In recent times Private Equity has become a force to reckon with in global financial markets, by
raising huge amount of capital and using it to make big-ticket acquisitions.
The PE model is based on raising huge sums of money from investors, buying companies that
offer scope for significant value addition, turning them around and selling them for a profit, 20% of
which (carried interest) is major source of income for PE firms.
However starting July ’06, the credit supply has dried out owing to crisis in subprime mortgage
segment, which has made it difficult for PE firms to raise huge sums of money to keep the deal-
making engine running. Credit Crunch coupled with new tax proposals in US which would tax PE
firms’ earnings at rate of 35% instead of 15% earlier, indicates that private equity boom might
Judged by number of deal happenings, the Indian PE scenario seems to be immune from global
imbalance at least for the time being, for the reason being Indian deals are not highly leveraged
Once the market stablilizes and interest rates fall again the Private Equity will again be on the
path of growth: beginning of a new golden age.
Golden Age of Private Equity: Is the end in sight?
Private Equity led leveraged buyouts (LBO) worth $ 700 billion (which is 20% of total M&A in
2006), Assets under management (AUM) of $ 600 billion: this testifies what buyout king Henry
Kravis lauds as the “Golden Age” of Private Equity and strangely this golden age might come to
an abrupt halt.
Nothing can indicate this better than the performance of shares of one of the biggest Private
Equity firm (PE), Blackstone that went public on June 22 ‘2007. The share is presently trading
($24.42 as on August 27, 2007) at a discount from its offer price of $31 a share.
Exhibit 1 (Source: www.forbes.com)
PRIVATE EQUITY MODEL
Private Equity generally functions as Leveraged Buyout Funds (LBO). The PE firm (called as
Sponsor or General Partner) raises money from investors (called Limited Partners) who generally
are big pension funds, public and private endowments, foundations, banks and insurance
companies (see exhibit 2). The Limited Partner contributes between 90 to 97 percent of initial
capital and the General Partner contributes remaining. The LP might need to raise additional
capital (bridge capital) by way of debt.
Exhibit 2 (Data Source: Private Equity Intelligence)
Capital Commitments to Private Equity by Source
(Percent of capital invested in PE by GP type)
Public Pension Funds
Banks & Financial Services
Funds of Funds
PE firms then identify undervalued targets that offer scope for value addition and buy them out.
They create value by restructuring the business, aligning management, cost consolidation etc and
finally sell the structured and improved business at a profit in three to five years.
Taxed at 15%
2% of AUM
Sell out at premium
20% of Profits
80% of Profits
Exhibit 3: The Private Equity Ecosystem
Primarily there are two means by which PE firms earn money: Carried Interest and Management
Carried Interest: LPs are entitled to receive a return of their invested capital plus an
additional return of upto a specified percentage of capital invested, usually 8-9 percent (called
hurdle). If there are profits above this amount, the total profits are divided in 80:20 ratio
between Limited Partner and General Partner. This 20% of profit is called as carried interest
and is major source of income for PE firms
Management Fee: PE firm is made a payment for day to day services performed by it on
behalf of the fund, and is usually around 2% of total partnership capital
The carried interest coupled with low taxes on earnings compared to regular corporations
(discussed in later part of this article), takes the income of Private Equity firm to huge proportions.
P R O F I T S
Restructuring | Cost
FLOW OF CHEAP CREDIT FUELLED PE ACTIVITY
Till recent times, the credit markets were going too easy with plenty of money. With so much
cheap money available, it was easy for buyout funds to raise a huge pile of cash for investments.
Fundraising activity in the LBO sector attained new heights in 2006, as shown in exhibit 4.
