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Posts Tagged ‘hedge funds’

See prior September 18. 2017 blog post  for important background regarding PERS adoption of age weighted IAP accounts.

Once again, it appears that younger workers are being short changed by PERS in the adoption of age weighted IAP accounts.  Remarkably, there was no opportunity for public discussion on vendor selection or strategy regarding how the age based portfolios would be constructed.

Rather, it was announced in September that the French insurance conglomerate AXA’s subsidiary Alliance Bernstein, what some call the AIG of France, would be awarded the contract to manage more than $8.2 billion in participants IAP accounts.   Some will argue that this isn’t really an $8.2 billion contract since it will simply involve reshuffling assets among participants internally.  My thought would be, tell that to the participants.

Paris Based AXA and Le Vie Bonne Courtesy of Oregon PERS

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One obvious question to PERS directors and Democratic State Treasurer Tobias Read is why a domestic vendor was not chosen for this important public contract.  All sitting members of the Oregon Investment Council were appointed by Democratic Governors.   And where were the labor unions?

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Warren Buffett has announced his largest buyout in history, the $38 billion takeover of Portland, Oregon based Precision Castparts.  This is almost twice the size of the Heinz takeover, one of his largest prior takeovers.

Heinz and other Buffett enterprises, including Burlington Northern and Pacific Power, are having a strong negative impact on the Oregon economy.

This includes potato farmers in Eastern Oregon who had a win/win long term relationship with Heinz cancelled, and local communities battling to prevent oil and coal from being shipped by rail thru their communities without adequate safety guidelines.

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Disclsoure and Media Development Background:  Parish & Company maintains no speculative investments in the health care companies discussed and does not collaborate with any private equity or hedge funds.  It’s goal is to identify high quality health care opportunities suitable for long term oriented investment.

This effort includes providing high quality news material to leading journalists including Gretchen Morgenson of the NY Times, Mark Maremont and Rich Rubin of the Wall Street Journal, Joseph Tanfani of the LA Times and Margaret Collins of Bloomberg.

In doing its research Parish & Company has revealed a massive price fixing scheme, both in medications and medical equipment, being orchestrated by private equity and hedge funds, often financed by public pensions including Oregon PERS.   These firms purchase drug and medical equipment royalty cash flows and, in conjunction with the use of various drug and medical procedure distribution systems, including hospitals, specialized clinics and pharmacies, are price gouging patients and fleecing taxpayers via Medicare and Medicaid reimbursements.

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In late 2014 the tax exempt Oregon Historical Society sold the Sovereign Apartment building, after owning it more than 30 years.  The Society maintains an outstanding board of directors and this was clearly a difficult decision. As part of the sale the society negotiated a long-term lease for itself yet its 44 tenants were last month given six months to vacate.

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The following letter was sent to SEC Chair Mary Schapiro and IRS Commissioner Doug Shulman on “tax day” with the hope they will jointly work at restoring the integrity of cash flow statements, without question the most important analytical tool for investment advisors like myself.  It is simply astonishing, given their material nature, that listed companies are not fully disclosing purchased and accumulated net operating losses nor the impact of complying with the “fractions rule” in the case of private equity partnerships.

 

Parish & Company
10260 S.W. Greenburg Rd., Suite 400
Portland, OR 97223
Tel:(503)643-6999 Fax:(503)293-3507
Email: bill@billparish.com

April 15, 2011

Mary Schapiro
Office of the Chairman
Securities and Exchange Commission
Mail Stop 1070
100 F Street NE
Washington, D.C. 20549

cc: Elise B. Walter – SEC Commissioner
Troy A. Parades – SEC Commissioner
Robert Khuzami – SEC Director
Doug Shulman – IRS Commissioner
Heather Maloy – IRS Commissioner Large Business Division
Walter Harris – IRS Director Financial Services
Elise Bean – Congressional Oversight Committee

Dear Chair Schapiro,

In 15 years as an investment advisor I have always done my best to support the SEC’s work, having led many key corporate governance related initiatives. Past Chairs Levitt, Pitt and Donaldson are all familiar with my work, which has also been reported in front page stories in leading publications including Bloomberg, the New York Times, Barrons and USA Today.

The purpose of this letter today is to alert you directly to an alarming trend with respect to the rapidly eroding integrity of cash flow statements filed with the commission. The culprit is non-disclosure of important tax related transactions involving material net operating losses, in addition to compensation and related expense allocations subject to the “fractions rule”and NOL loss limitation rules that are material to past, present and future cash flows involving publicly traded partnerships, such as Blackstone, in which tax exempt investors participate. The NOL related limitation issues are also a significant issue in mergers and buyouts of public companies.

Back in late 1999 when I provided original research to Gretchen Morgenson, David Cay Johnston and Floyd Norris of the NY Times regarding how Microsoft paid no federal income tax I was told that this was ridiculous. You discredit your excellent work by saying such a thing, Morgenson added. Six months later she did a front page story outlining the scheme involving the issuance of NQ stock options. Similarly Bob Herdman, Chief Operating Officer at the Commission, thought the idea ridiculous at first.

