As calls for taxes on the super-rich grow louder, Wall Street's smartest dealmakers have quietly discovered a new way to unlock value and circumvent taxes. It's minting buyout billionaires by the dozen
Emerging power duo: Behdad Eghbali (left) and José E Feliciano of Clearlake Capital, which made $800 million on its recent sale of Sage Automotive alone Image: Robert Gallagher for Forbes
When the Detroit Pistons opened their 2017-2018 season to a sellout crowd and a big welcome from rapper Eminem, the team’s owner, billionaire Tom Gores, beamed courtside.
Yes, the gleaming new $863 million downtown arena was worth celebrating, but Gores was finalising the deal of his lifetime, a ten-digit payout from his Beverly Hills buyout firm, Platinum Equity.
The deal was done quietly, without fanfare or a press release. Gores forked over an estimated 15 percent of his stake in Platinum to another firm, Dyal Capital Partners, which will garner $1 billion for him over four years. In doing so, Gores, who’s now worth $5.6 billion after the transaction, scored a huge personal windfall, raised the valuation of his firm, which he still controls—and avoided taxes.
He’s hardly alone. In the last four years, no fewer than 60 private equity (PE) firms have followed the same playbook, selling slivers of their general partnerships (GP), according to PitchBook, frequently at eye-popping valuations. More than $20 billion is being raised this year alone for more such deals, half by Dyal, a unit of the large New York asset manager Neuberger Berman, the rest by others, including units of Blackstone Group, Goldman Sachs and Jefferies. Secretary of Education Betsy DeVos and her husband, Richard, are getting into this game, out of their family office. Former Florida governor Jeb Bush has teamed up with Bahrain’s Investcorp to invest in private equity general partnerships, as well.
“Some firms have grown rapidly and are seeing increasing GP commitments. Many also want to invest more in their own deals, and this is an efficient mechanism as the proceeds raised usually are funded over time matching the needs, and there are some tax advantages,” says Evercore’s Saul Goodman, the investment banker on most of the general-partnership-stake (GP-stake) deals.
Private equity firms, normally secretive about their internal economics, are loath to discuss these sales. Gores declined to comment, as did pretty much all his private equity tycoon peers. However, based on months of reporting and dozens of interviews with insiders and investors in these funds, Forbes has been able to identify 13 new billionaires who have unlocked fortunes by this financial engineering. Ever heard of Steven B Klinsky, Egon Durban, Mike Bingle or Scott Kapnick? All are part of a new guard of private equity titans who are taking advantage of a world awash in cheap capital and tax advantages and driving a boom in the buyout business.
As investment banks and hedge funds struggle, private equity—a business predicated on raising capital subject to long-term lockups to invest in assets using large amounts of leverage—is enjoying go-go times. The decade-long bull market has helped the group log average annual returns of 13.69 percent over the 15 years ending March 31, 2019, according to Cambridge Associates, compared with 8.57 percent for the S&P 500. Last year alone, PE deals amounted to some $1.4 trillion, and in the US, private equity firms now own more than 8,000 companies, compared with 4,000 in 2006.
Down the road from Gores’s palatial offices, in Santa Monica, California, José E Feliciano and Behdad Eghbali operate Clearlake Capital, a boutique firm with a relatively modest $10 billion in assets. Feliciano grew up in Bayamón, Puerto Rico, a city known for fried pork rinds, before attending Princeton. Born in Iran, Eghbali arrived in the US in 1986 at the age of 10 on a tourist visa with his parents, who wanted to avoid his conscription in the Iran-Iraq War. After graduating from college, both Feliciano and Eghbali paid their dues toiling at old-guard private equity firms like TPG Capital. Then in 2006, they teamed up to form Clearlake Capital.
By all accounts, their firm, which tends to buy little-known software, industrial and consumer products companies, has been a roaring success. Clearlake’s 2012 fund, for example, has posted an annual net internal rate of return of 42.7 percent. So last year, as the GP-stakes market was exploding, a bidding war heated up for Clearlake. Feliciano and Eghbali got Dyal and Goldman to team up for a slice that valued Clearlake at a rich $4.2 billion, making Feliciano, 46, and Eghbali, 43, two of the youngest billionaires in private equity.
The business reasons for these stake deals are abundant. Cash is pouring into private equity. When new funds are formed, institutions generally insist that firms show skin in the game by putting their own money into funds. However, liquidity can be an issue, especially for younger firms. These GP-stake sales free up cash, provide permanent capital and can help solve complex succession issues.
But there is another factor driving these deals: Skirting Uncle Sam. Private equity already enjoys the most absurd tax break in America—“carried interest”, which allows these big fund managers to pay capital gains taxes, rather than income taxes, on their profit bonuses, on the idea that their intellectual contributions should be treated equally to the profits made by their investors. Carried interest has been a lightning rod with politicians for years. In 2016 even Donald Trump decried carried interest, which basically lets private equity executives pay a lower tax rate than many wage earners. But Washington has yet to curtail its widespread use (Blackstone’s Stephen Schwarzman famously compared former US President Barack Obama’s effort to eliminate carried interest to Hitler’s invasion of Poland), and it again survived the most recent tax reform bill.
