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Today Oregon PERS approved a $400 million investment in Stonepeak, a firm that invests in “infrastructure projects.”

In his presentation Stonepeak’s managing director Michael Dorrell noted their strategy is to invest in “essential infrastructure assets with an economic monopoly, much like an airport.”  This includes water, power plants, transportation and telecom with a focus “outside the auction process.”  They expect an annual return of 12 percent over 30 years.

One of their major projects he discussed is the largest desalination operation in the western hemisphere, in Southern California.  The key development partner is Poseidon Resources, “former GE guys.”  Dorrell noted they obtained the exclusive rights to such desalination projects.  They brought these rights over from their former employer Blackstone, who is entitled to 50 percent of the carried interest from this project. The expected return is 14 percent over 30 years and the City of San Diego could not do much about this high rate since Stonepeak has rights to the “only viable site near San Diego.”

In the old days government entities would issue municipal bonds for such improvements in order to make sure the public interest is served with respect to keeping costs down.  One might question why Oregon PERS is investing in such projects via private equity firms rather than directly funding them via a firm specializing in this area working with the municipality?

This also highlights why it is so important for Oregon PERS to fully disclose carried interest fees and partnership audit reports to the public.  Key questions regarding Blackstone’s participation in 50 percent of the carried interest from the desalination project were simply not asked.  They include noting whether Blackstone has other businesses independent of Stonepeak with a stake in the project,  etc.

Put another way, more disclosure of private equity and hedge fund fees is important, not only with respect to their own funds yet also in terms of how much these funds have allocated fees to outside supposedly independent firms like Blackstone, especially if they come in the form of stock options.  At a minimum, Stonepeak should update its SEC ADV filing noting that Blackstone has a material participation in its largest project.

Remarkably, one of Stonepeak’s principal equity owners, per SEC filings, is TIAA-CREF.  Given that TIAA-CREF is tax exempt, along with Oregon PERS and most of the other limited partners, its not hard to see why tax rates are going up for the rest of us.  The overall corporate tax base is simply vanishing behind tax exempt status.

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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 building’s new owner is the Randall Group, a prominent locally based owner of numerous residential and commercial buildings.  The stated reason for the forced eviction is to undertake a major remodel resulting in much higher rents.  The Randalls are prominent local philanthropists and make significant contributions to OHSU.

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Rather than use its own property management subsidiary, CTL, the Randall Group has chosen instead to use Norris Beggs, Simpson.  Tenants were offered the last two months free rent if they stay until the eviction date, December 31, 2015.  At the same time Norris Beggs is advertising short term rental rates below current tenants rates.  Of course some of the long term tenants find this disappointing.

Ironically, the Randall Group receives a significant amount of financing from tax exempt public pensions via CBRE, what they call structured finance in the real estate industry.  In 2012 Oregon PERS invested $100 million in one such CBRE fund.

Unlike New York, there is no rent control in Portland, Oregon and therefore this type of forced eviction effective December 31, 2015 to pave the way for a significant rent increases is an accepted business strategy.

In New York prominent private equity firms regularly purchase rent control buildings, financed by public pension co-investors including Oregon PERS, with the stated strategy of forcing a certain percentage of renters out of their apartments by cutting off utilities, not making key repairs, etc, what could be considered suggested evictions.  By doing this, they can often raise the rent 500 percent for new occupants.

Where it gets interesting is that the Oregon Historical Society was playing by the rules in that it held its ownership of the apartment building in a taxable subsidiary C corporation.

Therefore, they paid full taxes on its income, including $1.3 million or a 40 percent overall tax rate on the gain at the time of sale.

The following footnote is from the 2014 annual audit report.  Note the taxes paid on the sale, again, the society is a tax exempt entity.

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So while the Historical Society is playing by the rules, other prominent Oregon based foundations including the Meyer Trust, Oregon Community Foundation, Ford Foundation and others invest aggressively in private equity based real estate partnerships that use foreign blocker corporations based in the Cayman Islands and pay no tax on either their income from the investments nor from gains on sales.  This is similar to Goldman Sachs renting a Post Office box in the Caymans, claiming it as its main office, and averting billions in taxes.  Tax attorneys call this tax efficiency while other more simply minded might consider it criminal tax evasion.