While everyone was focused on the future dilution of options, my focus was instead on the historic tax based cash flow impact of options. What made this original research possible was a cash flow statement that analyzed cash flow and, in conjunction with footnotes, provided a good general idea of tax related impacts.

More recently, since last summer, I have tried to get the NY Times to do a story on how major private equity and hedge funds may indeed be escaping taxation completely via gaming carried interest deductions in violation of two key IRS reforms established by former President Reagan, the “fractions rule”and limitations on purchased NOLs.

The Times chose to focus on publicly traded GE and in their story never fully highlighted how GE is using NOLs. How could the Times put their reputation on the line based upon my work without adequate SEC disclosure? Also interesting to note is that at one time over the last two years, one private equity firm, Harbinger, owned more than 10 percent of the NY Times. Similarly, per Yahoo finance, JP Morgan owns almost 10 percent of Gannett, parent to USA today.

Media consolidation and outright ownership of media by major financial institutions, including private equity and hedge funds that have bitterly fought to undermine both the SEC’s and IRS efforts, has complicated this task. Perhaps now is a good time for the SEC and IRS to be more vigilant and oriented at making news aimed at solving fundamental problems before they accumulate and lead to major market problems. While leading attorneys at major law firms representing the private equity crowd enjoy great access with top officials via conferences and other venues, independent advisors like myself with a distinguished record can barely get a phone call returned.

GE was low hanging “media fruit” so to speak. Clearly the much bigger issue is that involving the takeover of public companies by private equity and hedge funds, effectively converting these formerly tax paying entities to the equivalent of tax exempts using NQ option and carried interest schemes resulting in an NOL pyramid scheme. Again, the bulk of these NOLs were never cash expenses but simply NQ options and carried interest.

If these private equity and hedge funds were indeed catering only to affluent investors that would be fine yet today many of these organizations receive most of their funding from public pensions. I have written about this extensively over the last 5-7 years and pushed hard to get the concept behind carry fees fully understood and disclosed. Again, numerous examples of this work appear in major publications.

One of the big lessons of the dot.com era was the need for the SEC to collaborate more with the Federal Reserve and see the economic impact of accounting irregularities. Most notable of course back then were merger and stock option accounting related issues. Former San Francisco Fed President Robert Parry told me, look Bill, “accounting issues were not in the fed’s purview” in late 1999. This was when the market was more focused upon whether Alan Greenspan took a bath before a meeting of the Federal Reserve.

The key lesson in the recent crisis involving mortgage financing and related derivatives was of course that conflicts of interest with key regulators and rating agencies can lead to similarly disastrous results. If Moody’s had done their job, we would have had no crisis. Also germane was the impact of top government officials such as Robert Rubin moving to industry and aggressively attacking important safeguards, Glass-Steagall in his case.

The reason I have copied your former colleague at FINRA, current IRS Commissioner Doug Shulman, is that to date there has been almost no discussion regarding how tax policy played a major role in both crises and in my opinion, with the proposed repeal of the fractions rule, could ignite the next. My work in this area goes back to 1999.

My hope is that you will work together to restore integrity in what is clearly the most important disclosure of all for any public company, the cash flow statement and related footnotes. Doing so will also greatly enhance overall tax equity, in my judgement. The notion that major tax related impacts not be disclosed is a significant fraud upon all statement users and puts the whole system at risk.

More specifically, someone at the Treasury has proposed repealing the fractions rule in the 2012 revenue guidelines. To that, I only have the following thoughts: Robert Rubin/Glass-Steagall; Wendy Graham/Derivatives Deregulation. It is absolutely ridiculous when it was such an important reform and there has been almost no enforcement of it for years, perhaps not unlike mortgage underwriting standards. The industry failed in Congress and failed to get an American Bar Association sponsored revenue ruling ,yet now it the Treasury itself advocating the repeal of the fractions rule.

While some companies will argue rightfully that tax returns are private and not required to be disclosed, such material NOL and “fractions rule” related information must be disclosed when public firms are taken private or in the event of significant sales or mergers. This is fundamental accounting 101. Some would add that failure to do so is the very essence of fraud because it fuels the notion that investing is an insider’s game. What it also does is allow problems to accumulate and ultimately exacerbate major problems in the market.

These cash flow based disclosures are vital information to an SEC Registered advisor like myself, and other investors. And for the last couple of years I have found increasing frustration in dealing with leading journalists because they are simply not getting the mandatory public disclosure required to corroborate my research findings and forward key corporate governance initiatives.

A good recent example is the General Electric sale of NBC to Comcast. So why do these two completely independent firms get to “game the system” with respect to the allocation of net operating losses belonging to GE via a special allocation partnership, subsequent to a sale of the business? One might ask, is this a fraud upon taxpayers, investors, both or simply much ado about nothing? When I make such an observation to a leading journalist, they need to be able to see a footnote that confirms or refutes my claim. This is as basic as corroborating total revenues per the income statement.