But these new deals go further. They effectively transform the 2 percent management fees (separate from the standard 20 percent profit participation) from ordinary income into capital gains, as well. How? Take Gores as an example. In selling his minority stake to Dyal, he also gave that firm a right to a portion of his management fees. Voilà: A stream of ordinary income becomes a windfall of capital gains, reducing the maximum rate of 37 percent to 23.8 percent—and potentially deferring that tax payment for years.
“The official story [to limited partners] has always been we don’t make any money on management fees, we only make money on carried interest,” says Ludovic Phalippou, Oxford professor and author of Private Equity Laid Bare. “What this says is: I don’t make money only with carried interest, I make lots of money with management fees.”
When the world’s biggest private equity firm, Blackstone Group, went public in 2007, co-founder Stephen Schwarzman threw an infamous star-studded 60th-birthday bash at New York City’s Park Avenue Armory that many consider to be the high-water mark of pre- crisis excess. That year, billionaire Schwarzman enjoyed a $684 million payout.
But then came the Great Recession, the massive government bailout of financial institutions and the Occupy Wall Street movement. Schwarzman and other Wall Street denizens suddenly became villains. So it’s no surprise that the current boom in buyout billionaires is happening out of the spotlight.
By most accounts, the new wave of GP-stake deals started in 2015 when Vista Equity Partners’ founder, Robert F Smith, went to talk to investment banker Saul Goodman of Evercore about finding capital in the private market. No one embodied the new era of private equity more than Smith. Vista invested exclusively in software deals, an industry once seen as off-limits to leveraged buyouts and ignored by the biggest PE firms. Smith had proved that systemic software LBOs were not only possible but exceptionally lucrative, scoring some of the private equity industry’s best returns.
The leading private equity billionaires preceding Smith—like Schwarzman, David Rubenstein and Henry Kravis—had all gone public, listing their private equity firms on the stock market in an attempt to cash out and bring in permanent capital. But they were also forced to contend with public company challenges—from analyst calls to seemingly irrational market gyrations. Smith didn’t want the hassle of dealing with stock market investors on a quarterly basis.
So he tapped Goodman, who worked at Evercore, the small investment bank founded by former deputy US Treasury secretary Roger Altman. Together they met with Michael Rees, who ran Neuberger Berman’s Dyal Capital unit, which had been buying stakes in hedge funds. In July 2015, Dyal bought more than 10 percent of Smith’s Vista Equity at a valuation of nearly $4.3 billion. At the time, Vista had only $14 billion under management; today it has $50 billion. “The Vista deal woke everybody up,” says one senior Wall Street dealmaker.
Rees quickly pivoted to focus on private equity. By September 2015 he was telling institutional investors like the New Jersey State Investment Council that Dyal’s private equity stake deals were a “natural continuation of its existing business in acquiring similar stakes in hedge fund managers”. He marketed the Dyal private equity general partnership funds as steady income-gushers, with yields in the low teens, at a time when Treasury bills were near zero and AAA corporates paid less than 4 percent. For the liability-matchers of the pension and insurance world, it was music to their ears.
The hedge fund boom was ending, and private equity—with its ten-year life-span funds—seemed like a better deal. Assets under management are stable, making those 2 percent fees associated with them more predictable. Limited partners almost never default on the capital commitments.
By contrast, hedge funds proved inherently more volatile. In early 2015, for example, Dyal bought a 20 percent stake in activist hedge fund Jana Partners at a $2 billion valuation when Jana managed $11 billion. But within four years Jana was down to $2.5 billion in assets managed as returns went south and investors yanked their capital. Private equity’s leveraged, long-term model had seemingly been tailor-made for a low-interest-rate prolonged bull market.
Clearlake’s 2012 fund has posted an annual net internal rate of return of 42.7 percent
In a typical deal, Rees would spend between $400 million and $800 million over a two- to four-year period and in return receive a 10 percent to 20 percent stake in all of a private equity firm’s net management fees and half of its performance fees, or carry, meaning Dyal would get, say, 15 percent of the future management fees and 7.5 percent of the carry. Dyal’s minority stakes were passive—Rees would have no say in the running of the private equity firm. To make it work, Rees structured his Dyal funds as perpetual vehicles with a life span as long as forever, meaning Rees would never be forced to sell his general-partnership stakes—so he and his institutional investors could hold on to them like a high-yield annuity.
If the private equity managers selling decide to leave the proceeds in their firm or roll it into its other funds, the PE managers pay no tax on it—the tax bill is deferred—until the money comes out. In other words, the seller gets to turn future ordinary income into long-term capital gains—and if they leave the money in the fund, they effectively invest pre-tax and put off the tax bill indefinitely.
