Private Equity

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Posted by kaori 03/15/2009 @ 23:10

Tags : private equity, investors, finance

News headlines
BankUnited Bid Seen As Major Test For Private Equity - Wall Street Journal
By Joe Bel Bruno NEW YORK (Dow Jones)--For the private equity industry, the future of Florida's BankUnited Financial Corp. (BKUNA) might be the most closely watched deal of the year. The Coral Gables-based thrift, with 85 branches scattered mostly in...
Whitehall Cash Call Adds Insult to Losses - Wall Street Journal
By ANTON TROIANOVSKI and LINGLING WEI There is more pain to come for investors in Goldman Sachs Group Inc.'s biggest real-estate private-equity fund. The fund spent $3.7 billion between May 2007 and August 2008 to buy a portfolio of casinos,...
KKR Private Equity Investors Reports its Financial Results for the ... - FOXBusiness
The work of our company management teams, private equity industry teams, KKR Capstone team and capital markets team to improve company operations, address refinancing issues and proactively optimize capital structures allows us to, in general,...
The Week In Private Equity: Boss Tweed Lives! - Wall Street Journal
That's not even the only bidding war out there, as software company SumTotal Systems said an unsolicited bid from Vista Equity Partners is superior to a previous merger agreement the company had with Accel-KKR. And Candover Investments and Cinven Group...
Cuomo Treads Where SEC Failed on 'Pay-to-Play' Rules - Bloomberg
“These problems have existed for quite some time and they didn't get the attention because the amounts of capital committed to private equity were relatively insignificant,” said David De Weese, a partner with private-equity firm Paul Capital Partners...
House to Investigate Former PBGC Director Millard - Bloomberg
Goldman in October was awarded a contract to invest $700 million of PBGC assets in private equity, and JPMorgan and BlackRock were each given contracts to invest $600 million in real estate and $300 million in private equity, according to the report....
Renewed Neuberger raises funds from Lehman ashes - Reuters
By Simon Meads LONDON (Reuters) - Asset manager Neuberger Berman has started fundraising for new private equity funds after the completion last week of an employee-led buyout from the wreckage of former owner Lehman Brothers.(LEHMQ....
Private equity eyes mine services firm BUMA-sources - Reuters
By Michael Flaherty and Saeed Azhar HONG KONG/SINGAPORE, May 14 (Reuters) - The owners of Indonesian mining services company BUMA have put the company back up for sale, sources said on Thursday, with private equity firms expected to bid for the roughly...
CalPERS looks at upping private equity, cash - Pensions & Investments
By Pia Sarkar CalPERS' investment committee is leaning toward increasing the $178.5 billion system's private equity and fixed-income allocations and adding cash while reducing its global equity exposure. The investment committee of California Public...
Gulf private equity faces family company challenge - Reuters
MANAMA, May 12 (Reuters) - Private equity houses are eyeing acquisitions in the Gulf Arab region, but deal-making is challenging in a region dominated by family owned conglomerates, bankers said. The Gulf Arab region has been a hunting ground for...

Private equity

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In finance, private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange. Investments in private equity most often involves either an investment of capital into an operating company or the acquisition of an operating company. Capital for private equity is raised primarily from institutional investors.

There is a wide array of types and styles of private equity and the term private equity has different connotations in different countries.

Among the most common investment strategies in private equity include leveraged buyouts, venture capital, growth capital, distressed investments and mezzanine capital. In a typical leveraged buyout transaction, the private equity firm buys majority control of an existing or mature firm. This is distinct from a venture capital or growth capital investment, in which the private equity firm typically invests in young or emerging companies, and rarely obtain majority control.

Leveraged buyout, LBO or Buyout refers to a strategy of making equity investments as part of a transaction in which a company, business unit or business assets is acquired from the current shareholders typically with the use of financial leverage. The companies involved in these transactions are typically mature and generate operating cash flows.

Leveraged buyouts involve a financial sponsor agreeing to an acquisition without itself committing all the capital required for the acquisition. To do this, the financial sponsor will raise acquisition debt which ultimately looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an LBO is often non-recourse to the financial sponsor and has no claim on other investment managed by the financial sponsor. Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage. This kind of financing structure leverage benefits to an LBO's financial sponsor in two ways: (1) the investor itself only needs to provide a fraction of the capital for the acquisition, and (2) the returns to the investor will be enhanced (as long as the return on assets exceeds the cost of the debt).

As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a transaction varies according the financial condition and history of the acquisition target, market conditions, the willingness of lenders to extend credit (both to the LBO's financial sponsors and the company to be acquired) as well as the interest costs and the ability of the company to cover those costs. Historically the debt portion of a LBO will range from 60%-90% of the purchase price, although during certain periods the the debt ratio can be higher or lower than the historical averages. Between 2000-2005 debt averaged between 59.4% and 67.9% of total purchase price for LBOs in the United States.