It is understandable that many journalists have expressed no interest in covering the proposed repeal of the “fractions rule,”simply because they don’t understand it. The reason of course is that these public partnership firms are not providing adequate disclosure to the SEC. In addition, something appears very amiss at the Treasury department. Who is behind this repeal, really? If you do a search of Blackstone’s 10K you will find no references to the fractions rule, nor related financial adjustments made to confirm to it. Similarly, no one at the Internal Revenue Service is willing to discuss this. (See attached letter to Curt Wilson, Associate General Counsel Passthroughs at the IRS).

At https://billparish.wordpress.com you can also see a blogpost that features a brief audio, taken from an American Bar Association Conference in which one of the nations leading attorneys, Sanford Presant, explains how investors received $7 in tax deductions for each $1 invested prior to the fractions rule. Also included is a brief audio clip from a top IRS official, Curt Wilson, who volunteered to sit on a panel, noting he sees no enforcement issues with the “fractions rule.”

How can we transfer our angst over the fractions rule to you,”a King and Spaulding attorney asked the IRS’s Wilson? Wilson later told me that the fractions rule was not being considered for repeal yet it is now in the 2012 Revenue Guidelines for repeal. Wilson will not confirm who is involved in the repeal nor its specifics. Again, in my mind this will be the genesis of a crisis if not prevented, similar to the repeal of Glass-Steagall or the rules regarding derivatives trading.

Per my analysis, firms with inadequate cash flow disclosure to the commission with respect to NOL and fractions rule related considerations include, but are not limited to Bank of America, Goldman Sachs, JP Morgan Chase, Morgan Stanley, Citigroup, General Electric, Comcast, Blackstone, KKR, TPG (via acquisitions including J Crew since TPG is not publicly traded), Apollo and Fortress.

For example, if Blackstone is going to purchase a publicly traded company and thereby assumes significant accumulated NOLs, those valuable NOLs must be disclosed fully to existing shareholders prior to a sale. In addition, the same partnership must disclose the impact of the fractions rule, specifically, how much of the deductions cannot be taken due to having tax exempt investors in the purchasing partnership. Such investors often represent more than 80 percent of all funds in major private equity partnerships.

Also relevant are the limitations on the deductibility of purchased NOLs, and whether they are being fully deducted using a reverse scheme, in which an entity with significant NOLs purchases a firm paying significant taxes, thereby escaping the required amortization reform put forth by Reagen. My original research identified this scheme in 2001 subsequent to the takeover of Time Warner by AOL.

It is not enough to say, we need not disclose such information since it is an item on our tax return. Full disclosure and materiality mandate such disclosure of material tax driven cash flow items directly on the cash flow statement or in the footnotes.

In another example, if TPG purchases J Crew and by doing so receives $1 billion in net operating losses, a large part of which are tax deductions created from stock options, how are these valuable net operating losses treated. These expenses never resulted in a cash outlay, and if the partnership at TPG buying J Crew has 80 percent tax exempt investors, are these NOLs being stripped away in violation of the fractions rule prior to being put in the partnership? And, if so, is this not a violation of the fractions rule resulting in a LILO like leasing doubling up of tax deductions for taxable general partners, etc?

One could argue such non-disclosure to the SEC is manufacturing a tax deduction pyramid or flipping scheme in which private equity firms take companies private, public, private again and then public. Each time creating staggering NOLs in the form of stock option or carried interest deductions, not resulting from an outlay of cash for equipment or wages, but rather a paper tax deduction pyramid scheme.

Regarding Blackstone, another potential issue includes the valuation of partnership interests that create valuable tax deductions? Are these straight up or are they the equivalent of a stock option back dating scheme being used that is aimed to increase tax deductions by awarding such units at artificially low strike prices, achieving the same impact as backdating? Of course tax exempt partners may not care, yet what of the future cash flow impact for public unit holders? In reviewing the history and Blackstone’s limited public disclosure, something just does not look right, in my opinion.

Furthermore, if Blackstone executives exchange unvested NQ options with Blackstone partnership units based upon carried interest, the strike price value difference between each should be fully disclosed to shareholders, not simply in aggregate.

In my original research on stock options back in 1999 I often noted this backdating impact and was simply amazed that at the time there was no concern. It was sad to see how this developed into a legal feed bucket for law firms that never acknowledged the most damaging part of the scheme, that being the creation of a tax deduction pyramid scheme.

In 2000, I arranged a related story on this for Gretchen Morgenson of the NY Times involving two employees at Microsoft who expressed an interest in becoming clients. I tentatively agreed to accept them as clients only if they were willing to discuss their situation with Morgenson given the important tax governance related involving their situation. Similarly, Morgenson agreed that, if she did the story, she would mention my simple idea regarding a pivotal tax reform.