The solution is simple and that is to make sure any tax reform plans also incorporate various tax-exempt entities.

My proposal would be to provide tax free treatment on investment gains for tax exempt entities only if an investment is held 5 years and standard capital gain treatment if held less.  The only exception would be investment in government issued securities, the gains of which would be tax free without exception.  Of course an added benefit would be to reduce the rampant speculations being made with tax exempt investment funds,  or as one prominent short-seller Jim Chanos says, only tax exempts should short sell due to “tax efficiency” reasons.

It will be interesting to see how long the Randall Group hangs on to the Sovereign building or whether it will be sold to a private equity real estate pool using an offshore blocker so that tax exempts can invest and pay no tax on income or gains from sales.

Even CPA firms better known for crafting tax strategies have moved aggressively into private equity.  One such firm, which began as the CPA firm Parrot and Associates, now calls itself Vergepoint Capital.  It recently sold a $52 million complex to the Randall Group with financing provided to Randall by CBRE.

The next chapter in the Sovereign’s life might simply be a takeover by another more “tax efficient” tax exempt.  Not only is this bad public policy yet it is also aggravating an acute shortage or reasonable housing in downtown Portland.

It is astonishing how leading Presidential Candidates banter about tax rates with no recognition that public pensions, foundations and endowments via investments in offshore based private equity and hedge funds now control trillions of the US economy, and since they pay no tax on either income or gains, no tax reform will work without bring a discussion of tax exempt to the table.

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Disclosure:  This post is the first of several regarding the 2016 Presidential candidates.  One post will be done on each major candidate and the focus will be their primary financial backers and their respective foundations.  Bill Parish maintains no ties to any candidate nor does he have knowledge of any client owning positions in private equity or hedge fund partnerships.  Parish & Company only recommends publicly traded securities.

With Hillary Clinton likely to win the Democratic nomination, barring a major mistake, her most influential financial backers will be analyzed first.  They are Tony James of Blackstone and Jim Simons of Renaissance, the world’s largest private equity and hedge funds respectively.

The purpose of this post is to present an inside look at both firms and how they might influence national economic policy.

Primary Backer 1.  Tony James, President and Chief Operating Officer, Blackstone

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Bill Parish with Tony James, Blackstone President and COO, at the April 2015 Oregon Investment Council meeting.  At the meeting, James secured an additional investment of $500 million from Oregon PERS.   James is seen as a leading candidate for Treasury Secretary in a Clinton administration.   And although clearly able to do the job, the key question might be, does James have the capacity to turn his back on his natural constituency, private equity and hedge funds, as Teddy Roosevelt did, and represent the country.

His firm, Blackstone, is involved in what some might consider blatant tax evasion schemes resulting from its heavy use of tax-exempt fund sources for its various investment partnerships.  It has also become a job destruction machine as they aggressively acquire, consolidate and outsource good paying jobs.  For Blackstone it is a short term orientation and related “race” to earn carried interest fees.

Blackstone’s key tax evasion scheme involves realizing its “carried interest” fees in the form of stock options.  They are essentially taking a full tax deduction for these options issued in taxable subsidiaries not owned by its tax exempt limited partners, even though the options involve executives at companies owned by the same tax-exempt limited partners  Put another way, taxable general partners are using tax deductions that belong to tax-exempt limited partners and are by definition unusable.

Of course Blackstone can rightfully claim that everyone is doing it, as summarized in the following study by PricewaterhouseCoopers showing that industry wide indeed 70 percent of all carried interest fees are paid in stock options.  Even Warburg Pincus, where former Treasury Secretary Tim Geithner is now president,  pays more than 50 percent of all carried interest fees in the form of stock options.

And while many look back at the .com era and see accounting excesses, the reality is that the whole bust was driven by the excessive use of stock options.  It was the quest to inflate earnings and related share and option prices that drove the “creative accounting.”   The key factor was that the options resulted in massive tax deductions, even though not paid in cash but rather simply by printing up new shares.  Yet the value of these shares was not shown anywhere on the income statement as an expense.

What private equity firms have essentially done is reinvent the same scheme behind the private equity curtain by using “economic net income,” which excludes these carry related option costs.  Portfolio companies’ values are then inflated by being valued using economic net income times a multiple, for example 8.  This has triggered deal specific carry fees, essentially overcharging limited partners with respect to carried interest in the equivalent of a “pyramid scheme loop.”