Venture capital is a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business. Venture investment is most often found in the application of new technology, new marketing concepts and new products that have yet to be proven.

Venture capital is often sub-divided by the stage of development of the company ranging from early stage capital used for the launch of start-up companies to late stage and growth capital that is often used to fund expansion of existing business that are generating revenue but may not yet be profitable or generating cash flow to fund future growth.

Entrepreneurs often develop products and ideas that require substantial capital during the formative stages of their companies' lifecycles. Many entrepreneurs do not have sufficient funds to finance projects themselves, and they must therefore seek outside financing. The venture capitalist's need to deliver high returns to compensate for the risk of these investments makes venture funding an expensive capital source for companies. Venture capital is most suitable for businesses with large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. Although venture capital is often most closely associated with fast-growing technology and biotechnology fields, venture funding has been used for other more traditional businesses.

Growth capital refers to equity investments, most often minority investments, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.

Companies that seek growth capital, will often do so in order to finance a transformational event in the their lifecycle. These companies are likely to be more mature than venture capital funded companies, able to generate revenue and operating profits but unable to generate sufficient cash to fund major expansions, acquisitions or other investments. Growth capital can also be used to effect a restructuring of a company's balance sheet, particularly to reduce the amount of leverage (or debt) the company has on its balance sheet.

In addition to these private equity strategies, hedge funds employ a variety of distressed investment strategies including the active trading of loans and bonds issued by distressed companies.

Mezzanine capital refers to subordinated debt or preferred equity securities that often represent the most junior portion of a company's capital structure that is senior to the company's common equity.

Secondary investments refer to investments made in existing private equity assets including private equity fund interests or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors. Often these investments are structured similar to a fund of funds.

The seeds of the private equity industry were planted in 1946 with the founding of two venture capital firms: American Research and Development Corporation (ARDC) and J.H. Whitney & Company. Before World War II, venture capital investments (originally known as "development capital") were primarily the domain of wealthy individuals and families. ARDC was founded by Georges Doriot, the "father of venture capitalism" and founder of INSEAD, with capital raised from institutional investors, to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC is credited with the first major venture capital success story when its 1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million after the company's initial public offering in 1968 (representing a return of over 500 times on its investment and an annualized rate of return of 101%). It is commonly noted that the first venture-backed startup is Fairchild Semiconductor (which produced the first commercially practicable integrated circuit), funded in 1959 by what would later become Venrock Associates.

The leveraged buyout boom of the 1980s was conceived by a number of corporate financiers, most notably Jerome Kohlberg, Jr. and later his protégé Henry Kravis. Working for Bear Stearns at the time, Kohlberg and Kravis along with Kravis' cousin George Roberts began a series of what they described as "bootstrap" investments. Many of these companies lacked a viable or attractive exit for their founders as they were too small to be taken public and the founders were reluctant to sell out to competitors and so a sale to a financial buyer could prove attractive. Their acquisition of Orkin Exterminating Company in 1964 is among the first significant leveraged buyout transactions.. In the following years the three Bear Stearns bankers would complete a series of buyouts including Stern Metals (1965), Incom (a division of Rockwood International, 1971), Cobblers Industries (1971), and Boren Clay (1973) as well as Thompson Wire, Eagle Motors and Barrows through their investment in Stern Metals. By 1976, tensions had built up between Bear Stearns and Kohlberg, Kravis and Roberts leading to their departure and the formation of Kohlberg Kravis Roberts in that year.

During the 1980s, constituencies within acquired companies and the media ascribed the "corporate raid" label to many private equity investments, particularly those that featured a hostile takeover of the company, perceived asset stripping, major layoffs or other significant corporate restructuring activities. Among the most notable investors to be labeled corporate raiders in the 1980s included Carl Icahn, Victor Posner, Nelson Peltz, Robert M. Bass, T. Boone Pickens, Harold Clark Simmons, Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and Asher Edelman. Carl Icahn developed a reputation as a ruthless corporate raider after his hostile takeover of TWA in 1985. Many of the corporate raiders were onetime clients of Michael Milken, whose investment banking firm, Drexel Burnham Lambert helped raise blind pools of capital with which corporate raiders could make a legitimate attempt to take over a company and provided high-yield debt financing of the buyouts.