The couple had exercised options but failed to sell shares to pay the tax until they filed their return several months later. The subsequent drop in Microsoft’s stock price left them with a large tax bill and insufficient assets to pay the tax. I had expected that the story, which appeared on the front page, would include my comment that the IRS provide a one-time adjustment in such situations, provided the total options were less than x in value. Unfortunately the comment did not appear yet it was however recognized as a key story with Morgenson being awarded the Pulitzer Prize.

My guess is that the Times advertisers, including Microsoft and Cisco Systems, did not want the story done because if employees were allowed to “look back” on a one time basis, this would clearly eliminate the tax deduction the companies were taking. More centrally, it would challenge the stability of this innovative tax deduction pyramid scheme that began with NQ options and has now morphed into carried interest.

Of course this is particularly germane if a CEO orchestrates the sale of a public company and stays on with the private equity firm as a shareholder. Perhaps Tony James, Blackstone’s president, put it best by saying,“Now we can just exchange the unvested portion of an executive’s NQ options with our partnerships units and not expend valuable cash in order to bring them on board and get the deal done.” You can see this summarized at https://billparish.wordpress.com in two blog posts. One is dated August 2010 and the second March 31, 2011. Both provide important background for this letter.

I spoke with Mark Zehner in your office about this issue last fall, specific to the fractions rule, and frankly must reflect significant disappointment at the lack of follow up, especially given the stellar work he did in the municipal finance area. This is not a UBTI driven issue unique to tax exempt investors in public partnerships but rather an assault on the basic integrity of“the key financial statement” used by advisors like myself to analyze the merits of a particular investment opportunity, the cash flow statement.

We all want the economy to turn around, yet in my opinion, that will only happen when integrity and confidence are restored to the cash flow statement. Doing so will allow numerous peripheral areas to self correct ranging from capital flows to overall tax equity.

Thank you for considering these thoughts and of course I will make myself available for follow up commentary. The opportunity to develop some level of dialogue with the commission would be much appreciated. This could include someone at the commission suggesting I be invited to speak at a major conference, etc.

Sincerely,

Bill Parish

** Blog posts and related audio clips at https://billparish.wordpress.com

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Note (Not Copyrighted) : This basic post was updated December 10, 2010 given the current debate in Congress over extending the Bush tax cuts and numerous inquires regarding my position in this debate.  The purpose of this post is to highlight that although rates are important, perhaps more important are overall fairness issues associated with two situations in particular.  Put another way, why don’t we all forget about the rates and focus on basic fairness first.  Doing that should allow rates to come down in all brackets.

With the financial reform package now passed, all eyes are on the setting of specific rules regarding its implementation.  And while lobbyists attempt to direct the debate away from where it should be, let’s instead visit the core issue, tax rules.

This rollout of specific rules related to the Volcker Rule and related tax considerations will squarely position Paul Volcker, pictured on the lower left below and current IRS commissioner Doug Shulman, lower right, against Blackstone Group LP’s Steve Schwarzman and other leveraged buyout artists operating under the guise of “private equity.”  Why are tax rules key one might ask, especially if these rules have nothing to do with the debate over carried interest?

This is because two specific tax rules have profoundly shaped the current investment markets via a major impact on cash flow. They have also in a more basic fashion functioned as the seeds from which all the other market dysfunctions have originated. The purpose of this post is to briefly explain these two rules and then connect the dots.  Also see related March 31, 2011 post titled Blackstone Tax Engineers, Inspired by GE, attempt to repeal the fractions rule.  This post includes brief audio recordings from leading attorneys and an IRS official regarding the fractions rule.

1)  Net Operating Losses: This involves the practice of creating large pools of net operating loss tax deductions, mostly from unusable technology firms’ stock option deductions when these firms are bought by private equity funds.  These private equity firms then do leveraged buyouts of profitable companies and offset these profitable companies profits into the pool of losses to make the profitable companies tax exempt.

Back in the 1980’s this loophole was intended to be closed when Congress prohibited profitable companies from purchasing such losses and using them all immediately.  The new law required they be amortized over several years.   As former Senate Finance Chair Bob Packwood noted in an Oregonian article, the Treasury never foresaw firms escaping the loophole by using partnerships with large pools of losses to purchase profitable companies.   Essentially, the same transaction in reverse.

Who would think that a partnership whose primary asset were losses would be able to purchase profitable companies. All that was needed in the legislation to prevent this was the term “and vice versa.”  Remarkably, there has been no discussion of this amazing situation, perhaps the biggest tax story in 10 years.

2)  “The Fractions Rule” This rule was put in place at about the same time and designed to prevent tax exempt entities such as public pensions from trading tax deductions they were not entitled to use with taxable partners.  The fractions rule also was designed to discourage tax exempt entities from investing in leveraged buyouts (LBO’s) via partnerships with private equity firms and other taxable partners.   Clearly this would give such firms purchased an unfair marketplace advantage when competing with tax paying businesses.  Or put another way, who would be left to pay tax if all the tax paying firms got gobbled up by partnerships in leveraged buyouts fueled with tax exempt investor funds.

