Private equity IPOs unfazed by tax man
Only a market shift, not regulation or taxation, can slow private equity's dizzying pace. Fortune's Katie Benner reports.
(Fortune Magazine) -- The timing couldn't be more poetic for Kohlberg Kravis Roberts. Reports that it will have its own IPO stole some of the thunder from arch rival Blackstone's New York Stock Exchange debut Friday, signaling that the firm is still a titan in the world of private money.
But the possibility of a KKR IPO is more than just another chapter in a decades-long rivalry between Blackstone's Stephen Schwarzman and KKR's Henry Kravis. It is further evidence that it will take more than higher taxes to dampen investor hunger for a piece of private equity and its outsized returns.
This may be in part because the tax battle is a dog-and-pony show for citizens outraged by the idea that a man who makes billions of dollars a year could pay less in taxes than his cleaning lady.
In reality, politicians have already lined up behind private equity by working for its firms, and we're unlikely to see Washington rein in the industry with a couple of tax proposals.
According to The Wall Street Journal, KKR began preparations for an offering months ago; and it has retained underwriters including Morgan Stanley (Charts, Fortune 500) and Citigroup (Charts, Fortune 500)-owned Citibank, reports CNBC.
The decades-old firm is no stranger to the IPO market, having floated shares in 2005 for its real estate investment trust KKR Financial (Charts). The REIT was recently given a 'strong buy' rating from JMP Securities, in large part because of its ties to the private equity sector.
If KKR is considering an IPO, it must certainly have been encouraged by demand for Blackstone's shares that raised $4.13 billion for the firm in the biggest U.S. initial public offering in five years.
The house that Schwarzman built was valued at around $33 billion and the payout for its founder is estimated at a whopping $7.7 billion.
This initial success came amid a fight over how much private equity firms should pay in taxes. The battle has generated a lot of noise in the press while doing very little to harm Blackstone's offering. Buyout firms have been under scrutiny in the U.S. and the UK as lawmakers respond to outrage over the fact that they pay a much lower capital gains tax on profits from their investments, also known as the carried interest.
In the U.S. this amounts to about 15 percent and in the UK about 10 percent versus corporate taxes that normally top out at 35 to 45 percent. Washington politicians hope to force publicly-traded private equity firms to pay the same tax rate as other corporations, increasing the tax burden on a firm that makes the decision to go public.
A second proposal to increase taxes on profits made when firms sell their portfolio companies is also gaining support in Congress; this would affect the entire industry. Gordon Brown, who soon takes over as the UK's prime minister, is reviewing the private-equity industry's tax structure in that country.
On paper, it provides a blow to companies that have thrived largely in a world of little regulation and favorable tax rates. But America's largest publicly traded companies are not exactly throwing their hard-earned money at Uncle Sam.
During the first three years of the Bush administration, federal corporate tax collections fell to their lowest sustained level in six decades, according to the public policy group Citizens for Tax Justice.
In a report covering 275 companies in the Fortune 500, the group found that more than 80 companies paid zero or less federal income tax in at least one year over this time period. In the years they paid no income tax, they earned $102 billion in pretax U.S. profits, the study found, which would amount to about $35 billion in income tax at the 35 percent corporate tax rate.
Thanks to a combination of tax breaks and loopholes, aerospace and defense companies paid, on average, 1.6 percent in taxes over the three-year period, the study found, much less than the 15 percent private equity now pays on its carry.
As Bob McIntyre, the report's co-author wrote, "Most of the loopholes and tax dodges that corporations use to slash their taxes may be technically 'legal' in the sense that the tax law allows them," McIntyre said. "But remember that these subsidies got into the tax code because corporations lobbied to put them there."
Private equity's friends in high places
And when it comes to making friends inside the beltway, the private equity industry has been extremely successful. Not only does it have a rich lobbying group, the Private Equity Council, but at least four current presidential candidates have worked in the industry. Employees at the hedge fund Elliott Management have given Rudolph Giuliani $195,800, according to the Center for Responsive Politics, a non-partisan group that tracks money in politics.
Mitt Romney helped found the private equity firm Bain Capital, and he has raised about $100,000 from former colleagues at the firm. The CRP says Hillary Clinton has raised more than $100,000 in campaign donations from firms such as Farallon Capital Management and Avenue Capital Group, which incidentally employs her daughter Chelsea. And John Edwards, champion of unions and a supposed populist, has been an advisor at the hedge fund Fortress (Charts), where employees have donated more than $180,000 to his campaign.
Moreover, top directors at some of the most powerful buyout companies and hedge funds read like a list of political power players from both sides of the aisle. An abbreviated list could include former Treasury Secretary John Snow (Cerberus), former vice president Dan Quayle (Cerberus), former president George Bush (Carlyle), former secretary of state James Baker (Carlyle), former British prime minister John Major (Carlyle), former Clinton chief of staff Thomas McLarty (Carlyle), and former FCC Chairman Michael Powell (Providence).
As the buyout industry reshapes corporate America at a staggering pace and companies as revered as Chrysler and as large as TXU go private, the specter of regulation is unlikely to stop the flurry of deal making.
Only a cyclical shift will put an end to the private equity gravy train. Much like the tech bubble of a decade ago, the signs are here but it will be months before the pop. If anything trims private equity's huge profits, it will be higher interest rates, stricter lending terms, and high stock valuations. It won't be the government. As my colleague Adam Lashinsky is fond of writing in his blog, everyone always says it's different this time. But of course it isn't.