One of the final major buyouts of the 1980s proved to be its most ambitious and marked both a high water mark and a sign of the beginning of the end of the boom that had begun nearly a decade earlier. In 1989, KKR closed in on a $31.1 billion takeover of RJR Nabisco. It was, at that time and for over 17 years, the largest leverage buyout in history. The event was chronicled in the book (and later the movie), Barbarians at the Gate: The Fall of RJR Nabisco. KKR would eventually prevail in acquiring RJR Nabisco at $109 per share, marking a dramatic increase from the original announcement that Shearson Lehman Hutton would take RJR Nabisco private at $75 per share. A fierce series of negotiations and horse-trading ensued which pitted KKR against Shearson Lehman Hutton and later Forstmann Little & Co. Many of the major banking players of the day, including Morgan Stanley, Goldman Sachs, Salomon Brothers, and Merrill Lynch were actively involved in advising and financing the parties. After Shearson Lehman's original bid, KKR quickly introduced a tender offer to obtain RJR Nabisco for $90 per share—a price that enabled it to proceed without the approval of RJR Nabisco's management. RJR's management team, working with Shearson Lehman and Salomon Brothers, submitted a bid of $112, a figure they felt certain would enable them to outflank any response by Kravis's team. KKR's final bid of $109, while a lower dollar figure, was ultimately accepted by the board of directors of RJR Nabisco. At $31.1 billion of transaction value, RJR Nabisco was by far the largest leveraged buyouts in history. In 2006 and 2007, a number of leveraged buyout transactions were completed that for the first time surpassed the RJR Nabisco leveraged buyout in terms of nominal purchase price. However, adjusted for inflation, none of the leveraged buyouts of the 2006–2007 period would surpass RJR Nabisco.

By the end of the 1980s the excesses of the buyout market were beginning to show, with the bankruptcy of several large buyouts including Robert Campeau's 1988 buyout of Federated Department Stores, the 1986 buyout of the Revco drug stores, Walter Industries, FEB Trucking and Eaton Leonard. Additionally, the RJR Nabisco deal was showing signs of strain, leading to a recapitalization in 1990 that involved the contribution of $1.7 billion of new equity from KKR.

Drexel Burnham Lambert was the investment bank most responsible for the boom in private equity during the 1980s due to its leadership in the issuance of high-yield debt.

Drexel reached an agreement with the government in which it pleaded nolo contendere (no contest) to six felonies – three counts of stock parking and three counts of stock manipulation. It also agreed to pay a fine of $650 million – at the time, the largest fine ever levied under securities laws. Milken left the firm after his own indictment in March 1989. On February 13, 1990 after being advised by Secretary of the Treasury Nicholas F. Brady, the SEC, the NYSE and the Federal Reserve, Drexel Burnham Lambert officially filed for Chapter 11 bankruptcy protection.

The combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies (specifically the Sarbanes-Oxley Act) would set the stage for the largest boom private equity had seen. Marked by the buyout of Dex Media in 2002, large multi-billion dollar U.S. buyouts could once again obtain significant high yield debt financing and larger transactions could be completed. By 2004 and 2005, major buyouts were once again becoming common, including the acquisitions of Toys "R" Us, The Hertz Corporation , Metro-Goldwyn-Mayer and SunGard in 2005.

As 2005 ended and 2006 began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of 2006 through the middle of 2007. In 2006, private equity firms bought 654 U.S. companies for $375 billion, representing 18 times the level of transactions closed in 2003. Additionally, U.S. based private equity firms raised $215.4 billion in investor commitments to 322 funds, surpassing the previous record set in 2000 by 22% and 33% higher than the 2005 fundraising total The following year, despite the onset of turmoil in the credit markets in the summer, saw yet another record year of fundraising with $302 billion of investor commitments to 415 funds Among the mega-buyouts completed during the 2006 to 2007 boom were: Equity Office Properties, HCA, Alliance Boots and TXU.

In July 2007, turmoil that had been affecting the mortgage markets, spilled over into the leveraged finance and high-yield debt markets. The markets had been highly robust during the first six months of 2007, with highly issuer friendly developments including PIK and PIK Toggle (interest is "Payable In Kind") and covenant light debt widely available to finance large leveraged buyouts. July and August saw a notable slowdown in issuance levels in the high yield and leveraged loan markets with few issuers accessing the market. Uncertain market conditions led to a significant widening of yield spreads, which coupled with the typical summer slowdown led many companies and investment banks to put their plans to issue debt on hold until the autumn. However, the expected rebound in the market after Labor Day 2007 did not materialize and the lack of market confidence prevented deals from pricing. By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG announced major writedowns due to credit losses. The leveraged finance markets came to a near standstill. As 2007 ended and 2008 began, it was clear that lending standards had tightened and the era of "mega-buyouts" had come to an end. Nevertheless, private equity continues to be a large and active asset class and the private equity firms, with hundreds of billions of dollars of committed capital from investors are looking to deploy capital in new and different transactions.

