Mitt Romney’s attorney said Tuesday the GOP presidential nominee didn’t participate in a fee-waiver program at Bain Capital in which the firm’s executives sought to lower their taxes by converting more than $1 billion of ordinary income into capital gains.
R. Bradford Malt, an attorney who manages the Romney family finances, mostly through blind trusts, said in an email that Mr. Romney’s retirement agreement from Bain “did not give the blind trust or him the right to do this, and I can confirm that neither he nor the trust has ever done this, whether before or after he retired from Bain Capital.”
I’m not sure I get it. The fee waivers date back to Fund VII, if not earlier, which was organized before he fully retired from Bain in January 2003. Romney still owned 100% of the management company that would have waived the fees in 2002.
Page 32 of Romney’s 2006 financial disclosure lists over $1 million in income from Bain Capital Partners VII, the partnership that would have received the converted management fees from Bain Capital Fund VII. That income is reported as dividends, interest, and capital gains, which is consistent with fee conversion, not ordinary income. The same financial disclosure reports income from “Bain Capital,” which appears to be Bain Capital LLC, the management company. That income is reported as “dividends,” which presumably means distributions from the LLC.
So the documents show that Romney held a financial interest in both the management company and the GP of Fund VII, and Fund VII performed $55 million in fee conversions as of the end of 2009. I would need to see the severance agreement and the partnership agreement to confirm what Mr. Malt is saying, but at this point, the documentary evidence suggests that Romney benefited directly from fee conversion.
It’s unlikely that Mr. Malt would have been involved in any decision to waive the fees. The fee waiver provisions are set up in the underlying partnership agreement, and the active partners at Bain, not Mr. Romney or Mr. Malt, would have made the election to waive the fees. But that election would have been binding on Mr. Malt and Mr. Romney, and would have benefited Romney directly.
How do they work? Conversion of management fees is a tax-motivated transaction that transforms a fund manager’s management fees (payable in cash) into a “priority allocation” of partnership equity. The goal of the transaction is to add just enough entrepreneurial risk to the payment to change its tax treatment, without changing the actual economics of either the fund managers or investors. Each arrangement is a little bit different, and the details matter for tax purposes. Bain’s arrangement was fairly aggressive, as the Bain managers could elect each quarter whether to waive the fees and take “priority profit” or instead take the cash. If the chose to waive the fees, they could cherry-pick which investment to allocate the waived fees to. Because the fund managers are in a good position to know which portfolio company is likely to have some accounting income in the following year, it’s not very risky at all. In theory, the managers could lose some of their management fees. In reality, the Bain managers always got paid in full (at least as far as we can tell from the financial disclosures.)
Back in 2001, Wilson Sonsini published a presentation on how to convert management fees. From the manager’s perspective, it’s quite an attractive deal. Suppose you’ve got a $10 million fee due in the next year. You can take the cash, and get $6.5 million after-tax, or you can wait a few months and get a special allocation of partnership equity, coupled with a special distribution of cash, and get $8.5 million after-tax. The objective is simple, according to Wilson Sonsini: “… to achieve Carried Interest tax treatment, without reducing GP cash flow or adding unacceptable risk. (p.4)” How much economic risk is there? Not that much — the presentation shows examples where the managers get paid in full even if the fund breaks even (p. 11).
Is it legal? No, at least not the way Bain did it. Wilson Sonsini and many other law firms advised fund managers that conversion of management fees was a balance of tax risk and economic risk. I don’t think any law firms made a practice of offering legal opinions to bless the fee conversions, as they would for a tax-free reorganization or securities offering. The choice of how to structure the fund is ultimately up to the fund managers, and we don’t know what their outside counsel said. But close analysis of the arrangement shows that fee conversions are subject to serious challenge by the IRS, and in my opinion, if challenged in court, Bain would lose.
Is Romney responsible? In my view, yes. He was the sole shareholder of the management company when some of the funds were created. (Fee conversions are set up when the fund is first organized.) This means that he was responsible (in both the legal and business sense) for determining how Bain was structuring its compensation arrangements.
What is the IRS doing about it? We don’t know. We do know that the IRS issued a statement in 2007 identifying fee conversions and other common tactics as “possible areas of noncompliance.” Because audits are private, however, we do not know whether the IRS has challenged Bain, and if so, what kind of settlement was reached. My best guess is that the IRS does raise these issues on audit, and the results probably vary from fund to fund, depending on the arrangement and the amount of time the auditor is willing to devote to the issue.
For the last five years, the tax community has been in a bit of a holding pattern because of the possibility that Congress would change the tax treatment of carried interest, which would moot the issue of fee conversions. So I’m not too surprised that the IRS and Treasury have declined to issue authoritative guidance in the meantime. With billions of tax dollars at stake, however, and no end to the carried interest battle in sight, an additional statement would be appropriate.
Two and Twenty. Private equity fund managers are compensated in two primary ways: management fees and carried interest. The management fee, traditionally two percent annually, is paid to the managers to cover overhead, salaries, and so forth. The carried interest, traditionally twenty percent, is a share of the profits from the underlying investments. My paper Two and Twenty described the typical arrangement. Management fees are taxed at ordinary income rates; carried interest is often taxed at capital gains rates. I focused in the article on why the carried interest portion is better viewed like bonus compensation and should be taxed at ordinary income rates.
