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Explainer: The Romney Tax Documents, Part I
I am a longtime fan of Gawker – Twitter motto: today’s gossip is tomorrow’s news- even though it’s not a site known for its financial news. That’s why it was such a pleasant surprise that Gawker’s razor-sharp investigative reporter John Cook, a master of the FOIA request, turned his attentions to acquiring a 950-page document dump of Bain Capital records.
Cook’s purpose: to crowdsource an answer to one of the nagging questions posed by many pundits in this election cycle: is former Bain Capital founder Mitt Romney paying a smaller tax rate than his millions would necessarily require?
Keep in mind, Romney has freely admitted to paying a 13% tax rate. And there are 950 pages of documents that it would take a good tax lawyer at least a week to comb through. But with the documents up, this is a good time to share some context and history about how private equity partnerships work, and to distinguish between hype and fact. Check out the explainer below and leave comments if you want to continue the discussion.
I’ve got my country’s 500th anniversary to plan, my wedding to arrange, my wife to murder and Guilder to frame for it; I’m swamped. Why should I care, at all, about Mitt Romney’s taxes?
There’s the image issue, if you’re into politics (which I am not). That tune goes like this: Mitt Romney thinks you should not care about his taxes, because it’s a distraction from what he’s trying to communicate about the economy. President Barack Obama and his team thinks you should, because they see this election as, in part, about winning the hearts and minds of the middle class.
But financially, why you should care is because tax cuts, and tax treatments, are a major theme in this election and it’s always instructive to see how a presidential candidate – particularly one who’s running on financial savvy – has approached his own personal finances.
What does Bain Capital have to do with anything, though?
Romney was a founder of Bain Capital, and it’s a major source of his wealth. To get a sense of Romney’s taxes, you have to get a sense of his wealth. To get a sense of his wealth, you have to look at what he made from his time at Bain – including any returns he made after his retirement in 1999.
So how do people at Bain make their money?
Here’s the deal. Bain has three functions. Its first is as a consulting firm, which is the kind of firm you call in if you have a major problem with your company and you want to restructure it. Consulting firms, as their name suggests, consult CEOs on how best to improve the operations of their businesses. The consulting side gets paid by fees: they do a job and get paid for it.
The other two parts of Bain work like partnerships. Partnerships are easy to understand if you think of them like groups of law-abiding pirates: all the partners put money in, then they seek booty, then they collect the profits from the booty and split it up evenly.
One of Bain’s partnerships is its venture capital arm, which pours private money into startups and young companies. People with money – like foundations, colleges, states, cities and rich individuals – give Bain their money. They pay Bain to manage that money by investing it in young companies. Bain helps nurture the young companies, and then sells them to other companies (in mergers) or sells part of them to the public (in IPOs, which are listing a stock on a public exchange.) That amounts to a profit. Bain pays its investors a portion of the profit, and then keeps what’s left over for its partners.
And lastly, Bain has a private equity arm. “Private equity” is a meaningless term that came about in the 1990s to whitewash what used to be known, a little derisively, as “leveraged buyouts.” Private equity firms work like venture capital firms – they collect money from rich investors and then invest that money into companies. The people who invest the money at Bain – like Mitt Romney and other partners – are known as “general partners,” or GPs, because they not only put money in, but they also run the place in general. The investors from colleges and mutual funds and pension funds who put the money in and don’t get a daily voice in the investments are called “limited partners” or LPs.
The type of company is very different in private equity. Generally, private equity firms look for struggling companies, or ones that can be improved.
Okay. Sorry, look. I’m embarrassed to ask this, but…um, how does private equity actually, you know, work?
It’s actually not horribly hard. The private equity firm – Bain – has its eye on a company, and they run some numbers about how they can make a profit by taking over that company. Bain, say, figures out how much it would cost to buy the company – say, $1 billion – and then figures out a way to pay a very, very, very small part of that in equity, or cash.
Then Bain goes to a group of banks and borrows all the rest of the money. So the company becomes very highly mortgaged.
The goal is to make the company run well enough – or to sell it for enough money – that it’s worth enough in three to seven years to make a rich profit. Of course, private equity firms often don’t like to wait that long, so they might do other things that make people a little mad, like piling deeper debt on a company in order to pay themselves a dividend.
And of course, the path to profitability doesn’t run smooth. Very often, private equity firms have to shut down plants, renegotiate labor agreements, fire workers, and do a lot of other cost-cutting. PE firms might break up a company, or end up driving it into bankruptcy and then pulling it back out as a shell of its former self. That’s how your capitalist sausage gets made, and that kind of thing gets the industry involved in a lot of controversy.
Oh, and one other thing: when private equity firms take over a company, they don’t really take it over. They create another, shell, company to be the true owner. This means that the partners of the private equity firms don’t have to bear personal financial losses when one of their companies is in financial trouble.
Also, a point about structure: every few years, private equity firms raise what’s called “a fund.” The firms, like Bain, go out to meet investors in one year and raise, say, $10 billion. Their goal is to invest that entire $10 billion in companies X, Y and Z. But when they get down to say, $3 billion left, they usually go out and raise another fund to invest in companies A, B and C. These two funds work completely separately. The funds also often have really excitingly obvious numerical names, like Bain Capital Fund X or Bain Capital Fund IX.