Institutional investors provide private equity capital in the hopes of achieving risk adjusted returns that exceed those possible in the public equity markets and will typically include private equity as part of a broad asset allocation that includes traditional assets (e.g., public equity and bonds). Most institutional investors do not invest directly in privately held companies, lacking the expertise and resources necessary to structure and monitor the investment. Instead, institutional investors will invest indirectly through a private equity fund. Certain institutional investors have the scale necessary to develop a diversified portfolio of private equity funds themselves, while others will invest through a fund of funds to allow a portfolio more diversified than one a single investor could construct.

For the above mentioned reasons, private equity fund investment is for those who can afford to have capital locked in for long periods of time and who are able to risk losing significant amounts of money. These disadvantages are offset by the potential benefits of annual returns which range up to 30% for successful funds.

The private equity secondary market (also often called private equity secondaries) refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds. Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. For the vast majority of private equity investments, there is no listed public market; however, there is a robust and maturing secondary market available for sellers of private equity assets.

Increasingly, secondaries are considered a distinct asset class with a cash flow profile that is not correlated with other private equity investments. As a result, investors are allocating capital to secondary investments to diversify their private equity programs. Driven by strong demand for private equity exposure, a significant amount of capital has been committed to secondary investments from investors looking to increase and diversify their private equity exposure.

Investors seeking access to private equity have been restricted to investments with structural impediments such as long lock-up periods, lack of transparency, unlimited leverage, concentrated holdings of illiquid securities and high investment minimums.

Because private equity firms are continuously in the process of raising, investing and distributing their private equity funds, capital raised can often be the easiest to measure. Other metrics can include the total value of companies purchased by a firm or an estimate of the size of a firm's active portfolio plus capital available for new investments. As with any list that focuses on size, the list does not provide any indication as to relative investment performance of these funds or managers.

Additionally, Preqin (formerly known as Private Equity Intelligence), an independent data provider, ranks the 25 largest private equity investment managers. Among the larger firms in that ranking were AlpInvest Partners, AXA Private Equity, AIG Investments, Goldman Sachs Private Equity Group and Pantheon Ventures.

Private equity fundraising refers to the action of private equity firms seeking capital from investors for their funds. Typically an investor will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself. As a result, an investor will only benefit from investments made by a firm where the investment is made from the specific fund in which it has invested.

As fundraising has grown over the past few years, so too has the number of investors in the average fund. In 2004 there were 26 investors in the average private equity fund, this figure has now grown to 42 according to Preqin ltd. (formerly known as Private Equity Intelligence).

The managers of private equity funds will also invest in their own vehicles, typically providing between 1–5% of the overall capital.

Often private equity fund managers will employ the services of external fundraising teams known as placement agents in order to raise capital for their vehicles. The use of placement agents has grown over the past few years, with 40% of funds closed in 2006 employing their services, according to Preqin ltd (formerly known as Private Equity Intelligence). Placement agents will approach potential investors on behalf of the fund manager, and will typically take a fee of around 1% of the commitments that they are able to garner.

The amount of time that a private equity firm spends raising capital varies depending on the level of interest among investors, which is defined by current market conditions and also the track record of previous funds raised by the firm in question. Firms can spend as little as one or two months raising capital when they are able to reach the target that they set for their funds relatively easily, often through gaining commitments from existing investors in their previous funds, or where strong past performance leads to strong levels of investor interest. Other managers may find fundraising taking considerably longer, with managers of less popular fund types (such as European venture fund managers in the current climate) finding the fundraising process more tough. It is not unheard of for funds to spend as long as two years on the road seeking capital, although the majority of fund managers will complete fundraising within nine months to fifteen months.

Once a fund has reached its fundraising target, it will have a final close. After this point it is not normally possible for new investors to invest in the fund, unless they were to purchase an interest in the fund on the secondary market.

A record $686bn of private equity was invested globally in 2007, up over a third on the previous year and more than twice the total invested in 2005. Private equity fund raising also surpassed prior years in 2007 with $494bn raised, up 10% on 2006. Despite growing turbulence in the financial markets in the latter part of the year, activity was split equally between the first and second half of the year. Buyouts further increased their share of investments to 89% from a fifth in 2000. Early indicators show that activity is down in the first half of 2008 in comparison to the same period in 2007. The contraction in the credit markets caused by the sub-prime crisis, triggered a slowdown in private equity financing and it became more difficult for private equity firms to obtain debt financing from banks to complete private equity deals.

The regional breakdown of private equity activity shows that in 2007, North America accounted for 71% of global private equity investments (up from 66% in 2000) and 65% of funds raised (down from 68%) (Table 1, Chart 2). Between 2000 and 2007, Europe’s share of investments fell from 20% to 15% and funds raised from 25% to 22%. This was largely a result of stronger buyout market activity in the US than in Europe. Between 2000 and 2007 there was a rise in the importance of Asia-Pacific and emerging markets as investment destinations, particularly China, Singapore, South Korea and India. Asia-Pacific’s share of funds raised increased from 6% to 10% during this period while its share of investments remained unchanged at around 12%.