When I introduced myself to James and noted I was the guy who took on Microsoft over stock options. James replied  “you changed the world since those deductions can no longer be taken.”  I then added, but isn’t the private equity industry doing the same thing since carried interest is mostly paid in stock options.  James replied, “well, that’s right.”   So essentially the private equity firms have reinvented the scheme behind the private equity curtain, which is exactly why they so aggressively fight any form of disclosure regarding their activities

Here is a key page from the PricewaterhouseCoopers study on carried interest and stock options.   Remarkably, neither the Wall Street Journal nor New York Times has reported this, what is clearly the biggest financial story in 10 years.  Private equity firms now control trillions of dollars of the US economy.

PwCcarryfeestockoptions

Note: A slide from a presentation by PricewaterhouseCoopers in July 2014 highlighting that “PE funds continue to avoid using restricted stock as the primary equity award due to US tax treatment and valuation constraints.”  A key detail is that approximately 70 percent of carried interest is paid in the form of stock options, per PricewaterhouseCoopers’ own study.

Given on average at least 75 percent of the limited partners in these partnerships are tax-exempt, by allocating internal carried interest as options to portfolio company executives as internal carry, they are essentially creating tax deductions that do not exist.  This is a clear violation of the fractions rule, in addition to having no substantial economic effect.

When I first provided this analysis to leading academics like Victor Fleischer and Gregg Polsky in 2010 they were  focused mostly on the debate between ordinary income and capital gain treatment, what Fleischer called the 2 and 20 debate in a well written analysis.  Leading portfolio managers, analysts and journalists were similarly focused on rates. Unfortunately, this debate is meaningless if taxable income is zero due to illegitimate carried interest deductions.

Back in the .com era the debate de jour was whether or not stock options were recognized as an expense, just as Fleischer and Polsky later focused the private equity debate over the tax rate assessed on income, that is, ordinary or capital gain.  Looking at how expenses were allocated, including tax deductions, was simply not seen as significant.

As with stock options back in the .com era, the debate should be on these expenses and related tax deductions, specifically, how much is being created in expenses and tax deductions and to whom they are being “allocated.”  This is especially important since most of the limited partners are tax-exempt and deductions allocated to them are by definition unusable.  To do so would create a double tax deduction.

If this idea seems a stretch, consider the following chart provided by Blackstone in its April 2015 presentation that netted $500 million of additional funds from the Oregon Investment Council (OIC).

Parish & Company has pushed the OIC to disclose the specifics of these fees and expenses and related partnership audit reports for its various private equity partnerships since 2003.  This includes making regular public comments at monthly OIC meetings.

Blackstonefundperformance

Performances and Returns from a presentation by Blackstone to the Oregon Investment Council, prepared for the exclusive use of the Oregon Investment Council, April 2015. One need only compare the gross IRR to the net IRR to frame the discussion.

Parish & Company has written extensively about these allocations, in addition to highlighting one key effect of these practices, that being tax-exempt investors have been overcharged with respect to “deal specific” carried interest charges in the equivalent of an Enron like tax deduction pyramid scheme.   Oregon PERS was one of the biggest losers on Enron related investments.

Here is an example of one recent public comment, provided both in formal testimony and in writing via email, to Chief Investment Officer John Skjervem at the February 2015 OIC meeting.  Note that Skjervem deleted the final paragraph from the official record and when asked to have it reinserted both he and current Chair Katy Durant both noted they would not do so.  Whether or not this is an ethical or administrative breach of public records law is secondary to the reality that it is simply poor judgement.

As you read this comment keep in mind that I have approximately 20 clients who are participants in Oregon PERS.

“Bill Parish, an independent Registered Investment Advisor, addressed the Council regarding its private equity and hedge fund investments.  He specifically requested that the council post the refund OPERS will receive from KKR’s settlement with the SEC regarding limited partners being overcharged fees.

Parish also suggested that the recent expansion into investing more heavily into private equity led drug royalty investments raises important public policy questions given that these strategies’ revenue originates primarily from Medicare and Medicaid reimbursements.

Just as Enron price fixed the energy markets in California by artificially constricting supply, creating rolling brownouts in the late 1990’s, price fixing of generic drugs and key medical procedures being led by private equity investors constricting supply through takeovers and other means is raising important public policy questions.”