Okay, so. Gawker?
Gawker’s goal is this: to reveal “the tax-dodging tricks available to the hyper-rich that he has used to keep his effective tax rate at roughly 13% over the last decade….the mind-numbing, maze-like, and deeply opaque complexity with which Romney has handled his wealth, the exotic tax-avoidance schemes available only to the preposterously wealthy that benefit him, the unlikely (for a right-wing religious Mormon) places that his money has ended up, and the deeply hypocritical distance between his own criticisms of Obama’s fiscal approach and his money managers’ embrace of those same policies. They also show that some of the investments that Romney has always described as part of his retirement package at Bain weren’t made until years after he left the company.”
So, do the documents show this?
Pretty much yes. Well, it’s a sure bet that a complicated, messy group of financial documents will definitely show that there are “maze-like” arrangements here. They are definitely maze-like! But as to “tax-dodging,” these arrangements are not illegal by any means; in fact, they’re commonly used by most people with considerable wealth. Romney’s are probably just more complicated because he was in the game for so long.
The real question is: sure, this is common and legal, but is it unpleasant to contemplate? And yes, like much of the tax code, it is. John Cook is absolutely right that incorporating a fund in the Cayman Islands is a laughable fiction – the fund can pay Caymans taxes, but it really does do business in the United States, and the U.S. could use that money.
How about the thing where Romney still has significant investments in Bain properties?
Okay, start here.
Gawker: When Romney left in 1999, he and his wife retained significant investments in many of those Bain vehicles—he claims they are “passive investments” and that they are managed in a blind trust (though the trustee isn’t blind enough to meet federal standards of independence).
This is true. One thing to remember, however, is that point about how long private equity firms hang on to certain properties: three to seven years, and longer, in some cases. So it’s common for partners in private equity firms to hold on to investments for years until the firm can sell the companies. Romney, as a founder of Bain, got a sweet, special deal where he could get a share of its profits for a longer time than you’d usually expect – 10 years, in fact.
It is not evil. (Probably). It is mainly boring. Romney reported under $15,000 invested in Sankaty, which, let’s be honest, is pocket change for him.
Gawker is correct that Sankaty experienced a lot of losses. What Sankaty does is basically buy up junk bonds, bad debt, and other loans at cut-rate prices and holds on to them until, hopefuly, they’re worth more money and then it sells them to make a profit on them. It’s like buying old comic books, but with complicated debt instead of actual, um, comic books. When the loans are for companies that go bad, Sankaty will lose money. That’s what happened. Way back in 2008 I wrote a little about Sankaty and its relationship with Bain, when Sankaty helped bail Bain out of a potentially troublesome deal; check it out if you have the stomach to really delve into it.
What’s interesting, really, is that Sankaty is like a little Bain-influenced satellite that helps Bain work out its financing troubles. Most big private equity firms have something similar, because they hate having to depend on banks all the time.
So why would Romney claim he couldn’t get access to Sankaty’s list of investments?
Did you see the returns on that thing? Lots of losses. Bain was probably embarrassed.
Also, private equity funds like Bain own entire companies, which can maybe be in the dozens; bond funds like Sankaty own bonds and loans, which can number in the hundreds or thousands. Disclosing all that data is what Wall Street describes as “granular,” which is code for ” too much work.”
It doesn’t really shed much light on Bain, or Romney, to know that Sankaty owned the debt of some unsavory casinos.
How about these equity swaps that Gawker talks about?
A perhaps less well-known, and sketchier, method for avoiding taxes is something called an equity swap, and several of Romney’s funds make use of the trick, according to the documents. Simply put, equity swaps are agreements to exchange the gain or loss on a particular set of assets without actually transferring ownership. According to a 2008 Senate Finance Committee report, they are also a “key type of transaction used by U.S. financial institutions to help offshore clients, including offshore hedge funds, dodge payment of dividend taxes.” The New York Times reported in 2010 that the IRS is scrutinizing equity swaps as a tax avoidance scheme, because the agency “suspects that the banks are disguising who owns stock[s] in order to help their offshore hedge fund clients avoid the withholding tax — a tax the banks are supposed to collect.”
Well, that’s all correct.
Equity swaps – also known as total return swaps in many cases – are legal but they haven’t always been loved by the IRS. The IRS pushed the matter to 2012, however. And total return swaps have also made shadowy appearances where investors used them to try to take over companies while skirting SEC rules and hiding their movements from prying eyes.
Total return swaps often can be helpful, however. For instance, in 2008, when Goldman Sachs saved CIT Group, Goldman chose to use a total return swap to protect itself financially in case CIT hit more bad times. The ability to structure the deal as a swap probably made it more appealing to Goldman, which made it more likely that CIT would get help rather than going out of business.
Wait, I just read those links. Total return swaps are derivatives. Derivatives? Derivatives? Again with the derivatives!
We know, we know.
So what should I do with all these documents?
Look through them if you have time and do what financial reporters do – look to see if there are any companies you recognize, and see a little of how the investment business works.
You named this Part 1. What’s Part 2?
The explainer that comes after I do more reading of the documents, naturally. It will probably be just as long as this one. Share your questions and thoughts in the comments below and let’s start the conversation.