The biggest fund type in terms of commitments garnered was buyout, with 188 funds raising an aggregate $212 billion. So-called mega buyout funds contributed a significant proportion of this amount, with the ten largest funds of 2006 raising $101 billion alone—23% of the global total for 2006. Other strong performers included real estate funds, which grew 30% from already strong 2005 levels, raising an aggregate $63 billion globally. The only fund type to not perform so well was venture, which saw a drop of 10% from 2005 levels.

In terms of the regional split of fundraising, the majority of funds raised in 2006 were focusing on the American market, with 62% of capital raised in 2006 focusing on the US. European focused funds account for 26% of the global total, while funds focusing on Asia and the Rest of World accounted for the remaining 11%.

Venture capital is considered a subset of private equity focused on investments in new and maturing companies.

Mezzanine capital is similar class of alternative investment focused on structured debt securities in private companies.

In the past the performance of private equity funds has been relatively difficult to track, as private equity firms are under no obligation to publicly reveal the returns that they have achieved from their investments. In the majority of cases the only groups with knowledge of fund performance were investors in the funds, academic institutes (as CEPRES Center of Private Equity Research) and the firms themselves, making comparisons between various different firms, and the establishment of market benchmarks to be a difficult challenge.

The application of the Freedom of Information Act (FOIA) in certain states in the United States has made certain performance data more readily available. Specifically, FOIA has required certain public agencies to disclose private equity performance data directly on the their websites. In the United Kingdom, the second largest market for private equity, more data has become available since the 2007 publication of the David Walker Guidelines for Disclosure and Transparency in Private Equity.

The performance of the private equity industry over the past few years differs between funds of different types. Buyout and real estate funds have both performed strongly in the past few years (i.e., from 2003-2007) in comparison with other asset classes such as public equities. In contrast other fund investment types, venture capital most notably, have not shown similarly robust performance.

Within each investment type, manager selection (i.e., identifying private equity firms capable of generating above average performance) is a key determinant of an individual investor's performance. Historically, performance of the top and bottom quartile managers has varied dramatically and institutional investors conduct extensive due diligence in order to assess prospective performance of a new private equity fund.

It is challenging to compare private equity performance to public equity performance, in particular because private equity fund investments are drawn and returned over time as investments are made and subsequently realized. One method, first published in 1994, is the Long and Nickels Index Comparison Method (ICM). Another method which is gaining ground in academia is the public market equivalent or profitability index. The profitability index determines the investment in public market investments required to earn a target profit from a portfolio of private equity fund investments. Driessen, et al. have recently pushlished a paper, A New Method to Estimate Risk and Return of Non-Traded Assets from Cash Flows: The Case of Private Equity Funds, on using Generalized Method of Moments estimators to simultaneously solve for alpha and beta. The methodology relies on asymptotics, but it does allow the calculation of risk adjusted returns, which have previously been unavailable or unreliable.

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Taxation of private equity and hedge funds

Private equity funds and hedge funds are private investment vehicles used to pool investment capital, usually for a small group of large institutional or wealthy individual investors. They are subject to favorable regulatory treatment in most jurisdictions from which they are managed, which allows them to engage in financial activities that are off-limits for more regulated companies. Both types of fund also take advantage of generally applicable rules in their jurisdictions to minimize the tax burden on their investors, as well as on the fund managers. As media coverage increases regarding the growing influence of hedge funds and private equity, these tax rules are increasingly under scrutiny by legislative bodies. Private equity and hedge funds choose their structure depending on the individual circumstances of the investors the fund is designed to attract, as discussed below.

A private equity or hedge fund located in the United States will typically be structured as a limited partnership, due to the lack of an entity-level tax on partnerships and other flow-through entities under the U.S. tax system. The limited partners will be the institutional and individual investors. The general partner will be an affiliate of the manager of the fund. Typically, the manager of the hedge fund is compensated with a fee based on 2% of the gross assets of the fund, and a profits interest entitling the manager (or, more typically, its affiliated general partner) to 20% of the fund's return (subject to minimum guaranteed returns for the limited partners).

