Private equity firms shell out large sums of money for advice in many forms. There are strategy consultants, market research firms, accountants, management assessment organizations, etc, etc, etc. There is a long list of organizations that have experienced a large influx of fees as the private equity industry has grown.
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None of them is called more frequently, loved more or sent bigger checks than the tax adviser.
Having been a partner in a private equity firm, these conversations all center on one topic: HOW DO WE SWINDLE THE GOVERNMENT?
Through its initial public offering, The Blackstone Group (The Fortress Investment Group has a similar structure and according to filings, KKR and another group, Och-Ziff Capital Management, intended to employ a similar structure upon going public) and its tax advisers has found a way to make PAYING TAXES PROFITABLE TO THEM.
When the average American sells a house or a stock position, the profit earned is taxed at a 15% capital gains rate. If a home is bought for $200,000 and sold for $250,000, Uncle Sam gets 15% of $50,000 or $7,500. If a number of shares are bought for $10,000 and sold after a few years for $15,000, the government gets 15% of $5,000 or $750. There is no way around it.
This example works when you apply it to the selling of a business. If a founder of a company starts a business with $100,000, builds it up over decades and sells it when he or she wants to retire for $20,000,000, the IRS needs to get 15% of $19,900,000 or $2,985,000.
This is fairly straightforward. There are no clever ways to get the money back or find some way to get around paying.
Unless you are The Blackstone Group.
They have devised a clever manipulation of the accounting term of goodwill and worked it to their benefit. Goodwill is a term created to capture the intangible benefits that a company has by being an on-going operation. I’m sure you are familiar with the term 1 + 1 = 3? It is similar to that notion. In the business example I used above, the $20,000,000 the seller of the business receives is more than the sum total of the values of each individual machine, piece of property or product in inventory. It is an acknowledgement that you could buy all of the machinery, property and products of the company for less than $20,000,000, but you wouldn’t have a business that is generating income. You would still need to hire people, find customers, etc., etc.
The value of a name brand is also captured in the notion of goodwill. To appreciate this, consider that a prospective buyer of a shoe company would willingly pay more for Nike than they would for ABC Shoe Company, even if they had the same revenues and profitability. Why? The brand has tremendous value.
Now, there are two important facets of this notion of goodwill. First, the government acknowledges that the value of goodwill is a multi-year benefit. It allows you to recognize as an expense for fifteen years the amount of goodwill being received. To go back to our example, let’s say the business being sold for $20,000,000 has $5,000,000 of physical assets (real estate, equipment, inventory, etc.). Hence, to keep it simple, let’s assume the goodwill is $15,000,000. The buyer of the business will be able to expense that $15,000,000 over 15 years, or $1,000,000. The result is less profit being reported and less taxes being paid. In this case, the buyer would pay $350,000 less in taxes.
The key for this is that the benefit of this goodwill deduction is supposed to go to the BUYER of a business.
Not if you are The Blackstone Group, however.
In all of their generosity they have told their investors – we know there is this huge goodwill benefit out there. Well, even though we are the seller and we shouldn’t stand to benefit, we are going to create a separate entity, transfer YOUR goodwill there and split it with you. We’ll take 85%, you keep 15%. Deal?
The diagram below from the New York Times captures it graphically and with the actual numbers.
Through its initial public offering, The Blackstone Group had $3.7 billion in gain to be taxed. The bill is $553 million. They transfer this $3.7 billion in goodwill to a new entity and create an expense of roughly $247 million each year for fifteen years in that new entity, or put another way, showing $247 million of less profit every year for fifteen years. Hence, there is slightly more than $86 million in taxes each year that they won’t have to pay, if you apply a 35% tax rate. Over fifteen years that’s $1.3 billion in tax savings.
That $1.3 billion is worth $751 million today. Compare that to the tax bill of $553 million and you have a nearly $200 million profit.
Wouldn’t our business owner like to pay $2,985,000 in taxes today and have a $7,000,000 tax benefit over the next fifteen years, worth $4,059,600 today?
Aseem K. Giri is the author of “Imposters at the Gate: A Novel about Private Equity”
