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FEATURESMARCH 2020 FORBES ASIA
interest has been a lightning rod with politicians for years.
In 2016 even Donald Trump decried carried interest, which
basically lets private equity executives pay a lower tax rate
than many wage earners. But Washington has yet to cur-
tail its widespread use (Blackstone’s Stephen Schwarzman
famously compared President Obama’s effort to eliminate
carried interest to Hitler’s invasion of Poland), and it again
survived the most recent tax reform bill.
But these new deals go further. They effectively trans-
form the 2% management fees (separate from the standard
20% profit participation) from ordinary income into capital
gains, as well. How? Take Gores as an example. In selling
his minority stake to Dyal, he also gave that firm a right to a
portion of his management fees. Voilà: a stream of ordinary
income becomes a windfall of capital gains, reducing the
maximum rate of 37% to 23.8%—and potentially deferring
that tax payment for years.
“The official story [to limited partners] has always been
we don’t make any money on management fees, we only
make money on carried interest,” says Ludovic Phalippou,
Oxford professor and author of Private Equity Laid Bare.
“What this says is: I don’t make money only with carried
interest, I make tons of money with management fees.”
hen the world’s biggest private equity firm,
Blackstone Group, went public in 2007,
cofounder Stephen Schwarzman threw an
infamous star-studded 60th-birthday bash
at New York’s City’s Park Avenue Armory
that many consider to be the high-water mark of precrisis
excess. That year, billionaire Schwarzman enjoyed a $684
million payout.
But then came the Great Recession, the massive gov-
ernment bailout of financial institutions and the Occupy
Wall Street movement. Schwarzman and other Wall Street
denizens suddenly became villains. So it’s no surprise that
the current boom in buyout billionaires is happening out
of the spotlight.
By most accounts, the new wave of GP-stake deals started
in 2015 when Austin, Texas-based Vista Equity Partners’
founder, Robert F. Smith, went to talk to investment banker
Saul Goodman of Evercore about finding capital in the pri-
vate market. No one embodied the new era of private eq-
uity more than Smith. Vista invested exclusively in software
deals, an industry once seen as off-limits to leveraged buy-
outs and ignored by the biggest PE firms. Smith had proved
that systemic software LBOs were not only possible but ex-
ceptionally lucrative, scoring some of the private equity in-
dustry’s best returns.
The leading private equity billionaires preceding Smith—
like Schwarzman, Carlyle Group’s David Rubenstein and
KKR’s Henry Kravis—had all gone public, listing their
private equity firms on the stock market in an attempt to
cash out and bring in permanent capital. But they were also
forced to contend with public company challenges—from
analyst calls to seemingly irrational market gyrations. Smith
didn’t want the hassle of dealing with stock market investors
on a quarterly basis.
So he tapped Goodman, who worked at Evercore, the small
investment bank founded by former deputy U.S. Treasury
secretary Roger Altman. Together they met with Michael
Rees, who ran Neuberger Berman’s Dyal Capital unit, which
had been buying stakes in hedge funds. In July 2015, Dyal
bought more than 10% of Smith’s Vista Equity at a valuation
of nearly $4.3 billion. At the time, Vista had only $14 billion
under management; today it has $50 billion. “The Vista deal
woke everybody up,” says one senior Wall Street dealmaker.
Rees quickly pivoted to focus on private equity. By Sep-
tember 2015 he was telling institutional investors like the
New Jersey State Investment Council that Dyal’s private eq-
uity stake deals were a “natural continuation of its existing
business in acquiring similar stakes in hedge fund manag-
ers.” He marketed the Dyal private equity general partner-
ship funds as steady income-gushers, with yields in the low
teens, at a time when Treasury bills were near zero and AAA
corporates paid less than 4%. For the liability-matchers of
the pension and insurance world, it was music to their ears.
The hedge fund boom was ending, and private equity—
with its ten-year life-span funds—seemed like a better deal.
Assets under management are stable, making those 2% fees
associated with them more predictable. Limited partners al-
most never default on the capital commitments.
By contrast, hedge funds proved inherently more vola-
tile. In early 2015, for example, Dyal bought a 20% stake
in activist hedge fund Jana Partners at a $2 billion valua-
tion when Jana managed $11 billion. But within four years
Jana was down to $2.5 billion in assets managed as returns
went south and investors yanked their capital. Private equi-
ty’s leveraged, long-term model had seemingly been tailor-
made for a low-interest-rate prolonged bull market.
In a typical deal, Rees would spend between $400 mil-
lion and $800 million over a two- to four-year period and
in return receive a 10% to 20% stake in all of a private eq-
uity firm’s net management fees and half of its performance
fees, or carry, meaning Dyal would get, say, 15% of the fu-
ture management fees and 7.5% of the carry. Dyal’s minority
stakes were passive—Rees would have no say in the running
of the private equity firm. To make it work, Rees structured
his Dyal funds as perpetual vehicles with a life span as long
as forever, meaning Rees would never be forced to sell his
general-partnership stakes—so he and his institutional in-
vestors could hold on to them like a high-yield annuity.
If the private equity managers selling decide to leave the
proceeds in their firm or roll it into its other funds, the PE
managers pay no tax on it—the tax bill is deferred—until
the money comes out. In other words, the seller gets to turn
future ordinary income into long-term capital gains—and
if they leave the money in the fund, they effectively invest
pretax and put off the tax bill indefinitely.
Either way, the government is collecting less tax revenue,
because Dyal’s investors are often foreign and tax-exempt
institutions and its funds use structures known as “corpo-
rate blockers,” which protect investments from taxation.
It’s a pretty slick tax-avoidance trick, and there’s noth-
ing illegal about this or about corporate blockers. A decade
ago, tax lawyers called “management fee waivers”—in whichW