Because the manager is compensated with a profits interest in the fund, the bulk of its income from the fund is taxed, not as compensation for services, but as a return on investment. Typically, when a partner receives a profits interest (commonly referred to as a "carried interest"), the partner is not taxed upon receipt, due to the difficulty of ascertaining the present value of an interest in future profits. Instead, the partner is taxed as the partnership earns income. In the case of a hedge fund, this means that the partner defers taxation on the income that the hedge fund earns, which is typically ordinary income (or possibly short-term capital gains), due to the nature of the investments most hedge funds make. Private equity funds, however, typically invest on a longer horizon, with the result that income earned by the funds is long-term capital gain, taxable to individuals at a maximum 15% rate. Because the 20% profits share typically is the bulk of the manager’s compensation, and because this compensation can reach, in the case of the most successful funds, enormous figures, concern has been raised, both in Congress and in the media, that managers are taking advantage of tax loopholes to receive what is effectively a salary without paying the ordinary 35% marginal income tax rates that an average person would have to pay on such income. To address this concern, Congressman Sander M. Levin introduced H.R. 2834, which would eliminate the ability of persons performing investment adviser or similar services to partnerships to receive capital gains tax treatment on their income. However, the Treasury Department has suggested, both in testimony before the Senate Finance Committee and in public speaking engagements, that altering the tax treatment of a single industry raises tax policy concerns, and that changing the way partnerships in general are taxed is something that should only be done after careful consideration of the potential impact.

Congressman Rangell included a revised version of H.R. 2834 as part of the "Mother of All Tax Reform" and the 2007 House extenders package. The provision passed the House and has been referred to the Senate, where it is unclear if a carried interest proposal could receive 60 or more votes.

In mid-2007, the Blackstone group, a major private equity fund, went public. Ordinarily, a publicly-traded partnership is taxed as a corporation. There is, however, an exception for publicly-traded partnerships earning only “passive-type” income, such as interest and dividends. Although the investments made by a private equity fund are actively managed, Blackstone took the position that the investments they engaged in fell squarely within literal language of this exception to the usual treatment for publicly-traded partnerships. To address what they viewed as a loophole in the law, Senators Baucus and Grassley introduced S. 1624, which would remove the ability for publicly-traded partnerships performing asset-management and related services to avoid being taxed as corporations. The result of this bill would be to change the tax treatment of private equity and hedge funds from a single level of taxation at a 15% rate (or 35% in the case of most hedge funds) to a corporate-level tax of 35%, plus a 15% tax on dividends when distributed. While acknowledging that there are concerns with the current treatment of publicly-traded partnerships, Treasury Secretary Paulson has declined to endorse the treatment that would be provided under S. 1624.

The House extenders package included a carried interest provision that would apply to publicly traded partnerships beginning in tax years after 12/31/2009.

Various private equity and hedge fund managers followed Fortress, the first fund manager to go public as a PTP. The funds include Oaktree, Blackstone and Och-Ziff. KKR filed an S-1 statement with the SEC. Apollo is interested in going public, and there are press rumors that Carlyle is considering using the PTP structure.

Although a partnership structure is advantageous for most investors due to the elimination of an entity-level tax, it is not the desired form for all investors. In particular, foreign investors and domestic tax-exempt organizations both have reasons to prefer to interpose a corporation in the private equity or hedge fund structure.

Foreign investors are generally not required to file tax returns unless they have “effectively connected income,” derived from the active conduct of a U.S. trade or business. Passive investment in a corporation does not give rise to a U.S. trade or business. However, active investment management of the type performed by private equity funds or hedge funds typically does. Because partners in a partnership are treated as engaged in whatever business the partnership itself is engaged in, this means that if a foreign investor invests in a hedge fund or private equity fund, it will generally be forced to file a U.S. tax return. To avoid this requirement, a foreign investor will often invest through a blocker corporation (usually located in the Cayman Islands or another offshore jurisdiction). The corporation itself will be required to file U.S. tax returns, and will pay taxes at the normal U.S. corporate tax rate, but the foreign investor will receive only dividends or capital gains from the blocker, and will therefore not be required to file a U.S. return. As an alternative to the “blocker” structure, hedge funds seeking to attract foreign investors can also structure as partnerships, but simply restrict themselves to activities that are not treated as a U.S. trade or business. For example, U.S. tax law provides that trading in securities for the taxpayer’s own account will not constitute a U.S. trade or business.

Domestic tax-exempt entities face similar concerns when investing in funds structured as partnerships. While tax-exempt on income related to their tax-exempt purpose, tax exempt entities are required to file tax returns and pay income tax on “unrelated business taxable income,” commonly referred to as UBTI. Because the activities of an entity structured as a partnership flow through to its investors, if the partnership receives income that would be UBTI in the hands of the tax-exempt investor, the investor is forced to file an income-tax return and pay unrelated business income tax. To avoid this requirement, tax exempt entities use offshore blocker corporations in much the same way foreign investors do. To date, no bill has been introduced to change this treatment, although concerns over the tax gap have led to increased scrutiny of business structures involving offshore corporations in general. For example, in May 2007, the Senate Finance Committee held a hearing about offshore structures used for tax evasion .

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Early history of private equity


The early history of private equity relates to one of the major periods in the history of private equity and venture capital. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital experienced growth along parallel although interrelated tracks.