Either way, the government is collecting less tax revenue, because Dyal’s investors are often foreign and tax-exempt institutions and its funds use structures known as “corporate blockers”, which protect investments from taxation.
It’s a pretty slick tax-avoidance trick, and there’s nothing illegal about this or about corporate blockers. A decade ago, tax lawyers called “management fee waivers”—in which buyout managers gave up management fees in exchange for more carried interest—the “holy grail” because the waivers converted top-bracket taxable income to capital-gains-rate income and deferred taxation for years.
But in 2015 the Internal Revenue Service indicated that it would begin auditing these fee waivers. Thoma Bravo, the private equity firm run by billionaire Orlando Bravo, for example, told its investors that the IRS was auditing its management fee offsets in its 2012 fund. With fee waivers out, these stake deals allow Wall Street’s billionaires club to continue to admit new members. Some have even coined a name for them: “Synthetic fee waivers.”
The current deal bonanza reflects another reality: Firms are selling off pieces of themselves to build staying power. What followed Blackstone’s initial public offering in 2007 was a six-fold increase in assets in the ensuing decade, from $88 billion to $545 billion currently. Today’s private stake deals offer a glimpse into the up-and-coming firms that will dominate tomorrow’s Wall Street.
In July 2016, Silver Lake, a PE firm known for tech deals like Skype and Alibaba, tapped Dyal to raise $400 million. At the time, the Silicon Valley-based firm managed $24 billion and the deal valued the operation at about $4 billion. Silver Lake was founded in 1999 by tech investing pioneers Jim Davidson, Glenn Hutchins, Dave Roux and Roger McNamee. McNamee left early on in 2004, and by 2013 Davidson, Hutchins and Roux had also moved on. The firm’s younger partners, led by Egon Durban, Kenneth Hao, Mike Bingle and Greg Mondre, wanted more cash to continue investing in the firm’s enormous new funds. They were asset-rich but in need of liquidity.
The new managing partners used part of the $400 million raised by Dyal to increase their own commitments in their funds. Some of the proceeds went to the founders, part of an agreed-on sum related to the transfer of the firm, by investing on their behalf in Silver Lake’s funds. After the Dyal deal, Durban and the other remaining Silver Lake partners wound up with 90 percent of the firm’s future net free income. Davidson retained a slice of future performance fees in Silver Lake Fund V. Meanwhile, Durban, 46, masterminded an incredible deal for Dell that has so far returned $4.4 billion in profit. Silver Lake now manages $43 billion, and Forbes estimates that Durban, Hao, Bingle and Mondre, all under 52, are billionaires.
A few months after the Silver Lake stake deal, Dyal’s Rees bought a stake in Starwood Capital, a real-estate-oriented firm owned by Barry Sternlicht, which now manages $60 billion. Another Dyal deal from 2016 was a near 15 percent stake in HIG Capital, a private equity firm run by Sami Mnaymneh and Tony Tamer. The stake deal gave Sternlicht an estimated net worth of $3.1 billion. Mnaymneh and Tamer are now worth $4 billion each.
Credit-oriented PE firms—which have been thriving as heavily regulated bank lenders have retreated from riskier loans—are also getting in on the game.
Take the case of Scott Kapnick. A former co-head of investment banking at Goldman Sachs, Kapnick founded HPS Investment Partners in 2007 while working for JPMorgan Chase’s Highbridge Capital hedge fund unit. HPS’s private credit platform, which specialised in senior debt and mezzanine lending, was so successful that Kapnick became CEO of all of Highbridge when its co-founder billionaire Glenn Dubin left the bank in 2013. But in 2016, JPMorgan decided to spin out most of HPS with Kapnick as its CEO.
Fast-forward two years to July 2018 and HPS is managing $45 billion. Dyal’s tax-advantaged bite of HPS has turned former career banker Kapnick, 60, into a billionaire.
Don’t expect populist cries about income inequality to slow down the blizzard of private equity stake deals coming to market.
In December 2018, Blackstone, which is ramping up its GP-stake business, bought just under a 10 percent stake in a little-known New York City firm called New Mountain Capital run by a Forstmann Little refugee named Steven B Klinsky. Blackstone’s cash injection helped put Klinsky’s net worth at an estimated $3 billion. (New Mountain vehemently denies Forbes’s valuation, arguing the net present value assumes success for many years.)
Vista’s Smith has gone as far as to tap the well for a second helping. In 2017 Dyal bought another sliver of Smith’s firm, valuing it at $7 billion. Mnaymneh and Tamer of HIG have also sold a second stake. Kuwait’s sovereign wealth fund is now making investments in general partnerships, as is a firm run by Jeb Bush and another created by the family office of Richard and Betsy DeVos.
“There is a need for capital. These businesses can consume a lot of capital, so the capital is important,” says Dyal Capital’s Rees. “The vast majority of our invested capital stays in the business to fund GP commitments and product extensions.”