Pri­vate Eq­uity’s New Bil­lion­aire Ma­chine


Forbes - - INSIDE - By Nathan Vardi and An­toine Gara

As calls for taxes on the su­per­rich 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.

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 fi­nal­iz­ing 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% 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 firms have fol­lowed the same play­book, sell­ing sliv­ers of their gen­eral part­ner­ships, 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 a very 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% over the 15 years end­ing March 31, 2019, ac­cord­ing to Cam­bridge As­so­ciates, com­pared with 8.57% for the S&P 500. Last year alone, PE deals amounted to some $1.4 tril­lion, and in the U.S., pri­vate eq­uity firms now own more than 8,000 com­pa­nies, com­pared with 4,000 in 2006. Down the road from Gores’ 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 U.S. in 1986 at age 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%. 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 Pres­i­dent 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% man­age­ment fees (sep­a­rate from the stan­dard 20% 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% to 23.8%—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 tons of money with man­age­ment fees.”

When the world’s big­gest pri­vate eq­uity firm, Black­stone Group, went pub­lic in 2007, co­founder Stephen Sch­warz­man threw an in­fa­mous star-stud­ded 60th-birth­day bash at New York’s City’s Park Av­enue Ar­mory that many con­sider to be the high-wa­ter mark of pre­cri­sis 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 U.S. 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% 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%. 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% 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% 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 tai­lor­made for a low-in­ter­est-rate pro­longed bull mar­ket.

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% to 20% 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% of the fu­ture man­age­ment fees and 7.5% 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 pre­tax 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 six­fold 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-and­com­ing firms that will dom­i­nate to­mor­row’s Wall Street.

In July 2016, Sil­ver Lake, a pri­vate eq­uity 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% 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% stake in H.I.G. 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’ pri­vate credit plat­form, which spe­cial­ized in se­nior debt and mez­za­nine lend­ing, was so suc­cess­ful that Kap­nick be­came CEO of all of High­bridge when its co­founder 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% stake in a lit­tle­known 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’ 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 H.I.G. 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.”

Emerg­ing power duo: Be­hdad Egh­bali and José E. Feli­ciano of Clear­lake Cap­i­tal, which made $800 mil­lion on its re­cent sale of Sage Automotive alone.

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