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@ Copyright May 2006

TITLE: The Amazing “Carry” and Tax Loophole Inside PERS
by Bill Parish

Today the true financial power in Oregon rests in Tigard, not Salem. Tigard is where the Oregon Investment Council (OIC) meets and awards contracts to manage PERS’ $63 billion in assets.

Both PERS participants and taxpayer advocates alike should begin to focus upon this board’s composition and expertise. Here’s a short list of potential troubles to look for: significant conflicts of interest and lack of SEC oversight, a highly speculative investment philosophy that could result in multi-billion losses and collapse the system, an overemphasis on foreign firms, which now manage more than 50 percent of total assets, and finally, explosive growth in “private equity” investments, commonly called leveraged buyouts or LBO's, and related “carry” fees as these private equity firms utilize a massive tax loophole.

In January and February 2006 alone two such private equity firms, KKR and the Texas Pacific Group, were awarded almost $2 billion to manage, from which they will likely make more than $400 million in “carry” fees.

The OIC is chaired by Dick Solomon, a practicing Certified Public Accountant (CPA) with no investment management experience, who until recently was treasurer of Governor Ted Kulongoski's re-election campaign. Solomon has also prepared previous OIC Chairman Gerard Drummond’s tax return for more than 20 years, and it is not known how many returns he prepares for lobbyists and corporate executives whose business interests intersect with the OIC. This is exactly why CPAs had been historically prohibited from direct involvement in investment management.

One of the great lessons of Enron and Arthur Andersen is that accountants should be accountants. If they do stray into investment management and other unrelated areas, at a minimum, they should obtain the necessary professional credentials and observe the highest standard for disclosing potential conflicts of interest. Solomon deserves thanks for filling in after Diana Goldschmidt's resignation, but should now resign himself to allow a more appropriate appointment.

The OIC's website does not even list background information on Solomon and other council members. Also on the council are Katy Durant, a real estate broker whose husband headed up Gov. Kulongoski's transition team, Harry Demorest, the former managing partner of the Portland Arthur Andersen office and now CEO of Columbia Forest Products, Mark Gardiner, former financial officer for the City of Portland and now an investment consultant, and State Treasurer Randall Edwards. Edwards, a career politician, does have a degree in economics in addition to an MBA yet his work experience is substantially all financial public relations and government policy related with no direct experience in investment management.

After the public controversy surrounding the Diana Goldschmidt resignation resulting from her husband’s role with the Texas Pacific Group, Edwards commissioned a “best practices review” of the council to be done by an attorney, Edward McAniff, who spent decades representing investment firms, for the agreed upon price of $1. The review found no problems, but its scope was particularly narrow.

In the OIC’s defense, after a few difficult years, Chief Investment Officer Ron Schmitz has produced solid returns. What could be problematic is that the fund now has more than 70 percent of its core assets in equities and real estate, far too aggressive for a public pension fund. Other states generally maintain less than 50 percent in these areas.  In addition, most of the managers chosen by the OIC are now also based outside the U.S.

Given the size of these important public pension government management contracts, a good question might be: Why can’t the OIC hire domestic firms, whether in California, Florida, Chicago or New York, especially if they perform equally well in their respective areas?

Perhaps the most startling trend is the fondness for “private equity” investments, the largest of which are KKR and the Texas Pacific Group, and the amazing “carry” fees such firms earn along with their use of a massive tax loophole. These private equity investments by the OIC now exceed $6 billion.

The carry is a term to describe the first positive returns from an investment, of which the private equity firm typically keeps 20 percent. For example, if the OIC invests $2 billion in private equity, once its original investment is paid back, 20 percent of the next $2 billion in return, called “the carry,” goes to the private equity firm.

The big surprise here is that the carry fees, designed to reward the underlying profitability and success created by these private equity managers, do not generally result from earning profits that generate cash from such investments, but rather from these private equity managers piling debt onto companies they purchase. Rather than reinvesting this cash generated from borrowing by the companies they manage, the private equity managers can instead pass this cash along to investors like the OIC. In other words, by piling debt onto these firms, KKR, TPG and other such private equity firms can ensure earning the massive carry fees while they simultaneously compromise the future of these businesses purchased by burdening them with excessive debt. With long-term interest rates now rising the impact of this debt and related interest payments will become more apparent.

The second powerful dynamic explaining the growth in private equity investments results from an amazing tax loophole being brilliantly manipulated by private equity managers. This all started in the 1980s when a loophole emerged that allowed businesses to purchase defunct companies with large tax losses. By consolidating, these businesses could then eliminate all corporate taxes. Then-Senate Finance Chair Bob Packwood led an effort to close this loophole, restricting such deductions to roughly 5 percent of the value of such losses purchased each year. Packwood notes, however, that no one ever conceived of the possibility that a company with losses might buy profitable companies, thereby escaping the loophole's intended closure. Here's how the scheme works.

Private equity firms buy money-losing firms carrying large net operating losses for tax purposes, often technology firms that have no hope of using these losses since they have no profits. These losses are then aggregated. The private equity firms then go out and buy profitable companies and, by consolidating with these tax losses, turn these companies purchased into tax-free entities, giving them a significant advantage over competitors that must pay taxes. The R in KKR, George Roberts, openly stated at a monthly OIC meeting that their primary strategy was to eliminate competition and then later raise prices.

Although innovative, now is a good time for both PERS participants and taxpayer advocates alike to “connect the dots” and understand the significance of the “carry” and this amazing tax loophole because although they put a smile on Wall Street, they are having a disastrous impact on Main Street as good companies along with their quality jobs and related tax payments that support vital government services, most notably PERS itself, fall prey to hostile takeovers by such private equity firms, financed by the OIC, who load them up with debt and compromise their long term future.

This discussion could begin with both PERS advocacy groups and taxpayer advocates joining to demand that the Governor remove Chair Dick Solomon from the council and appoint someone with a solid history of investment management experience who is able to understand and reign in the obscene carry fees being charged by private equity firms. In addition, perhaps State Treasurer Randall Edwards could call his former employer, Bob Packwood, and learn about this amazing tax loophole and why it may indeed make sense to close it, as intended by the Republican party leaders in the 1980's. PERS participants and taxpayers both deserve this leadership now.