March 22, 2007
The Blackstone IPO: Regulatory Arbitrage Extraordinaire
Posted by Victor Fleischer

Hat tip to Blackstone's lawyers for a fascinating deal structure.  Here's a link to the S-1

I'd been wondering if Blackstone was really going give up the tax advantage of the Two and Twenty structure in order to get some liquidity and acquisition currency.  Publicly-traded entities, of course, are usually taxed as corporations, and pay tax at the entity level. 

Blackstone's plan is to retain the partnership form and take advantage of an exception to section 7704, which generally dictates that publicly-treated entities be taxed as corporations.  Brilliant.  And aggressive.

The basic structure is as follows:  Blackstone is the GP in various investment funds.  The GP, itself a limited partnership, is the entity that's going public.  Investors will receive common units with economic rights (but limited voting rights) in Blackstone.

40 Act.  Before turning to the tax issues, though, it's worth a word about the 40 Act.  To avoid being regulated as an Investment Company, Blackstone is relying on a couple of delicate arguments.  First, they have to establish that they're not in the business of investing in securities.  Of course, if you ask most people what Blackstone does, that's exactly what people would say they do: buy and sell securities in portfolio companies.  Because Blackstone the GP is going public, however, and not the Blackstone funds, they can make the argument that they are an asset management firm.  From the S-1:

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. We hold ourselves out as an asset management and financial advisory firm and do not propose to engage primarily in the business of investing, reinvesting or trading in securities.

See S-1 at page 49.  If this works, they avoid section 3(a)(1)(A) of the 40 Act.  They then face the additional hurdle of arguing that the GP interests in underlying funds aren't "investment securities."  I'm not sure how they get there on this one -- I'll have to dig into the 40 Act regs and rulings to understand the argument.  Partnership interests sure seem like securities, but presumably there's some case law or regs distinguishing partnership interests from common stock for purposes of this section. 

Corporate Governance.  Retaining the partnership structure allows Blackstone to avoid the NYSE corporate governance restrictions, like having a majority of independent directors.  Blackstone clearly doesn't fetishize independence.  It will, however, have to become SOX-compliant. 

Tax.  Now to the key bit of regulatory engineering:  tax.  To review:  the Blackstone partners currently get capital gain treatment on the income that results from holding carried interests in the underlying funds.  This means that they usually pay tax at the long term capital gains rate of 15% instead of the top ordinary income rate of 35%.  Because going public usually means getting taxed as a corporation, you'd think Blackstone would have to give up the tax break and incur an entity-level tax at the corporate tax rate. 

But instead, Blackstone will remain structured as a partnership and will try to qualify to an exception to the publicly-traded partnership rules (section 7704).  Specifically, Blackstone will try to qualify as a partnership with "passive-type income" (7704(c)).  To do so, it'll have to establish that 90% of its income comes from interest, dividends, and most relevant here, gain from the sale or disposition of a capital asset.  I'll focus in more closely on this tax issue tomorrow, but I have to wonder if this tax treatment relies on the successful conversion of management fees into carry.

The beauty of the structure is in the arbitrage between the 40 Act and the tax code.  The key tax advantage here is the treatment of carry as investment capital that gives rise to long-term capital gain.  As I explain in Two and Twenty, however, the income to GPs is probably better characterized as a return on human capital, not investment capital.  GPs get this income in exchange for services provided.  Blackstone, of course, says this explicitly in the S-1 section on the 40 Act:  "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."

If you believe that Blackstone's income is properly characterized as service income, then how do you justify capital gains treatment? 

For the structure to work, then, what Blackstone does has to be active services for 40 Act purposes (we're an asset management/advisory firm, not a pass-through who lets you invest in a pool of securities) but passive for tax purposes.  I'm not saying the structure doesn't work - quirks in the rules often allow this sort of regulatory arbitrage -- just that it seems a little aggressive.  I don't think I've ever seen an entity go public with such uncertain tax treatment. 

More on the publicly traded partnership rules to come.  I'll also address how this relates to the Senate Finance Committee's interest in changing the tax treatment of carry, and a word about the "Wall Street Rule" and the enormous pressure this deal may put on the Treasury and the IRS. 

Update:  By way of comparison, here's the Fortress S-1.  It appears that Fortress uses a blocker entity to siphon off management fees; Blackstone will follow a similar structure.  The idea is that the blocker entity checks the box to qualify as a corporation, pays corporate tax on the fees, and then the payouts to the holding partnership are dividends, which count as "qualifying income" under 7704. 