Fundraising activity in Buyout Sector
Increase over 2005
No. of Funds
Amount raised (in $ billions)
Exhibit 4 (Data Source: Venture Economics)
Total capital raised by top 50 (on basis of capital raised) PE firms since Jan 2002 stands at $ 551
billion. Exhibit 5 shows the capital raised by Top 10 PE firms since Jan 1 ‘2002
Top Private Equity Firms (on basis of capital raised since Jan 1 ‘ 2002
Private Equity Firm
Capital Raised (in $ billions)
Goldman Sachs Principal Investment Area
TPG (earlier Texas Pacific Group)
Providence Equity Partners
CVC Capital Partners
Exhibit 5 (Source: Private Equity Intelligence)
However in recent years there is a fear that private equity boom is about to end primarily because
of two reasons: Global Credit Crunch & New Tax Proposals under consideration in US
HOW THE “CREDIT CRUNCH” HAPPENED
From the month of July 2007, the credit market started to collapse as financial panic spread the
world over, the reason being “re-pricing of risk”: a phenomenon when assets that were
fundamentally sound are hit by “supply demand imbalances” in the market. As a consequence
liquidity evaporated and market turmoil in a risky sub-sector of the US mortgage market spread to
impact market conditions globally.
Starting 2001, interest rates in US had been at historic low, US lenders flush with money started
offering credit to people who wanted home but had doubtful credit history and low income. This
marked the advent of subprime mortgage or NINJA loans (loans to people with “No Income, No
Job, and No Assets). These loans had a very low “below prime” introductory interest rate (most
commonly used method was 2/28 which offered a low teaser rate for first two years, then
adjusted for the remaining 28 to a rate that was often three percentage points higher than prime).
Other innovative products from mortgage lenders were balloon mortgage, option ARM, piggyback
loan, teaser loan etc. To hedge the risk these smart lenders turn these loans into securities that
can be sold to investors ($450 billion worth of such loans were converted into securities in 2006).
In themselves such loans are risky propositions so investment bankers bundle them with other
types of debt like credit card and auto loans; the result is an “asset backed security”. These
securities then make way to the commercial paper market.
Then by start of 2006, the housing prices started to flatten, lenders stopped borrowers from
refinancing, consequently more and more loans started going bad. Many hedge funds that held
subprime mortgage backed securities collapsed (two outfits run by Bear Stearns, Capital One’s
Greenpoint mortgage company, Lehman’s BNC Mortgage unit). By mid august at least 90 US
lenders have gone out of business.
FALLOUT OF CREDIT CRUNCH ON PRIVATE EQUITY
Private Equity is a “feast & famine” business. If one firm can raise lots of money, so can other
firms. Since 2003 conditions had been almost ideal for private-equity firms, with low interest rates,
lots of liquidity and rising asset prices. But with the recent evaporation of liquidity the additional
funds to keep the deal-making engine going on, were hard to come by. Banks were reluctant to
provide money for “bridge-financing” of PE deals. Several high profile equity transactions have
been cancelled like:
US Foodservice, an American wholesaler being bought by PE groups cancelled a $3.6 billion
The $45 billion acquisition of TXU, the Texan utility and £11 billion buyout of Alliance Boots,
the British retailer, by PE firm KKR have got stuck in syndication as investors refused to buy
the bank debt used to fund the deal
Even the planned $1.25 billion IPO of KKR has been postponed according to market reports.
PRIVATE EQUITY IN TAX TANGLE
Private Equity firms function as Partnerships, wherein they treat their major source of income
“carried interest” as capital gains (like profits on sale of stocks) and pay tax at the rate of 15%,
lowest in tax code whereas other corporation pay at the rate of 35%.
The tax proposal aims to clarify the US tax code so that publicly traded partnerships (PTP)
directly or indirectly deriving income from investment adviser or asset management services
would not be entitled to an exemption from corporate tax.
This issue gained prominence during the IPO of Blackstone Group when senators Max Baucus
and Charles Grassley sent a letter to US Treasury Department on June 14 ‘2007 and argued that
PE groups like Blackstone that become PTP under section 7704(b) of the Internal Revenue Code
should be taxed at corporate tax rate.