The following excellent story was done by Gretchen Morgensen of the New York Times on May 1, 2015 and further highlights issues regarding the allocation of expenses.

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Another key tool Blackstone is using with respect to expense allocations is their large Group Purchasing Organizations or GPOs, in particular Healthtrust, a GPO which claims to serve 25 percent of the health care market.  It is these types of delivery organizations that are contributing to a rapid consolidation in purchasing activity and driving up health care costs, due to lack of competition, ranging from generic drugs to basic procedures.

James claims its GPO is a non-profit yet Blackstone does not provide any details whether it is a registered tax-exempt with non-profit status nor what percentage each underlying owner maintains.  SEC filed documents do however clearly indicate Blackstone has conducted fee sharing in this area.

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The following article regarding stock options was written by Bill Parish for Barron’s in 2003 and Microsoft revamped its compensation practice within 30 days of its printing.

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The speech referenced below also highlighted the dramatic impact of stock options and explained how they were indeed the root cause of the .com collapse.

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Primary Backer 2.  Jim Simons, Chief Executive Officer, Renaissance Technologies

Simons is widely known as a brilliant financial engineer and many might also add a brilliant architect of tax evasion schemes.   Both Bloomberg and the Wall Street Journal have reported on some of theses strategies yet my personal favorite concerns Renaissance’s retirement plan and Simons’s foundation, both unreported to date.

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It is important to note that Renaissance does nothing productive for the economy, other than siphon off massive fees from public pensions and other tax-exempt investors resulting from short term speculations on security movements.  However, the real secret sauce to its strategy may indeed be tax evasion.

As Warren Buffet notes, successful investment requires keeping a laser eye on cash flow and generally the second largest cash outflow, after wages and benefits, is taxes.  Eliminate the taxes and you have a colossal structural advantage, provided such strategies are sustainable.  This is Simons’s key strategy.

With Clinton and other Democrats promoting their credentials with respect to protecting and expanding jobs for the middle class and related benefits such as a reasonable retirement, an examination of Renaissance’s own retirement plan is telling.

And the Simons Foundation, to be reviewed following the retirement plan, is where we see the 1 percent becoming the 99 percent.

Let’s start with the retirement plan.  The following notice was posted in the Federal Register from the Department of Labor in April of 2012.  The notice essentially granted an exemption to Renaissance that allows it to circumvent a key DOL rule that prevents companies from putting more than a certain percent of its own company stock into employees’ retirement accounts.  Essentially avoiding what would be considered prohibited transactions.

What Renaissance did was terminate its 401K plan in 2010 and roll the balances into a new employee IRA plan.  This new employee IRA plan is invested exclusively in Renaissance’s own partnerships, which violates key DOL and IRS rules.  Even though they have an exemption from the DOL rules with respect to ERISA-prohibited transaction rules, they are clearly in violation of IRS rules, which are different.

Think of it like a barber shop putting his business in his IRA so that he doesn’t pay any income tax.  Brilliant, creative but also against the rules.

The real beauty of the new Employee IRA Plan (no, this is not a SEP, not a 401K, not a profit sharing but rather a spectacular piece of what some call strategic non-compliance to the rules) is that Renaissance says to the IRS, just trust us that the the total investment in our own partnerships is less than a certain percent of the total IRAs of all employees, so we are following the rules.  Again, bear in mind that 100 percent of the IRA balances in the new plan are in Renaissance’s own partnerships and the value of these is determined by Renaissance’s own “valuation committee.”

And yes they also did start a new 401K for employees, independent of the New Employee IRA Plan.  The new 401K had 3 percent overall growth in assets in 2013 while the New Employee IRA Plan balances grew 43 percent.

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The following chart shows the sum of the balances for the year ending December 31, 2013 in the New Employee IRA plan in which 100 percent of the account balances are invested in Renaissance’s own partnerships.

Renaissanceemployeeirascheduleofassets

And here is the footnote to accompany its annual filing in which Renaissance states it has obtained an exemption from the DOL allowing it to not comply with the prohibited transaction rule.  The final sentence is spectacular in its deception as it states the administrator (which is Renaissance) believes that it complies with requirements of the IRC or Internal Revenue Code.  Again, the DOL ERISA requirement is separate and independent of the IRS rules.

