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Private equity’s new tax problem

FORTUNE — Dear private equity: You may have a new tax problem.

For years, private equity firms have charged so-called “monitoring fees,”  in which an acquired company pays its private equity owners an annual sum for ongoing management and advisory services. And, for years, I’ve criticized these payments — believing them to be more akin to dividends than fee for service. Here’s what I wrote last September:

Private equity firms have historically justified these fees by arguing that they are in lieu of their portfolio companies having to pay millions to a third-party consultant, like Boston Consulting Group or McKinsey & Co. What this ignores, however, is that: (a) The monitoring fee arrangements are determined at the time of sale, not at the time of specific consulting need; (b) Private equity firms already are being paid to oversee their investments, in the form of annual management fees paid by their limited partners (which typically are between 1%-2% of committed capital). Imagine any other business where you get paid a salary, but don’t show up to work until someone else also pays you to do the same job!

What I didn’t fully appreciate at the time, however, was the tax benefit of calling these payments “monitoring fee”s instead of “dividends.” Such nomenclature allows companies to write off such payments as deductible business expenses, whereas they would be required to pay tax on dividends (assuming, of course, that the company doesn’t have such large interest payments that its tax bill has already been wiped out). That means that the company remains richer and, when sold, generates more capital for its private equity sponsors (who pay capital gains rates on investment profits). In other words, the U.S. Treasury loses out twice.

“Wait a minute,” says rhetorical private equity investor. “We are required to pay ordinary income tax on fees, but would get to pay a lower rate on dividends, so there isn’t really a tax arbitrage here.”

Perhaps, except more and more private equity firms are rebating all of their monitoring fees back to their underlying investors (called “limited partners”). And a large number of those LPs are tax exempt organizations, including university endowments and charitable foundations. Should they be paying tax on this fee income as an unrelated business expense? If so, they aren’t (in part by structuring them as rebates to annual management fees — thus again reducing taxes for the general partner).

What’s particularly galling about all of this is that many of the private equity firms all but tell you that these “monitoring fees” are dividends, within the fine print of their merger documents. This was the subject of a new Tax Notes article this morning by UNC tax professor Gregg Polsky, who examined dozens of such agreements.

Take the case of HCA (HCA), which was taken private in 2006 for $21.3 billion by Bain Capital, KKR, Merrill Lynch and the founding Frist family. Three points:

1. The monitoring fee is split based on how much money each sponsor invested in the deal, not based on the services expected to be provided. In other words, this is about stock ownership (as it would be with a dividend), not about services.

2. No actual services are required. From the merger sub (my emphasis added):

Each of the Managers shall devote such time and efforts to the performance of services contemplated hereby as such Manager deems reasonably necessary or appropriate; provided, however, that no minimum number of hours is required to be devoted by Bain, KKR, ML or each Frist on a weekly, monthly, annual or other basis.

3. The fee has a 10-year term, but the sponsors may terminate the agreement at any time and for any reason — yet still receive all unpaid fees. This isn’t like paying a termination fee to your cellphone provider because you don’t want to fulfill the term of your two-year agreement. It’s like your cellphone provider terminating your service after six months, and then demanding the next 18 months of payment anyway.

HCA is just one example, but there are dozens of similar ones. And then there’s my favorite: GNC Holdings (GNC), which was in 2007 purchased in by Ares Management and Ontario Teachers’ Pension Plan (like HCA, it has since returned to the public markets).

Ares and OTPP were equal partners on the deal so they split the monitoring fees equally. The only difference was that Ares, a Los Angels-based private equity firm, referred to its $750,000 annual payment as a “management services agreement.” OTPP, a tax exempt Canadian pension system, on the other hand, referred to the exact same payment as a “special dividend.” Same fee paid by the same company for the same reason. This may look like apples and oranges, but clearly it was not.

From a legal perspective, there is a two-part test to determine is these “monitoring fees” are legitimate business expenses or disguised dividends. One is if the payments are reasonable in light of the services being performed. In this case, private equity firms may actually have an affirmative defense in select situations — assuming they can account for their services provided.

From my perspective, private equity firms already are well-compensated for the work they do with portfolio companies (via management fees paid by their investors). If they want to provide other services, then charge the companies for them. But stop taking a dividend and pretending its something else. Just because the IRS hasn’t caught onto this scheme yet doesn’t mean it won’t.

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