“A PTP is taxed as a corporation unless it satisfies the qualifying income exception under section
7704(c)… Qualifying income is defined in section 7704(d) to include: interest; dividends; rents;
gain from sale of a capital asset held for production of income; and gain from commodities
We believe that the PTP rules are being circumvented because the majority of the income is from
the active provision of services to the underlying funds and limited partner investors in those
The Senate Finance Committee has held two hearings till date, and with Senator Grassley and
Democrats who hold a majority in Congress getting behind the drive, odds are rising that private
equity firms will face higher tax bills.
IMPLICATIONS OF NEW TAX PROPOSAL ON PRIVATE EQUITY
Under new tax proposal, tax outgo will increase for publicly traded PE firms. That could triple
Blackstone’s annual taxes, shaving off around $525 billion of its earnings and cut $10 billion or 25
percent from its market cap.
Each year the carried interest granted to Private Equity firms is between $12 billion and $17
billion. If the tax system is changed, additional tax burden on PE firms would be between $2.4
billion and $3.4 billion.
(Source: Study “The Taxation of Private Equity Carried Interests: Estimating the
Revenue Effects of Taxing Profit Interests as Ordinary Income," by Michael Knoll, University of Pennsylvania
PE FIRMS JOINING FORCES
As a consequence of onslaught on PE on tax front the industry is shedding its reluctance to get
involved in politics. PE firms have increased lobbying and donations to lawmakers. They have
spent at least $5.5 million on lobbying in the first half of 2007 - almost four times the amount for
all of 2006 ($1.4 million). Twenty-four firms were registered to lobby for the largest private-equity
funds and their trade groups this year, up from 14 in 2006. They have forged industry
associations like the Washington based Private Equity Council whose members include
Blackstone, the Carlyle Group and KKR. The one firm, which is going to be most affected by tax
proposal, Blackstone spent another $3.7 million employing 13 tax lobbyists, 15 times its $240,000
for all of last year
(Source: Disclosures from Blackstone to the senate).
WAY OUT OF TAX TANGLE
In case of such a tax legislation being adopted PE firms can use these methods to evade higher
They can transfer increased payments to their portfolio companies.
They can use the blocker entity concept, as is being used by Fortress Investment after its
Since the proposed tax structure is applicable on partnerships, using a non-partnership
structure such a debt financing might avoid these rules.
To raise the money they might list themselves on private exchanges like Portal (Nasdaq’s
private exchange) or GSTruE (Goldman Sachs’ exchange), as in case of Oaktree Capital
Management, which raised $800 million by selling 15% stake on GSTruE.
INDIAN PE SCENARIO
As of now there doesn’t seem to be much effect of global credit crunch on Indian PE space.
Recently Blackstone bought a controlling stake in Gokaldas Exports for $165 million, in another
deal it bought 12.5% in Nagarjuna Construction Company for $150 million. 3i announced a $1
billion Indian infrastructure fund sometime back. The credit crunch that has made LBO costly in
developed countries won’t impact Indian PE scene primarily because deal sizes in India are much
smaller and the Indian laws anyway don’t permit much of leverage. Currently there’s about $5
billion worth of India-dedicated funds lying unutilized that has to eventually come to India only. To
that extent the adverse impact of global credit crunch on Indian PE scene seems remote, at least
in medium term.
However the critical factor is to distinguish between the cyclical and structural tide. The private
equity boom of 1980s ended due to the rising interest rates and a slumping economy. The same
combination might cause another slump over the next few years. But once that tide has ebbed,
and when interest rates inevitably fall again, the private-equity wave will once again capture new
grounds and it might well be start of another “Golden Age”.
Research study “The Taxation of Private Equity Carried Interests: Estimating the
Revenue Effects of Taxing Profit Interests as Ordinary Income," by Michael Knoll,
University of Pennsylvania Law School
United States Senate Committee on Finance (
Annual public disclosures by Blackstone group
Private Equity Intelligence
Private Equity Council
Submitted by: Vijay Singh Poonia, IIM Calcutta