SOURCE: USA Today Newspaper.Private equity firms, which receive the bulk of their funding from public pensions, are now aggressively using the most astonishing tax loophole in more than 20 years. Unfortunately, this USA Today article did not explain the mechanics of the loophole. For specifics regarding this loophole, see the archive and the June 22, 2004 column by Steve Duin of the Oregonian newspaper. Here is a brief summary of Duin's 2004 article followed by the September 15, 2006 USA article.
"For reasons only the accountants understand, private equity groups such as Texas Pacific can use the losses from one company to offset the profits of another company and not pay a dime in taxes. Back in the 1980s, the Senate Finance Committee realized profitable companies were buying companies with such operating losses -- for pennies on the dollar -- and deducting those losses against net income to escape any federal tax obligation.
Then-Sen. Bob Packwood, R-Ore., led the effort to shrink that loophole. "We changed the law when a profit-making company buys a losing company," Packwood said Friday. Instead of writing off the entire loss, the profitable company could write off only a small percentage of those losses each year. "That effectively stopped the practice," Packwood said, "because profitable companies weren't interested in buying losses if they had to spend five to 10 years spreading those losses out."
Packwood and the tax gurus never anticipated, however, that the companies with the huge operating losses would turn around and purchase corporations with the profits. They did not set similar restrictions on tax write-offs for the money-losing operations. That, Parish argues, gave America-Online the incentive to buy Time-Warner and, after combining losses and profits, pocket $4 billion in saved tax receipts."
As large as that price tag is, it ranked only ninth in a year that has seen a record blizzard of private equity deals worth $173.2 billion, says Dealogic. Private equity deals, which were once known as leveraged buyouts, involve taking a company private, loading it with debt and hoping to take it public again later at a profit.
This year's larger private equity deals have included HCA at $21.0 billion, Kinder Morgan at $14.6 billion and Univision at $12.2 billion, Dealogic says.
Those could soon be dwarfed by a wave of monster-size going-private deals that one investment strategist says could sweep up some well-known companies.
Morgan Stanley's Henry McVey says household names such as Home Depot and Dell could attract private equity offers topping $50 billion in the next 18 months. He says a confluence of factors has created a "recipe" for a megadeal to occur, including:
•Languishing big-company stocks. The Standard & Poor's 500 has gained only 26.7% over the past five years, or 4.8% a year. Meanwhile, the small-stock Russell 2000 has gained 74.2% or 11.7% a year.
Even CEOs bemoan their stock prices. "From this corner everything is up except the stock price," Philip Knight, chairman of Nike, one of the 30 companies on McVey's target list, wrote in his 2006 letter to shareholders. "We are a long-term growth company judged by short-term standards."
•Giant cash reserves. Public companies are sitting on so much cash and taking so few risks, McVey says. This makes them attractive and easy targets, because buyout firms can use that cash to help finance the takeover. Cash at Analog Devices, one of the potential targets McVey has identified, accounts for 61% of its total assets. Dell's cash has reached 37% of assets.
•"Club deals." Individual funds pool their money in "clubs" to afford even bigger targets. "It's like hunting in packs," says Fentress Seagroves, a partner at PricewaterhouseCoopers. For instance, Home Depot, the biggest on McVey's list at $77 billion in market value, might be too much for one private equity firm to swallow but doable by several.
•Tax benefits. Private equity firms can buy large companies and shield their income from taxes, keeping more for themselves as profit, by combining them with money-losing companies they already own, says Bill Parish of investment management firm Parish & Co. Private equity firms, hungry to take advantage of this tax loophole, want larger targets. "The bigger the company, the greater the tax savings," he says.
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