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In a further testament to the financial magic performed by Renaissance, which elevates its strategies to high comedy, is the following reference from Jim Simons’s multi billion dollar tax-exempt foundation.

In plain English, Simons is running a billion dollar investment company through his foundation, claiming that the foundation’s 99 percent ownership stake is only that of a “limited partner.”   There you have it, how the one percent becomes the 99 percent and makes aggressive speculative investments through the tax-exempt shell of a charitable foundation, paying no tax on gains.  Even Romney, a top notch financial engineer himself, would likely be impressed by this.

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Of course the key question becomes, does Clinton have the capacity to genuinely reform the tax code if she ends up relying on advice from James and Simons, especially if James becomes Treasury Secretary.

James knows full well that the problem with the tax code has nothing to do with rates but rather a simple lack of enforcement of the existing rules, which has allowed people like Simons to shift his tax burden to the rest of us.

And the key rule that CPAs like myself respect mightily is substance over form.  Put another way, structure it however you want yet in the end the underlying substance should determine its fate.

The message for investors is clear, avoid private equity and hedge funds and their related companies, whether spun off in IPOs or backing bonds, regardless of the posted results.

Quality publicly traded securities with robust SEC, DOL and IRS oversight should increase in value as the air comes out of this financial engineering bubble based upon tax evasion.

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Prior to the fractions rule, investors were investing $1 in order to get $5 to $7 in tax deductions.

President Reagan was so incensed that he signed into law new legislation, the “fractions rule,” specifically designed to end this scheme.  During this period no firm was more abusive with respect to tax avoidance than General Electric. Today Reagan’s reform is being challenged in an assault on taxpayer fairness led by the private equity firm Blackstone and its CEO Steve Schwarzman (pictured below left), in conjunction with the American Bar Association (ABA).  See my August 2010 blogpost “Blackstone: Private Equity or Public Theft,” for expanded background.

Before you consider the proposition of gaining $5 of deductions with a $1 investment preposterous, listen to the brief clip below of Sanford Presant of Greenberg Traurig, one of the nation’s leading real estate attorneys.  It is actually two short clips, the first is his introduction at a major tax conference and the second an explanation of what led to the fractions rule in his own words.

Presant is a national authority in this area and has had major roles with the ABA, in addition to heading up Ernst and Young’s real estate practice. The complete audio recordings for Presant’s remarks, in addition to those of Internal Revenue Service Associate Chief Counsel Curt Wilson, can be purchased at http://www.dcprovidersonline.com.

Also featured in the recording is Wayne Pressgrove of King & Spaulding, who makes a case to IRS Counsel Wilson for a revenue ruling to disable the fractions rule.   It is ironic that Reagan relied on the same law firm, King & Spaulding, to craft the fractions rule in the 1980’s, and these lawyers did brilliant work.

Audio Clip 1 (0:25)
Hear Sanford Presant Introduction and Background

mp3 file (for iPad users)

Audio Clip 2 (1:26)
Hear Presant Enthusiastically Explain How Investors Received $5 of Tax Deductions for Each Dollar Invested

mp3 file (for iPad users)

At a 2010 ABA conference, Internal Revenue Service Associate Chief Counsel Curt Wilson volunteered to sit on a panel and explained where the IRS stands on fractions rule enforcement. Wilson is introduced by Wayne Pressgrove of King & Spaulding.

Audio Clip 3 (3:32)
Hear IRS Associate Chief Counsel Curt Wilson Discuss the Fractions Rule

mp3 file (for iPad users)

Wilson notes there always seems to be “considerable angst” in the audience regarding compliance with this rule.  He added that one of the American Bar Association’s key initiatives was to amend the fractions rule. Remarkably, Wilson adds that he has seen almost no activity in this area at the IRS for years, either centrally or in the branches.  One might ask if this is just but another GE-like inspired scheme.

Earlier this year Wilson responded directly to me via email that the IRS was not planning to repeal the fractions rule.  However, the Treasury department’s February 2011 General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals were released and they include a repeal of the fractions rule (see page 90). Wilson now notes that someone else in his office is responsible for the fractions rule, yet he will not disclose who this is.

Why is this important for all investors?

