It’s curious, and telling, that this story, “Union in move to halt Blackstone IPO,” appears as a headline story at this hour for the Financial Times (meaning it will probably be featured in the news summary in the print edition) yet has no counterpart at the Wall Street Journal or New York Times websites.
The AFL-CIO in essence calls the Blackstone IPO a sham, arguing that it its structure is devised to evade the requirements of the Investment Company Act of 1940. This is a fair observation. Conglomerate, which is a legally-oriented, and pretty non-ideological blog, in its post “The Blackstone IPO: Regulatory Arbitrage Extraordinaire,” immediately honed in on several aggressive and untested elements of the Blackstone deal structure, and the ’40 Act issue was at the top of its list:
I’d been wondering if Blackstone was really going give up the tax advantage of the Two and Twenty structure in order to get some liquidity and acquisition currency. Publicly-traded entities, of course, are usually taxed as corporations, and pay tax at the entity level.
Blackstone’s plan is to retain the partnership form and take advantage of an exception to section 7704, which generally dictates that publicly-treated entities be taxed as corporations. Brilliant. And aggressive.
The basic structure is as follows: Blackstone is the GP in various investment funds. The GP, itself a limited partnership, is the entity that’s going public. Investors will receive common units with economic rights (but limited voting rights) in Blackstone.
40 Act. Before turning to the tax issues, though, it’s worth a word about the 40 Act. To avoid being regulated as an Investment Company, Blackstone is relying on a couple of delicate arguments. First, they have to establish that they’re not in the business of investing in securities. Of course, if you ask most people what Blackstone does, that’s exactly what people would say they do: buy and sell securities in portfolio companies. Because Blackstone the GP is going public, however, and not the Blackstone funds, they can make the argument that they are an asset management firm. From the S-1:
We believe that we are engaged primarily in the business of providing asset management and financial advisory services and not in the business of investing, reinvesting or trading in securities. We also believe that the primary source of income from each of our businesses is properly characterized as income earned in exchange for the provision of services. We hold ourselves out as an asset management and financial advisory firm and do not propose to engage primarily in the business of investing, reinvesting or trading in securities.
See S-1 at page 49. If this works, they avoid section 3(a)(1)(A) of the 40 Act. They then face the additional hurdle of arguing that the GP interests in underlying funds aren’t “investment securities.” I’m not sure how they get there on this one — I’ll have to dig into the 40 Act regs and rulings to understand the argument. Partnership interests sure seem like securities, but presumably there’s some case law or regs distinguishing partnership interests from common stock for purposes of this section.
Now if a guy who is pretty experienced has to dig through the regs to see if the structure works, you know it is at best artful. The AFL-CIO at least has a common sense argument in its favor, and it might even have a strong case based on how one reads the regulations.
Ah, but this is America. Unions are has-beens. The deal sponsors are confident the offering will proceed, and the WSJ’s and NYT’s indifference may confirm this view. Is is because we have the best regulatory system that money can buy?
From the FT:
America’s biggest union federation has called on US regulators to stop Blackstone’s $40bn landmark initial public offering. The move will raise the political heat on private equity and could complicate attempts by other buy-out groups to list.
The AFL-CIO, the 10m-strong labour group, has written to the Securities Exchange Commission arguing that Blackstone’s IPO falls foul of US laws and should be investigated.
The move is the first direct attack against a buy-out fund by US labour.
Private equity executives say the unions are fighting a political battle against the industry. They are confident that regulators will allow the IPO to proceed.
However, the AFL-CIO attack highlights the growing concerns among politicians and unions leaders over private equity funds and the vast wealth of their executives at a time of rising income inequality in the US.
The attack on the Blackstone IPO comes as Doug Lowenstein, head of the newly-created Private Equity Council lobby group, makes a first appearance on Capitol Hill on Wednesday to defend the industry against unions and other critics who say it destroys jobs while using its generous tax status massively to enrich a small group of executives.
In the letter, sent on Tuesday and seen by the Financial Times, the union says that the unique structure chosen by Blackstone’s senior executives to raise funds from stock markets while keeping a tight grip on the running of its business is an attempt “to evade the coverage” of the Investment Company Act of 1940.
In its March prospectus, Blackstone argued that its listed entity was a partnership exempt from the governance requirements of investment companies such as having a fiduciary duty to stock market investors and keeping a majority of independent directors on the board.
The AFL-CIO says Blackstone is an investment company and its corporate structure “serves no practical purpose aside from creating a mechanism for Blackstone Group to sell its shares to the public without being regulated by the Commission”.
Blackstone declined to comment because of SEC restrictions related to its IPO plans. The SEC also declined to comment.
Update: Further comment from Conglomerate. They think the Blackstone position on the 40 Act is winnable, but think their tax argument is dubious:
Partnership Equity under the 40 Act. I’m not a 40 Act expert, but as I understand it, the doctrinal question is whether Blackstone’s GP interests in its underlying funds (i.e. its profits interests in the partnerships) are “investment securities.” The statutory language of the Act doesn’t speak specifically to this question, although its broad language suggests that the term was meant to be inclusive. The AFL-CIO argues that because a carried interest functions economically like a call option, and a call option would clearly be an investment security under the Act, then the GP interests should be treated as investment securities. In its prospectus, Blackstone doesn’t explain its position, other than to say it doesn’t believe that the partnership equity interests are investment securities.
Doctrinally, this strikes me as a close question. The 40 Act is meant to protect passive investors. General partners aren’t normally passive investors, so Blackstone starts off on solid ground. But investors in Blackstone won’t actually have any meaningful control over their GP interests, so that makes them look more passive. Should the 40 Act apply? If these are securities for purposes of the Securities Act of 1933, why not the 40 Act?
From a policy perspective, though, I think Blackstone is probably right. It’s hard for me to see why the 40 Act would apply to Blackstone but not an investment bank. Investors are buying a piece of a management company, not investing in a fund. So I need to do some more 40 Act research here, but Blackstone sure feels like an active business to me, and probably should be able to skirt the 40 Act.
Regulatory Arbitrage. Of course, the fact that Blackstone is calling itself passive for tax purposes – so as to qualify for a “passive-type” income exception to the publicly-traded partnership rules – won’t help its case with the SEC. In my view, Blackstone’s avoidance of the corporate tax is what’s screwed up, not its avoidance of the 40 Act.