The origins of the modern private equity industry trace back to 1946 with the formation of the first venture capital firms. The thirty-five year period from 1946 through the end of the 1970s was characterized by relatively small volumes of private equity investment, rudimentary firm organizations and limited awareness of and familiarity with the private equity industry.

Investors have been acquiring businesses and making minority investments in privately held companies since the dawn of the industrial revolution. Merchant bankers in London and Paris financed industrial concerns in the 1850s; most notably Credit Mobilier, founded in 1854 by Jacob and Isaac Pereire, who together with New York based Jay Cooke financed the United States Transcontinental Railroad.

Later, J. Pierpont Morgan's J.P. Morgan & Co. would finance railroads and other industrial companies throughout the United States. In certain respects, J. Pierpont Morgan's 1901 acquisition of Carnegie Steel Company from Andrew Carnegie and Henry Phipps for $480 million represents the first true major buyout as they are thought of today.

Due to structural restrictions imposed on American banks under the Glass-Steagall Act and other regulations in the 1930s, there was no private merchant banking industry in the United States, a situation that was quite exceptional in developed nations. As late as the 1980s, Lester Thurow, a noted economist, decried the inability of the financial regulation framework in the United States to support merchant banks. US investment banks were confined primarily to advisory businesses, handling mergers and acquisitions transactions and placements of equity and debt securities. Investment banks would later enter the space, however long after independent firms had become well established.

With few exceptions, private equity in the first half of the 20th century was the domain of wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers and Warburgs were notable investors in private companies in the first half of the century. In 1938, Laurance S. Rockefeller helped finance the creation of both Eastern Air Lines and Douglas Aircraft and the Rockefeller family had vast holdings in a variety of companies. Eric M. Warburg founded E.M. Warburg & Co. in 1938, which would ultimately become Warburg Pincus, with investments in both leveraged buyouts and venture capital.

It was not until after World War II that what is considered today to be true private equity investments began to emerge marked by the founding of the first two venture capital firms in 1946: American Research and Development Corporation. (ARDC) and J.H. Whitney & Company.

ARDC was founded by Georges Doriot, the "father of venture capitalism" (former dean of Harvard Business School), with Ralph Flanders and Karl Compton (former president of MIT), to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC's significance was primarily that it was the first institutional private equity investment firm that raised capital from sources other than wealthy families although it had several notable investment successes as well. ARDC is credited with the first major venture capital success story when its 1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million after the company's initial public offering in 1968 (representing a return of over 500 times on its investment and an annualized rate of return of 101%). Former employees of ARDC went on to found several prominent venture capital firms including Greylock Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan, Holland Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan). ARDC continued investing until 1971 with the retirement of Doriot. In 1972, Doriot merged ARDC with Textron after having invested in over 150 companies.

J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno Schmidt. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. By far, Whitney's most famous investment was in Florida Foods Corporation. The company, having developed an innovative method for delivering nutrition to American soldiers, later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. J.H. Whitney & Company continues to make investments in leveraged buyout transactions and raised $750 million for its sixth institutional private equity fund in 2005.

Before World War II, venture capital investments (originally known as "development capital") were primarily the domain of wealthy individuals and families. One of the first steps toward a professionally-managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. Passage of the Act addressed concerns raised in a Federal Reserve Board report to Congress that concluded that a major gap existed in the capital markets for long-term funding for growth-oriented small businesses. Additionally, it was thought that fostering entrepreneurial companies would spur technological advances to compete against the Soviet Union. Facilitating the flow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of the SBIC program today. The 1958 Act provided venture capital firms structured either as SBICs or Minority Enterprise Small Business Investment Companies (MESBICs) access to federal funds which could be leveraged at a ratio of up to 4:1 against privately raised investment funds. The success of the Small Business Administration's efforts are viewed primarily in terms of the pool of professional private equity investors that the program developed as the rigid regulatory limitations imposed by the program minimized the role of SBICs. In 2005, the SBA significantly reduced its SBIC program, though SBICs continue to make private equity investments.

During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance.

It is commonly noted that the first venture-backed startup was Fairchild Semiconductor (which produced the first commercially practicable integrated circuit), funded in 1959 by what would later become Venrock Associates. Venrock was founded in 1969 by Laurance S. Rockefeller, the fourth of John D. Rockefeller's six children as a way to allow other Rockefeller children to develop exposure to venture capital investments.

It was also in the 1960s that the common form of private equity fund, still in use today, emerged. Private equity firms organized limited partnerships to hold investments in which the investment professionals served as general partner and the investors, who were passive limited partners, put up the capital. The compensation structure, still in use today, also emerged with limited partners paying an annual management fee of 1-2% and a carried interest typically representing up to 20% of the profits of the partnership.