This month NY Times reporter David Kocieniewski wrote a remarkable piece on General Electric, noting the company earned significant profits, yet paid no federal income tax in 2010.  The article also noted that GE maintains a “970” employee tax department headed by John Samuels, a former United States Treasury department official.

Such situations are important for all investors to consider because long-term cash flow is a primary determinant of  investor success.  Next to labor costs, taxes are often the most significant cash outflow for most businesses.  Clearly, tax avoidance alone is not sustainable long term and such a risk should be considered.   Other firms with significant such risk include Google and Cisco Systems.  The overall point again is simply, cash flow matters.

Given the opaque nature of these tax schemes at firms such as GE and Blackstone, it is often helpful to analyze them from the bottom up.   For example, Catalent Pharma Solutions is a Blackstone-owned company that files its own 10K with the SEC.   This provides valuable information including executive non-qualified (NQ) option agreements at Catalent and footnotes explaining how entities roll up to the Blackstone parent.   Much of this information is simply not available in Blackstone’s own 10K filing with the SEC.

The following list of entities shows exactly how Catalent eventually connects to Blackstone, its parent.  The Top Level partnership, Blackstone Holdings III L.P., appears in Blackstone’s SEC filings and org chart. It is mostly owned by tax-exempt public pensions. The carried interest fees these tax-exempt pensions pay is indeed Blackstone’s primary source of income, an expense to the tax-exempt pensions and revenue to Blackstone.

If Blackstone is manufacturing non-qualified (NQ) tax deductions at the Catalent wholly-owned subsidiary level, which are actually a pass-through of the carry fees (internal carry plan) paid from tax-exempt limited partners to company executives, then this could be a significant violation of the fractions rule.  Sound bizarre?   Perhaps that is the beauty of laundering activity through so many layers of entities, combined with transfer pricing algorithms managed by leading accounting firms. Keep in mind that Blackstone has hundreds of individual companies in its various partnerships.

Please note that given the opaque nature of these issues and related complexity, my hope is that a leading journalist will confirm the facts directly with Blackstone.  This material is not copyrighted and has been provided to both Gretchen Morgenson and Floyd Norris of the NY Times for review.  It was Morgenson who reported on my findings regarding the Microsoft Corporation in 2000, similarly noting a scheme which allowed them to pay zero federal income tax.  From an investment point, again, the key observation of this analysis is that “cash flow matters.”

One could argue that the only real company in this whole structure is Catalent.  Imagine how frustrated their competitors who pay significant taxes feel.  Perhaps this is the real nexus of the national debate over taxes.  Rates should be able to come down in all categories, yet this is simply not possible until the basic tax equity issues are addressed.   What we need is enforcement of the fractions rule, specifically with respect to compensation allocations, in my opinion.

Repealing the fractions rule is now the “Holy Grail” for many private equity firms, in particular with respect to the allocation of compensation deductions.  The 2012 Treasury Department revenue proposal refers to using a less restrictive rule that does not deal with the key issue involving tax exempt entities, perhaps returning us to the days when certain insiders can invest $1 and get $5 in tax deductions.

Despite all the controversy surrounding Reagan’s Presidency, one can be certain that he would have dealt with this nonsense swiftly.  We will soon see how the current Administration does.

These private equity firms failed to get the fractions rule repealed in Congress.  They then failed again in their request to obtain a revenue ruling, sponsored by the ABA, from IRS Commissioner Doug Shulman.  The ruling was designed to exempt compensation (carry fees) from fractions rule considerations. They now have remarkably gotten the United States Treasury Department itself advocating their cause per the 2012 Treasury Revenue Proposals which effectively repeal the fractions rule.

Somewhere out there is an underpaid lobbyist and about the only thing standing between their success in repealing the fractions rule is a good journalist.

The following letter was sent to Warren Buffett and his heir apparent, David Sokol, on March 24, 2011 because he like all investors will see diminished opportunities as companies are taken private by private equity firms such as Blackstone in order to implement what might be called a tax deduction pyramid scheme.

Interestingly,  Sokol resigned shortly thereafter on March 30, 2011.  By the way, does anyone really believe Warren Buffet would invest $9 billion in Lubrizol so Sokol could earn a profit of $3 million, perhaps the equivalent of a rounding error for his personal portfolio?  Similarly, does anyone really believe Sokol resigned solely based upon this investment?

