Private-equity tax measure could cut into state pensions

WASHINGTON — There's a little house four blocks from the Canadian border in Blaine, home to Barrie Hull. The 73-year-old former official in the Whatcom County Sheriff's Office gets a $2,200 monthly pension that helps him tend his one-acre garden in peaceful retirement.

The pension fund that helps finance Hull's retirement is one example of what's at stake in an expensive and increasingly volatile battle on Capitol Hill.

Leaders in the House and Senate are pushing for legislation to more than double the tax rates on fees earned by managers of private-equity firms — those financial giants that typically buy struggling companies, turn them around and then sell them at a big profit for themselves and their investors.

For Hull and more than 440,000 other retired state and local government employees, the returns earned by their pension funds over the years have been boosted by investments in these private-equity firms.

"To a plan like ours, private equity has provided a more meaningful return than we could have in publicly traded equities," said Joseph Dear, executive director of the Washington State Investment Board, which manages the state pension funds.

If taxes are raised on the fees paid to private-equity managers, Dear said, those managers may not be willing to make risky but more lucrative investments. And that could mean lower returns for the investors, including the state pension funds.

Furthermore, some of the state's contracts with private-equity funds require the state to pay the fund managers' tax bills, said state Treasurer Michael Murphy. If the taxes double, the state will foot the bill, Murphy explained.

Washington is the second-largest state investor in private-equity funds, behind only California. The state invests about 18 percent of its $63 billion in pension assets in such funds, Dear said.

The funds include the financial giants Kohlberg Kravis Roberts & Co. and the Blackstone Group.

The hundreds of millions in fees paid to the fund managers, based on the profits they earn investing for others, are taxed as capital gains at a rate of 15 percent.

Proposals in Congress would treat the fees as regular income, taxed at about 35 percent.

Democratic presidential candidates Barack Obama, Hillary Clinton and John Edwards want the taxes raised. But some big-name Democrats in the Senate, such as John Kerry and Chuck Schumer, do not.

Sen. Maria Cantwell, the Washington Democrat who sits on the Senate Finance Committee, has been silent on the issue. The panel will hold its second hearing on the tax controversy today.

Cantwell declined repeated requests for an interview or statement for this story. In a general comment to the Finance Committee on July 11, she said the issues involved "are just another example of the inconsistencies inherent in the tax code."

Lobbyists battle changes

Members of the finance panels in the House and Senate have been under siege by Wall Street lobbyists fighting any tax changes.

The House has a bill pending that would raise the taxes on the fees. The Senate is considering legislation but seems less determined to push it.

Cantwell is among the many senators who have been approached by the Private Equity Council, a lobbying association formed this spring by the Blackstone Group and other private-equity firms.

The Washington State Investment Board has not taken a formal position on any bills in Congress, said Dear, the board's executive director.

Blackstone and Kohlberg Kravis Roberts are among the two largest private-equity groups in which the state has invested. The investment board has put about $11 billion into Kohlberg Kravis Roberts in the past decade, with $8 billion more promised later.

Typically, fund managers keep 20 percent of the profits as their fee.

The president of the Private Equity Council cited Washington state in his testimony before a House committee this month.

"Let me give you a concrete example of what these numbers mean to real people," said the president, Douglas Lowenstein.

The state investment board has earned $9.7 billion on its private-equity investments since 1981, an average return of about 15 percent a year, Lowenstein told lawmakers.

"Put another way," he said, "the excess returns generated by private-equity investments during that period are worth $26,000 per retiree."

Sens. Kerry, D-Mass, and Schumer, D-N.Y., have said the issue is complex and that they have misgivings about any legislation to suddenly increase the tax rates.

Obama, Clinton and Edwards say the current tax scheme is a giveaway to the rich.

Frustration in Congress

"It's not so black and white," said Rep. Brian Baird, D-Vancouver, a member of the House Budget Committee. Because many major investors have abused the markets and tax loopholes, he said, "There's great frustration in Congress."

But Baird thinks the House bill may go too far. And he worries about the effect on pension-fund returns.

"I'm not inclined to vote for it," he said. Nonetheless, he said he is tired of hearing fund managers complain about all the "sweat equity" in their investment decisions.

"I represent loggers and fishermen. That," he said, "is sweat equity."

Dear said the investment board tries to make a minimum 8 percent annual return overall.

"Looking forward, over the next 20 years, we could not get that if we had to depend on bonds, government securities and publicly traded firms," he said.

The investment board's return for the first quarter this year was more than 10 percent, and more than 17 percent for the first half of the year.

If Congress decides to increase the taxes, Dear hopes the state's congressional delegation finds a way to minimize any potential impact on the pension funds.

Alicia Mundy: 202-662-7457 or amundy@seattletimes.com