Perhaps one of the nations leading attorney regarding the Fractions Rule, Sanford Presant of GreenburgTaurig, put it best in a 2008 American Bar Association meeting when he said.  “Back then it was tough to get in to our Thursday night committee dinners, they were by invitation only.  Boy was it tough to get in to listen to some of these people and their intelligent pearls.  The real debates were… Can you get 5 to 1 write-offs.  5 to 1?  How do you get 7 to 1!  Everybody was trading on tax benefits and as part of all this backlash, we got the fractions rule.”

Presant is pictured below on the left with Wayne Pressgrove of King and Spaulding on the right.  These two brilliant lawyers represent the leading private equity and hedge funds.

In the ensuing years, once again the industry has attempted to sidestep the fractions rules intent, which applies only to “partnerships,” by using blocker “corporations” set up in the Cayman Islands and other tax havens.  As a trained CPA I find this most disappointing since the IRS rules should be based upon the “substance” of the economic activity rather than the form or structure.  In any event, there is a whole cottage industry of law firms selling advice based upon such  blocker corporation schemes.

A brilliant team of lawyers at King and Spaulding helped write the fractions rule and key to it is the expression “and vice versa.”  This is key because it would prevent the gamesmanship that has occurred with operating losses noted above. Put another way, it would limit allocating deductions from tax exempt to taxable partners in addition to allocating income from taxable partners to tax exempt partners.

What surprises many non tax experts is that these special allocation partnerships can have one set of allocation rules for taxable income and deductions, and a completely different set of rules for cash flow.  The second key aspect of this situation that is creating considerable uneasiness among taxable partners in these partnerships is the rule regarding substantial economic effect, that is, you can’t be simply moving deductions and income between taxable and tax exempt investors unless the transaction has “substantial economic effect.”

This is particularly important with compensation, the numbers of which can be particularly large with private equity and hedge funds.   Large CPA firms now have entire divisions focused upon transfer pricing and expense allocations yet again one has to ask the question, if these transfers do not have underlying economic effect other than moving deductions around, why is this allowed.

It is somewhat ironic that King and Spaulding, the same firm that helped draft the fractions rule, is now leading an effort via the American Bar Association to gut the fractions rule by exempting certain key expenses and transactions.  One recent King and Spaulding partner, Dan Coates, was just elected to the US Senate and expressed interest in being on the Finance Committee, which oversees these rules via the IRS.

We’ve given up on repealing it all together, the ABA notes, and so we are now trying to be more tactical.  This has resulted in the fractions rule becoming what one leading attorney calls the “Mariana Trench” of the Internal Revenue Code.  Perhaps it is also why there has been so little enforcement to date from the IRS,  as noted by Curt Wilson, Associate Chief Counsel in the the office of Passthroughts and Special Industries, at the 2010 ABA Mid Year Tax Section meeting. Wilson noted, I find this surprising especially given the level of angst in industry over compliance with these rules.  See my letter to Wilson opposing granting this revenue ruling.

As an investment advisor I find this remarkable given the current debate over extending the Bush tax cuts.  While smaller LLC based businesses pay federal, state, property and various other forms of taxes and fees, it appears that these private equity and hedge funds are skirting the rules and paying close to nothing.  This of course introduces a significant fairness issue.

Again, the fractions rule specifically limits the trading of tax benefits from tax exempt entities to taxable partners, or vice versa.  Put another way, imagine if you were a taxable partner in a partnership and 90 percent of the other investors were tax exempt entities?  Imagine how difficult it would be to leave 90 percent of valuable tax deductions on the table as unusable?

Perhaps this is why gutting the fractions rule is one of the American Bar Association’s top priorities. (See ABA letter to IRS Commissioner later in this post.)

It could be argued that some private equity firms have become but a sophisticated shell for tax avoidance based upon a maze of interconnected companies and effectively converted to tax exempt status through the aggressive use of net operating loss tax deductions involving executive compensation and transfer pricing.  This has resulted in an unfair competitive advantage against profitable companies that pay taxes.  This has also enraged ordinary small business owners who are not using such schemes.

Investors in profitable companies that actually pay taxes get lower returns than they otherwise would have, making competing with such a scheme on a long term basis difficult.  The situation is even worse for their productive employees who suffer job losses due to takeovers inspired by this scheme, and essential government services which rely on a broad tax base.  This could be the big untold story of the current economic decline, a decline inspired and manufactured by certain private equity firms.  It also explains in large part the constant drumbeat of job outsourcing in that the first thing these private equity firms do is outsource everything off shore possible, no matter the long term consequences.