It strikes me as somewhat easier for Fortress, a hedge fund, to make the 7704 argument; 1.7704-3(a)(2) notes that income from trading or investing assets isn't income derived in the ordinary course of a trade or business (as opposed to being a broler, market maker, or dealer).   Private equity is none of those things, of course:  it makes its money from changing the management and/or financial structure of portfolio companies.  In my mind that creates some uncertainty (although the strength of the plain language of 7704(d)(1)(F) ("any gain from the sale or disposition of a capital asset ... held for the production of income ...") probably helps).  I'm being a little cryptic, but I'll try to elaborate and clarify later today, schedule permitting ....

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Comments (5)

1. Posted by Gordon Smith on March 22, 2007 @ 20:27 | Permalink

Thanks, Vic. I was just looking at the filing, and this helps a lot.


2. Posted by Natan on March 23, 2007 @ 9:30 | Permalink

Fortress (NYSE:FIG) used the same structure. Lee Sheppard discussed their structure in Tax Notes.


3. Posted by Vic on March 23, 2007 @ 9:59 | Permalink

Thanks, Natan. I hadn't followed the Fortress deal. I'll take a look.


4. Posted by Alex Dumortier on June 5, 2007 @ 16:15 | Permalink

Vic,

Great posts on Blackstone! One correction, though: Fortress isn't a hedge fund. It's a diversified alternative investment firm (just like Blackstone) that manages hedge funds, private equity funds and two publicly-quoted real estate funds.

Alex Dumortier


5. Posted by Wayne Isaacks on June 23, 2007 @ 13:23 | Permalink

I think Congress and many of us are overlooking the real impact of the Balckstone Tax Bru-Ha. The proposed Congressional tax intervention apprantly grants validitity to the Blackstone tax/regulatory arbitrage for 5 or more years. That is a gift, not an attack, because the validity of the Balckstone tax treatment under current law is an open question, certainly not a forgone conclusion. In fact, the Blackstone tax posture in its S-1 is one most experienced tax advisors, and many well-qualified commentators (tax-law academicians and paractitioners included) find incredulous under current law. Blackstone's boldness, and that of its tax counsel and securities counsel, is barely short of the Enron bunch. Probably some of the same. Perhaps I'm too conservative, but bringing an IPO with a purported tax treatment that is so agressively postured, without an advance Revenue Ruling is irresponsible - to the investors. But who reads the prosectus? I wonder if, and who rendered a "more likely than not" tax opinion on the validity of Balckstone's tax arbitrage? I think very few tax advisors would find their way clear to give such an opinion under current IRS Circular 230.

Moreover, the issue is two-fold. 1. the taxation of the Blackstonne "Carried Interest", and 2. future taxation as a C-corpoation of other Blackstone income. Fundamentally, neither issue requires legislation. The issues should be vetted by Treasury, and the courts regarding Blackstone. There is no need for a Congressional "grace period", is there? Why not let Blackstone's and investor tax fortunes play out under existing law, as would be the case for "the rest of us". Why should Congress consider a bill granting a 5-year grace perion or transition - which effectively blesses Blackstone's agressive and highly questionable tax position under current law tax?

The reason, of couse, is the sponsors of the bill are not trying to put a stop to this Blackstone tax coup. They are assuring the success of the Balckstone tax coup. Something that is not at all assured if left alone.

So, what is the mentality of the investors eager for Blackstone units? What makes a huge private equity firm that has bought up portfolio companies at historically high PE multiples, using extraordinary amounts of leverage (call this RISK) likely to deliver on the expectation of huge profits from its potfolio? Nothing. It's all "mojo". The formula to date has been, buy high (from the public) and sell it back higher (to the public).

Why sell Blackstone IPO shares to mutual funds and pension plans below expected post-debut price? To give the takers a pop, ensuring that what is a very risky investment (read the S-1 and all the uncertainties) looks like a good investment - making investment managers look good long enough for Blackstone's managers and investment bankers to cash in. Now other peoples' money is thier money. it wasn't before - not $billions, anyway.

Looks like they got key players in Congress to start a sham fracas to bless it all, while appearing to "do something" about abuse.

With the right mojo, the Emporer does not need any clothes.

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