Saturday, May 5, 2012

Carlyle's "Cash Tax Savings" Won't Go to Unit Holders


I admit it.  I missed the major thrust of The Carlyle Group's byzantine "cash tax savings" in their "tax receivable agreement.".  I mistakenly thought Carlyle's co-founders were being indemnified against any future tax increases on carried interest. Instead, it's a co-founder cash bleeding of affiliates

We will enter into a tax receivable agreement with our existing owners whereby the corporate taxpayers (affiliates) will agree to pay to our existing owners (partners) 85% of the amount of cash tax savings, if any, in U.S. federal, state and local income tax that they realize as a result of these increases in tax basis. 

This bizarre siphoning of cash from affiliates is based on the pass through of corporate overhead from Carlyle.  Pre-IPO Carlyle's owners estimated this cash sluice to be over $1 billion.  Removing the jargon from Carlyle's final S-1/A we get:

Based upon certain assumptions, we estimate that the corporate taxpayers aggregate amount (owed) would be approximately $1,035.6 million.
Post $22 per share IPO, Carlyle's latest filing has this down over $120 million::

Based upon certain assumptions, we estimate that the corporate taxpayers  aggregate amount (owed) would be approximately $915.2 million.

Driving home the cash drain intent is Carlyle's description of its Tax Receivable Agreement:

Payments under the tax receivable agreement will be based on the tax reporting positions that we will determine. The corporate taxpayers will not be reimbursed for any payments previously made under the tax receivable agreement if a tax basis increase is successfully challenged by the IRS. 

As a result, in certain circumstances, payments could be made under the tax receivable agreement in excess of the corporate taxpayers’ cash tax savings.

In the event that The Carlyle Group L.P. or any of its wholly-owned subsidiaries become taxable as a corporation for U.S. federal income tax purposes, these entities will also be obligated to make payments under the tax receivable agreement on the same basis and to the same extent as the corporate taxpayers.

It remains to be seen how that odd "qui pro quo" at the end materializes.  The end result is a cash bypass of new Carlyle stock holders.  These payments are made to exiting owners, not unit holders.

How many new Carlyle investors are aware of this?  I envision them standing and staring at their unit.

Update 5-7-12:  Forbes speaks of the potential conflict between PEU partners and unit/stock holders.

Update 8-3-15:  Naked Capitalism noted this PEU trick to strip cash from affiliates going public.