Management Fee Conversion. Current law on carried interest is already a sweetheart tax deal for private equity, but why not make it better? Private equity folks are not the type to walk past a twenty-dollar bill lying on the sidewalk. In the 2000s it became common for private equity fund managers to “convert” their management fees into carried interest. There are many variations on the theme, but here’s how many deals worked: each year, before the annual management fee comes due, the fund manager waives the management fee in exchange for a priority allocation of future profits. There is minimal economic risk involved; as long as the fund, at some point, has a profitable quarter, the managers get paid. (If the managers don’t foresee any future profits, they won’t waive the fees, and they will take cash instead.) In exchange for a minimal amount of economic risk, the tax benefit is enormous: the compensation is transformed from ordinary income (taxed at 35%) into capital gain (taxed at 15%). Because the management fees for a large private equity fund can be ten or twenty million per year, the tax dodge can literally save millions in taxes every year.
The problem is that it is not legal. Because the deals vary in their aggressiveness, there is some disagreement among practitioners about when it works and when it doesn’t. But in my opinion, and the opinion of many tax practitioners, the practices that were common in the private equity industry in the 2000s became very, very questionable, and it’s unlikely that they would have stood up in court.
Fund VII. Gawker today posted some Bain documents today showing that Bain, like many other PE firms, had engaged in this practice of converting management fees into capital gain. Unlike carried interest, which is unseemly but perfectly legal, Bain’s management fee conversions are not legal. If challenged in court, Bain would lose. The Bain partners, in my opinion, misreported their income if they reported these converted fees as capital gain instead of ordinary income.
Here’s one example, from Bain Capital Fund VII LP (2009), pp. 13-14 (see here). In any given year, the manager (Bain) can waive its management fees, and allocate the fees instead to a particular investment in the fund. If that investment appreciates in the future, the general partner (Bain) takes a “Priority Profit” off the top. While Bain did not waive its fees for this fund in 2009, it had done so earlier in the life of the fund, to the tune of tens of millions of dollars. (5% of its total holdings of Bombardier Recreational, for example, came from fee conversions — making the fee conversions alone worth about $7 million in 2009).
To be clear, there is some economic risk, and presumably this is how Bain’s tax counsel justified its reporting. The economic risk is that the priority profit must come from future profits, presumably from the investment to which the converted fee is allocated. On the other hand, the managers get to choose which investment in the portfolio they want to skim, and they are in a good position to know which investments are safest. Because the fees come off the top, they are not subject to real investment risk, but only the limited risk that even their best investments will decline in value, every single quarter, for the rest of the life of the fund. Even in 2009, an iffy year for Fund VII, the priority profit share increased in value by $3.8 million.
(UPDATE: Here’s another example. Bain Capital Fund X LP reported that it converted $338 million as of the end of 2009. At a 20% tax rate differential, that $67 million in taxes unpaid. Plus deferral.)
Bottom line: Mitt Romney has not paid all the taxes required under law.
(UPDATE: Yes, Romney left Bain in 1999 or 2002. But as part of his severance agreement, he continues to receive interests in these funds, which he has reported on his financial disclosures. In the usual case, a departing partner would receive an economic stake in the GP (Bain Capital Partners X, LP), rather than an economic stake in the LP (Bain Capital Fund X, LP) — representing a payment for the management services he provided in the past. Indeed, because he filed an 83(b) election, we can be sure that he received GP interests as part of his severance agreement, and that he therefore benefited personally from management fee conversions.
(UPDATE: A couple more points. The Romney camp has complained that because Romney was a “blind investor” in the funds after 2002, it’s unfair to blame him for any tax dodging. They don’t deny that he benefited economically from the fee conversion or the lower taxes that followed. So the question is, can we fairly attribute the tax dodge to Romney?
Romney here is not like a passive mutual fund investor. He helped engineer the funds in the first place. For at least some of the funds, the fee conversion was set in place at the time of the fund’s formation — in the case of Fund VII, when Romney was the sole shareholder of the management company that actually waived the fees (2000). It seems reasonable to infer that fee conversions were in place for earlier vintages of Bain Capital funds as well. I haven’t yet reviewed all of the Gawker documents, but we are talking hundreds of millions of dollars in tax liability on these funds — one hundred million in Fund IX alone (20% of the $500 million converted), another $70 million in fund X. It is unthinkable that in the 1990s through 2002, when Romney was putting together funds, that he was unaware of the fee conversion strategy, or that he was unaware that he continued to benefit from it today.
A note on the economic risk in these deals. The whole tax argument rides on the fact that, in theory, the priority allocation is not guaranteed. If it were as good as cash, then it would be taxed as cash (ordinary income on receipt). So the argument is that if the fund performs badly, the manager might not receive the waived fees. But here’s the thing. It’s hard to imagine a worse financial catastrophe than what we saw in 2008-09. And yet Bain did just fine and received most or all of its fees. The economic risk is entirely ginned up for the benefit of the tax authorities, and it’s not surprising that even in the midst of a financial crisis, the Bain managers got paid their compensation, in full, at capital gains rates. (Remember this is the part of the compensation that’s supposed to be taxed at ordinary income rates.) Now, I’ll check the financials of these funds to see if any of the waived allocations were impaired during the crisis. But from what I looked at today, the economic risk was indeed as ephemeral as it was designed to be.
Finally, I should underscore that fee conversions were really widespread in the PE industry. But that doesn’t make it legal. Audits are private, so I don’t know what, if anything, the IRS has been doing about it. There are no litigated cases that I am aware of, though I haven’t checked in a while. I’ll try to find some time to do that tomorrow; I welcome any assistance from practitioners who are more up to date than I am.)