In any event, here is the letter to Buffett, whom some argue is a leader in key corporate governance issues, including tax equity.


March 24, 2011

Warren Buffett

Berkshire Hathaway Inc.

3555 Farnam St.

Suite 1440

Omaha, NE 68131

cc: David Sokol

Dear Warren,

I hope you are well and enjoying things. The last correspondence we had resulted in that most memorable letter from David Sokol regarding the purchase of PacifiCcorp here in the Northwest.

The reason I am writing today is that I would like to reveal, similar to the work I did regarding Microsoft in 1999 that ultimately resulted in two reporters earning Pulitzer prizes and a veritable cottage industry of media tag alongs, a most astonishing taxation story. One that, if you do not address, will clearly hobble many of your portfolio companies.

On this issue, we should be on the same page. The challenge is that we will need to briefly visit what leading tax attorneys call the Mariana Trench of the Internal Revenue Code, that is the fractions rule, scheduled to be repealed per Obama’s 2012 revenue proposals. See link to blogpost titled “Blackstone, Private Equity or Public Theft,”at http://www.billparish.com

Recommendation: Have your top analyst take a look and confirm you will not only be priced out of many acquisitions but also see your portfolio companies hobbled if this is repealed. No matter how well run and efficient you are, and no matter how great the sloth at these PE firms, this will greatly impact you in my opinion.

There are many specific facets to this scheme yet they all revolve around ultimately allocating unusable tax deductions belonging to tax exempt partners to taxable partners. Most remarkable is that these are not real expenses such as depreciation but rather mostly compensation in the form of carried interest fees.

Substantive Facts:

1) Private equity funds now receive most of their funding from tax exempt sources, in particular public pensions. George Roberts and others now spend most of their time gathering such tax exempt investors.

2) The fractions rule was put in place to prevent GP’s like Blackstone and KKR from trading additional partnership benefits with tax exempts LP’s who had vast amounts of deductions that could not use, since they are tax exempt. As one leading attorney put it, investors were trading on tax benefits, at times getting 5-7 dollars of deductions for every dollar invested, and that is what brought us the fractions rule.”

3) Here is how the current scheme works and how it will cumulatively hobble you over time:

PE firms portfolio acquire companies and create vast stock option programs, what some call internal “carry plans,” and by doing so take NQ option deductions at the individual portfolio company level. In reality, this is nothing but a push down of the carry fees paid from mostly from tax exempts, which is non-deductible. These carry fees are an economic expense belonging to tax exempt, often booked as a balance sheet transfer, never hitting the P&L statement.

4) The reason this impacts Berkshire is that everything else equal, you cant compete on a long term cash flow basis with firms that pay no taxes at all In addition, as Roberts states, their strategy is to aggressively price competitors out of the various markets and then later raise prices.

While you may say, this won’t effect us Bill, do have one of your best analysts take a good took. Quite remarkable. I’ve also provided this information to the Internal Revenue Service yet they will not comment.

My basic point is that if the fractions rule is eliminated and compensation deductions, in particular carry fees, can be allocated without restriction by only needing to conform to more lenient rules, it will be one big mess. See http://www.billparish.com for link to blog post titled “Blackstone, Private Equity or Public Theft.”

5) IRS Perspective to Date: Curt Wilson in the office of passthroughs and special industries has noted in national ABA conferences that “although their is considerable angst regarding the fractions rule,”it has been off the IRS radar screen. He also responded to me via email earlier this year when I expressed concern over the ABA aggressively pushing for repeal, specifically lobbying him hard at national conferences, that the IRS did not support that. Remarkably, however, in February the Treasury issued guidelines for 2012 which include its repeal. When asked for additional information, Wilson replied that someone else is handling this in his office but I can’t get a response from him who this is, much less any specifics.

Please do take a look. and naturally I will make myself available if someone there would like to discuss in more detail. By the way, as you likely know, all four of the major CPA firms are making very significant revenues servicing private equity and hedge funds who aggressively use carry fees. I began my career at Arthur Anderson when it was a great firm in 1980’s. Perhaps helping prevent this repeal will also help prevent an Anderson like moment in the future for one of these firms. It is indeed possible that this is a bigger situation than LILO leasing.

Best regards.

Bill Parish

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