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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