Again, Congress supposedly foresaw this potential with passage of the “fractions rule”, Internal Revenue Code 514(c)(9)(e) in the late 80’s, to prevent tax exempt entities from trading deductions they cannot use with taxable entities.  One need only examine the growth in tandem of public pensions and private equity investment to see the dimension of this issue.

In the 1980’s the big issue was depreciation on real estate being given to taxable partners by tax exempt partners in exchange for other benefits.   If this were allowed to proliferate there would be no corporate income tax as private equity partnerships manage companies from a tax exempt status and drive tax paying competitors out of the market with lower prices.

One can forget that taxes are indeed one of the most significant business expenses and eliminating this expense would provide a significant competitive advantage for these private equity firms.

Private equity funds have grown dramatically since then, most notably Blackstone, KKR and TPG.  These firms now receive most of their funding from tax exempt public pensions, foundations and endowments, at times more than 80 percent for particular partnerships.  At the same time they are aggressively investing in businesses which derive most of their revenue from government programs.  A good example is Blackstone’s recent purchase of Oregon’s largest assisted living center, Sunwest, an entity whose primary source of sales are government medicare and medicaid payments.

Somehow the public has been fooled into thinking private equity is something other than a euphemism for leveraged buyout.  And while tax exempt investors, mostly public pensions, use sophisticated LBO strategies including  these Caymen Island based “blocker corporations” to avoid paying UBIT (unrelated business taxable income), they appear to have altogether neglected the significance of the “fractions rule” and basic economic substance requirements regarding allocations of financial results.

Congress set up the UBIT rules specifically to avoid a situation in which tax exempt entities are partners in private equity partnerships and investing in leveraged buyouts, to maintain a level playing field.  The idea was to tax these tax exempt entities on profits gained from such leveraged buyouts, that is UBIT tax.

As noted, the UBIT rules regarding leveraged buyouts have  however been circumvented through the use of off shore “blocker corporations” set up as an intermediary so that the tax exempt entities are seen as investing in a corporation rather than a partnership in which activity flows directly to them as a partner, for example profits and tax deductions.

Nevertheless, the fractions rule math is pretty simple as follows: if for example 70 percent of Blackstone’s investment partners are tax exempt, then 70 percent of certain tax deductions are unusable and can not be transfer priced or allocated into a situation, whether by using equity compensation, carry fees or other expenses in which they are transferred to and used by taxable partners.

While the nation debates whether to tax private equity and hedge fund partners at ordinary or capital gains rates, more interesting is whether or not these partners like Schwarzman are in clear violation of existing IRS tax rules due to an aggressive tax strategy using stock options and carry fees, and other deductions.  Once these machinations are fully understood, the tax benefits could be disallowed if the fractions rule has been violated.

As an example, let’s briefly examine the Blackstone Group more closely, whose President Tony James visited Portland, Oregon in July 2010.  Blackstone is arguably the global leader in private equity investment.  They are also a major risk for investment advisers like myself given their ability to takeover good companies and remove them from the marketplace.  This makes my job much more difficult, not only in selecting good investments, yet also in maintaining clients who suffer an unnecessary job loss due to one of these senseless takeovers that are now proliferating.

Blackstone and other private equity firms including KKR and TPG essentially set up partnerships with tax exempt entities like Oregon PERS, LLC’s,  and often have as little as 10 percent of their own equity in the deals.  “Tax efficiency reasons” are often cited for private equity funds’ low equity participation.  The partnerships then do buyouts of both public and private companies.  The above agenda summary is from a recent presentation by Blackstone in Oregon.

As Tony James noted in his presentation which led to a $200 million investment in a Blackstone partnership, they can now use Blackstone stock as currency to attract top executives by swapping out their unvested stock options for Blackstone options.

That may be convenient yet IRS rules are very clear in prohibiting the trading of valuable tax deductions between taxable entities and tax exempt entities such as public pensions due to abuses in the 1980’s.

Specifically, the “fractions rule”., IRC, 514(c)(9)(E)  was adopted and it only allows the taxable entities to take their share of economic interest in the partnerships.  For example, the taxable partners could only take 100 percent of the equity compensation tax deductions when there are no tax exempt partners.

What it also does not allow is an aggressive strategy using transfer pricing and allocations to circumvent the rule.  Such strategies may reduce tax exempt entities exposure to UBIT yet the fractions rule must still be met.

What the IRS clearly did not want was tax exempt entities like CalPERS and Oregon PERS taking a greater share in profits in lieu of trading unusable tax deductions, deductions they were not entitled to  as a tax exempt entity.  A related specific purpose of the rule was to provide a disincentive to do leveraged buyouts, thereby capturing large interest expense deductions and allowing taxable partners to avoid all tax on their profits.   And while Congress debates whether or not to levy ordinary income or capital gain tax rates on private equity managers, it is conceivable that a tax rate of 75 percent could still result in no tax being paid by general taxable partners such as Blackstone’s Schwarzman.

