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Will impending tax changes cause rush of consolidation?

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Thursday, May 20, 2010

Part of a wide-reaching bill (”American Jobs and Closing Tax Loopholes Act of 2010“) that Congress is considering right now could affect the pace of consolidation in the security industry, and fast.

The part I’m looking at concerns the “closing loopholes,” which will be interpreted as “raising taxes,” even if it doesn’t actually raise taxes so much as make sure people pay them (and also raise taxes a bit, I think).

Here’s one such loophole:

The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income. A transition rule would apply prior to January 1, 2013. This proposal is currently being estimated by the Joint Committee on Taxation.

Bold part is important. Basically, your firm’s income tax is going to be higher than your capital gains tax rate (which is also probably going up, which will also probably drive M&A, but that’s a different blog post I’ll write some other time).

The House Ways and Means Committee supplies a bunch of quotes about why they’re closing this loophole and whom it would affect. I’ll reproduce Warren Buffet’s:

If you‘re in the luckiest 1% of humanity, you owe it to the rest of humanity to think about the other 99% … If you run a partnership and you have capital gains, you have a 15% tax rate; and if you run a corporation and have capital gains, you have a 35% tax rate. When both entities are operating in a similar manner with many thousands of shareholders, freely tradable shares, people managing them who are attempting to evaluate investments, it seems a bit illogical to have that sort of a spread in the tax rate just depending on form.

Even Blackstone thinks it’s disingenuous for them to be taxed the way they are (from an SEC filing):

We believe that we are engaged primarily in the business of providing asset management and financial advisory services and not in the business of investing, reinvesting or trading in securities… We also believe that the primary source of income from each of our businesses is properly characterized as income earned in exchange for the provision of services.

Now, they’ll probably come up with a creative way not to have to pay taxes at all (they’ve got smart accountants), but if they can’t figure it out, here’s what Dan Primack estimates might happen:

One thing I’m hearing more and more is that firms might accelerate their attempts to exit existing portfolio companies. Remember, the tax bills for 2010 stay status quo, which means any distributions for the next seven months get treated as 15% capital gains.

A few investors have told me that they’ve held board-level meetings to examine the tax implications about selling a company this year as opposed to next year (or beyond). I have not heard that decisions have been made based on those calculations, but people are indeed doing the math.

If this is the chosen path for certain investments, expect trade sales instead of IPOs – since distributions on the latter would bleed beyond 2010. Will be very interesting if there’s a major Q4 spike in VC/PE-backed M&A…

Considering the private equity/venture capital money that’s in some of the start-up security manufacturers, is this the time for a bit of the shake-out that many people have been predicting? Will the big firms be gobbling up technology in the second half of 2010 as equity firms start making them good offers?