Private equity firms have grown into a massive force on Wall Street, moving around billions of dollars, mostly under the radar.
But now as the Blackstone Group is about to go public -- with an IPO expected to rake in more than $4.14 billion -- new scrutiny is being paid to this secretive world, particularly to the amount of taxes private equity firms pay.
To the surprise of many, private equity funds, including Blackstone, pay taxes at the 15 percent capital gains rate instead of at the 35 percent income tax rate most corporations face.
The issue surfaced on Capitol Hill last week when Sens. Max Baucus, D-Mont., and Chuck Grassley, R-Iowa, introduced legislation that would force publicly traded partnerships to pay taxes at the higher corporate rate.
The difference could mean billions of extra tax dollars for the federal treasury. But changing the rate could also hamper strong economic growth attributed to private equity dumping so much cash into the business world.
Nobody Pays Rack Rate
Just because the corporate tax rate is 35 percent doesn't mean companies actually pay that much. Just as individual taxpayers do, corporations often find ways to lower their taxes.
To encourage certain public policies, the government gives various tax breaks. For instance, to encourage home ownership, the government allows individuals to write off interest on mortgages. Other deductions are given for each child or dependent.
Companies do similar things to cut tax bills. They'll write off depreciation, capital investments, take advantage of research and development tax credits or keep profits earned in overseas markets in those countries. All of this is legal.
At the end of the day, most companies don't pay anywhere near the 35 percent rate.
For instance, General Electric paid a 9 percent effective tax rate on earnings last year, according to ABC calculations based on data from the Securities and Exchange Commission. Hewlett-Packard paid 13.3 percent, McDonald's, 28.3 percent. Walt Disney the parent company of ABC, paid 30.7 percent and Microsoft, 31 percent.
The capital gains tax rate was reduced as part of President Bush's 2003 tax cuts to encourage people to put money into the stock market.
Blackstone -- and its principals -- have certainly done that, pouring billions into the market and, many say, helping drive the value of stocks higher in the last few years.
Why the Lower Tax Rate?
Private equity funds are structured as partnerships. Investors give them money that is in turn invested in various companies or projects.
The funds make money two ways. First, they charge investors a fee -- typically 2 percent -- of money placed into the fund. That is treated as normal income subject to the higher tax rates.
But the real money for the management team comes from its cut of any gains on investments. Typically, the funds charge 20 percent on every dollar they earn for investors.
Under the current law, that fee is treated as a capital gains and taxed at the lower rate.
The reasoning is that the money comes from profit on investments, not from profit for corporate actions. The companies that the fund invests have already paid a corporate tax. Forcing a private equity fund to do so would be taxing them twice, many argue.
Reform in Washington
While the legislation is clearly aimed at Blackstone, the group wouldn't actually be affected by the legislation in its current form.
Currently, the bill calls for a five-year grace period and grandfathers any private equity firm that went public or filed papers to go public before June 14. Blackstone falls into that category.
If it were to pass, the bill could actually end up giving Blackstone an advantage over any competitor that goes public in the future. Others in the industry are watching and waiting to see how Blackstone's IPO goes. Just today, rival fund Kohlberg Kravis Roberts announced that it's taking steps to go public.
It's unclear how this bill, still very far way from becoming law, might affect Blackstone's IPO. Investors buying the stock tonight have no clue what tax changes might happen to Blackstone or any other private equity firms. It could take months to see the outcome of this or any other similar legislation.
Sen. Jim Webb, D-Va., raised "national security" concerns this week about the Chinese government's plan to buy a $3 billion stake in Blackstone. Rep. Henry Waxman, D-Calif., chairman of the House Oversight Committee, asked SEC Chairman Christopher Cox today to delay the Blackstone IPO, stating in a letter that it would expose "investors and the public" to "new and undisclosed risks."
A Big Pay Day
But no one doubts the IPO will make the managers of Blackstone even richer. Chief executive Stephen Schwarzman, who made $400 million in 2006, could cash in as much as $677.2 million of his stake during the IPO. He could still walk away with a 24 percent interest in the company valued at as much as $7.7 billion. That stake would be worth $1.8 billion.
So what are the new titans of Wall Street up to the night before their big day? A book party.
The daughter of Blackstone's co-founder Peter G. Peterson has written a book called "The Manny," about a male nanny working on the Upper East Side of New York. The author, Holly Peterson, who at one time worked at ABC News, just published the book, which taps into the world that private equity lives in. A book party is scheduled tonight at the Four Seasons.
One thing is certain: After everybody goes home and wakes up tomorrow, they will be a lot richer.