today posted some Bain documents today showing that Bain, like many other PE firms, had engaged in this practice of converting management fees into capital gain. Unlike carried interest, which is unseemly but perfectly legal, Bain’s management fee conversions are not legal. If challenged in court, Bain would lose. The Bain partners, in my opinion, misreported their income if they reported these converted fees as capital gain instead of ordinary income.

Here’s one example, from Bain Capital Fund VII LP (2009), pp. 13-14 (see here). In any given year, the manager (Bain) can waive its management fees, and allocate the fees instead to a particular investment in the fund. If that investment appreciates in the future, the general partner (Bain) takes a “Priority Profit” off the top. While Bain did not waive its fees for this fund in 2009, it had done so earlier in the life of the fund, to the tune of tens of millions of dollars. (5% of its total holdings of Bombardier Recreational, for example, came from fee conversions — making the fee conversions alone worth about $7 million in 2009).

To be clear, there is some economic risk, and presumably this is how Bain’s tax counsel justified its reporting. The economic risk is that the priority profit must come from future profits, presumably from the investment to which the converted fee is allocated. On the other hand, the managers get to choose which investment in the portfolio they want to skim, and they are in a good position to know which investments are safest. Because the fees come off the top, they are not subject to real investment risk, but only the limited risk that even their best investments will decline in value, every single quarter, for the rest of the life of the fund. Even in 2009, an iffy year for Fund VII, the priority profit share increased in value by $3.8 million.

Bottom line: Mitt Romney has not paid all the taxes required under law.

the rest:
http://victorfleischer.com/archives/306

References:

I talk about management fees on page 23-24 of Two and Twenty (NYU Law Review 2008).
http://victorfleischer.com/wp-content/uploads/2009/12/Two-and-Twenty.pdf

Gregg Polsky (North Carolina) has a terrific paper on the topic: Private Equity Management Fee
Conversions (Tax Notes 2009)
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1295443