Many creative and aggressive tax strategies have been adopted by large law and accounting firms to try to get around this fractions rule.   These firms, once referred to as the Big 8, yet now the “Final 4,” all have large divisions focused on hedge funds, private equity and transfer pricing related strategies, to minimize taxation.  In addition to being Blackstone’s auditor, Deloitte is also the auditor of record for Oregon’s private equity portfolio.

The question becomes, are the taxable partners at Blackstone using capitalized carry fees and aggressive transfer pricing rules to avoid all taxation?  My practice includes roughly 20 PERS participants here in Oregon and I made a public records request for Blackstone, KKR and TPG’s K-1 partnership filings, yet was told that Oregon does not receive them for most partnerships and for those it does, maintains no file of them.

Remarkably, the Oregon Attorney General’s office adopted the philosphy that since Oregon PERS is tax exempt they need not ask for nor review this critical document reported to the IRS, but rather rely exclusively on documents prepared by Blackstone, KKR and TPG for information.  For this reason the OIC does not even maintain files for K-1’s in general.  This is somewhat ironic since the current Chair of the Council is Harry Demorest, former managing partner of Arthur Andersen’s Portland Office.  Demorest  managed the tax practice at Arthur Andersen before assuming control over the entire office and clearly if anyone should understand the importance of receiving a K-1, it is Demorest.  Another council member, Richard Solomon, is also a practicing CPA.

The following are samples of the few K-1’s they maintain at Oregon PERS.  They are for KKR and TPG  and were obtained via public information request.  When asked for a simple description regarding the accounting treatment for carry fees, which do not appear directly on these K-1’s as capital transfers,  the Treasurer’s office refused to provide this information.

One obvious question is why the K-1 capital accounts are so low in relation to the publicly available investment summary by partnership.  Many things could explain this yet where is the basic transparency.  And why won’t the Oregon Investment Council even disclose the accounting treatment they are using for the significant carry fees being paid to general partners?  Also of interest is perhaps that KKR’s K-1 is done on a “tax books” basis while TPG uses GAAP accounting.

One could argue that tax exempt investors have nothing to gain from receiving a K-1, yet that is simply ridiculous.  The K-1 is a key document that includes information regarding values, distributions, etc.  My guess is that this is prevalent among public pensions and would it not be interesting to compare the K-1’s provided to taxable partners to those provided to tax exempt partners?

These private equity firms are famous for providing a wide range of “figures” on key reports and related valuations.   The Financial Times, (see summary visual) has reported that Blackstone valued one  investment at 125 percent higher than TPG when even though this investment is in the latter company for an equal amount.   These valuations are critical because they drive transfer pricing, related deductions and allocations, etc.

Goldman Sachs even has its own internal specialized exchange which values private equity interests and is where many such private equity interests are bought and sold.  It is called the GSTrUE system and is only accessible on approved Bloomberg terminals.  Remarkably, not even the Institutional Trading areas at TD Ameritrade or Charles Schwab have access.  Perhaps this “dark exchange” needs a little daylight cast, especially since the biggest investors in such partnerships are taxpayers via the various public pension systems.

Let’s face it, taxes can be boring yet this discussion is important to all investors given that the current level of “buyouts” is removing many quality investments from the market that are later loaded up with debt so that the private equity firms can more quickly earn their “carry fees,” which are generally 20 percent of all profits after returning the original investment to partners.   What also results is a job destruction machine that undermines the economy and stability of the financial markets, not to mention the tax base.  Most importantly, this undermines investor confidence with the perception that investing has become an insiders’ game of manipulation.

Here is a summary of a few potential “discussion issues” to consider affecting just one private equity firm, Blackstone.

1)  The CEO of Blackstone Tony James noted in a public meeting in Oregon that Blackstone options are being used in exchange for unvested options for various purposes, including attracting key management talent.   He also noted that Blackstone uses numerous internal “non-profit” cost centers to serve its various portfolio companies in the subsidiary partnerships, many of which have tax exempt investors.   The question becomes how this impacts transfer pricing and the allocation of valuable tax deductions.

One related question is the following: by manipulating the cost of products and services provided to portfolio companies, are they essentially creating compensation related carry/stock option tax deductions at the Blackstone level to be allocated to taxable partners, when they belong to tax exempt investors and should be unusable?

2)  Blackstone’s 10K for the period ending 12/31/2009 does not disclose what would be material adjustments for disallowed equity compensation deductions belonging to tax exempt investors.  These pertain to equity compensation in which the executives provide services to portfolio companies.  At the July 2010 Oregon PERS  public meeting, James used the example of hiring Gerry Murphy of Kingfisher, one of the UK’s largest firms, by swapping his unvested options for Blackstone options.  James also highlighted the service Murphy provides to specific portfolio companies in the partnerships.

If Blackstone is creatively allocating expenses to its various partnerships, why hasn’t it disclosed the portion of this equity compensation and other related deductions which should be disallowed because they belong to tax exempt partners via an allocation of related expense.