Although not strictly private equity, and certainly not labeled so at the time, the first leveraged buyout may have been the purchase by Malcolm McLean's McLean Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955. Under the terms of the transactions, McLean borrowed $42 million and raised an additional $7 million through an issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets were used to retire $20 million of the loan debt. The newly elected board of Waterman then voted to pay an immediate dividend of $25 million to McLean Industries.

Posner, who had made a fortune in real estate investments in the 1930s and 1940s acquired a major stake in DWG Corporation in 1966. Having gained control of the company, he used it as an investment vehicle that could execute takeovers of other companies. Posner and DWG are perhaps best known for the hostile takeover of Sharon Steel Corporation in 1969, one of the earliest such takeovers in the United States. Posner's investments were typically motivated by attractive valuations, balance sheets and cash flow characteristics. Because of its high debt load, Posner's DWG would generate attractive but highly volatile returns and would ultimately land the company in financial difficulty. In 1987, Sharon Steel sought Chapter 11 bankruptcy protection.

Warren Buffett, who is typically described as a stock market investor rather than a private equity investor, employed many of the same techniques in the creation on his Berkshire Hathaway conglomerate as Posner's DWG Corporation and in later years by more traditional private equity investors. In 1965, with the support of the company's board of directors, Buffett assumed control of Berkshire Hathaway. At the time of Buffett's investment, Berkshire Hathaway was a textile company, however, Buffett used Berkshire Hathaway as an investment vehicle to make acquisitions and minority investments in dozens of the insurance and reinsurance industries (GEICO) and varied companies including: American Express, The Buffalo News, the Coca-Cola Company, Fruit of the Loom, Nebraska Furniture Mart and See's Candies. Buffett's value investing approach and focus on earnings and cash flows are characteristic of later private equity investors. Buffett would distinguish himself relative to more traditional leveraged buyout practitioners through his reluctance to use leverage and hostile techniques in his investments.

The industry that is today described as private equity was conceived by a number of corporate financiers, most notably Jerome Kohlberg, Jr. and later his protégé, Henry Kravis. Working for Bear Stearns at the time, Kohlberg and Kravis along with Kravis' cousin George Roberts began a series of what they described as "bootstrap" investments. They targeted family-owned businesses, many of which had been founded in the years following World War II and by the 1960s and 1970s were facing succession issues. Many of these companies lacked a viable or attractive exit for their founders as they were too small to be taken public and the founders were reluctant to sell out to competitors, making a sale to a financial buyer potentially attractive. Their acquisition of Orkin Exterminating Company in 1964 is among the first significant leveraged buyout transactions. In the following years, the three Bear Stearns bankers would complete a series of buyouts including Stern Metals (1965), Incom (a division of Rockwood International, 1971), Cobblers Industries (1971) and Boren Clay (1973) as well as Thompson Wire, Eagle Motors and Barrows through their investment in Stern Metals. Although they had a number of highly successful investments, the $27 million investment in Cobblers ended in bankruptcy.

By 1976, tensions had built up between Bear Stearns and Kohlberg, Kravis and Roberts leading to their departure and the formation of Kohlberg Kravis Roberts in that year. Most notably, Bear Stearns executive Cy Lewis had rejected repeated proposals to form a dedicated investment fund within Bear Stearns and Lewis took exception to the amount of time spent on outside activities. Early investors included the Hillman Family By 1978, with the revision of the ERISA regulations, the nascent KKR was successful in raising its first institutional fund with approximately $30 million of investor commitments.

Meanwhile in 1974, Thomas H. Lee founded a new investment firm to focus on acquiring companies through leveraged buyout transactions, one of the earliest independent private equity firms to focus on leveraged buyouts of more mature companies rather than venture capital investments in growth companies. Lee's firm, Thomas H. Lee Partners, while initially generating less fanfare than other entrants in the 1980s, would emerge as one of the largest private equity firms globally by the end of the 1990s.

Management buyouts also came into existence in the late 1970s and early 1980s. One of the most notable early management buyout transactions was the acquisition of Harley-Davidson. A group of managers at Harley-Davidson, the motorcycle manufacturer, bought the company from AMF in a leveraged buyout in 1981, but racked up big losses the following year and had to ask for protection from Japanese competitors.

In the years that would follow these events, private equity would experience its first major boom, acquiring some of the famed brands and major industrial powers of American business.

The decade of the 1980s is perhaps more closely associated with the leveraged buyout than any decade before or since. For the first time, the public became aware of the ability of private equity to affect mainstream companies and "corporate raiders" and "hostile takeovers" entered the public consciousness. The decade would see one of the largest booms in private equity culminating in the 1989 leveraged buyout of RJR Nabisco, which would reign as the largest leveraged buyout transaction for nearly 17 years. In 1980, the private equity industry would raise approximately $2.4 billion of annual investor commitments and by the end of the decade in 1989 that figure stood at $21.9 billion marking the tremendous growth experienced.

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Source : Wikipedia