Blocker corporations may solve their UBIT tax issues, yet the fractions rule must also be independently satisfied.

Many other related questions arise when exchanging options for firms acquired.  These deductions need to stay at the acquired firms, yet their value would have been created by the transfer of the Blackstone options, even if the Blackstone Group LP company is not taking a deduction.

Where is the disclosure in Blackstone’s 10K regarding the disallowed carry executive compensation expense?  The firm recognized almost $24 billion of such carry related compensation expense reducing its income by more than $3 billion in 2009.

3)  The Blackstone 12/31/2009 10K displays the line item stating “non-cash equity compensation” of $3 billion.  This resulted in a net loss as shown of approximately $2.4 billion in 2009.

If this entire amount of equity based compensation listed above pertains to a tax deduction, as it usually does with respect to such a line item on a “cash flow statement,” this would imply that Blackstone pays no federal income tax for activity in 2009.

Granted they may indeed pay tax related to other areas, for example, property tax, timing differences from prior year.  The key question becomes, how much of this equity compensation amount pertains to services provided to portfolio companies and what part should be disallowed given that the portfolio company is now partly owned by a tax exempt entity?   Also, is this a material omission by Blackstone’s auditor, Deloitte?

4)  The Chair of the Section on Taxation for the American Bar Association wrote the following letter directly to the IRS commissioner Doug Shulman on January 19, 2010 concerning partnership allocations permitted under section 514(c)(9)(E).    What he is specifically asking for is a revenue ruling to permit more aggressive strategies with respect to the allocation rules regarding partnerships with tax exempt entities, i.e, violating the spirit of the fractions rule.  The entire letter with extensive comments can be accessed on-line with a Google search.

Following the letter in this blog post is a list of clients for the lawyer whose firm King &  Spalding was a key contributor in authoring the letter.

The key attorneys noted as contacts involved with drafting this letter to IRS Commissioner Doug Shulman on behalf of the American Bar Association are the following.

In a testament to their legal prowess, the first attorney noted works for King & Spalding, a firm that lists three of the four largest CPA firms, Price Waterhouse Coopers, Ernst & Young and KPMG as  clients, along with Goldman Sachs, Citigroup, Bank of America and Wells Fargo.

At the same time the ABA is seeking a revenue ruling waiver from the IRS, the private equity and hedge fund industries are pursuing a simultaneous track in Congress.  This was introduced in the 110th Congress and reintroduced as H.R.3497 in the 111th Congress.  Both bills are sponsored by Sanford Levin of Michigan (not to be confused with younger brother Carl Levin in the U.S. Senate).   H.R. 3497 has only three co-sponsors and has been referred to the appropriations committee where Sanford Levin is chairman.

Perhaps most interesting is that at the same time U.S. Representative Sanford Levin is introducing a bill that could dilute the fractions rule, he is also introducing another bill, H.R. 1935, to tax private equity partners at ordinary income rates.  The irony is that his one bill, H.R. 3497, could indeed result in no tax, regardless of the rate.

Meanwhile his younger brother Carl Levin is co-sponsoring a bill with Jeff Merkley of Oregon designed to help states avoid teacher layoffs.  Carl Levin has also been a leader in the effort to reform stock option accounting.  It is unfortunate that a key driver in the funding gap in state governments is increased Public Employee Retirement System contributions due to significant investment losses and concern over the lack of liquidity with respect to their private equity portfolios.

I have some simple advice for the current administration.  Aggressively enforce the fractions rule and prohibit tax exempt organizations from using blocker corporations or any other vehicle that ultimately results in a leveraged buyout within three years of a firms’ acquisition by a partnership in which they participate.  If we simply eliminate the fuel for these senseless takeovers, that is tax exempt pension and endowment money, we’ll go a long way toward protecting good companies along with their employees and current investors.

For those of you wanting to enjoy a little Sunshine and rub shoulders with Wayne Pressgrove and other key voices from the American Bar Association in this debate, including leaders at the Internal Revenue Service, consider attending the upcoming conference in January at the Boca Raton resort.  Details are provided below.  Perhaps it is somewhat ironic that indeed the Blackstone Group now owns the Boca Raton resort via one of its real estate partnerships.

Perhaps also ironic is that Blackstone’s novel approach of issuing a publicly traded security on the New York Stock Exchange, one that is not a stock but rather a partnership allowing tax benefits to flow directly to general partners, may afterall allow many of those same benefits, if indeed such deductions lack economic substance, to flow right back to the Treasury.   For taxpayers, both individuals looking at higher rates and corporate alike, including the likes of Warren Buffett who has roundly criticizes this structure,  this could amount to “sweet justice.”

Perhaps my alma matter, the University of Oregon, may indeed set a good precedent by defeating the Auburn Tigers, Pressgrove’s alma matter, the week prior in the BCS championship series.  Spending several hours putting this post together should allow me at least a little comic relief 🙂

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