New structures take taxable investors' particular situations into account. Rodney Goldstein is chairman and managing director of Frontenac Company, a Chicago-based private-equity investment firm.

By generating superior returns over the past decade, the private-equity industry has been rewarded with a growing share of institutional investment dollars, and has evolved in a growing economic force. Private equity attracted more than $300 billion in new investor commitments in 2006, according to a Thomson Financial report. A number of sophisticated institutions are said to have increased their allocations to "alternative" assets to between 15% and 20%. Perhaps because of that success, many investors -- particularly taxable investors -- have not paid enough attention to the tax aspects of their private equity holdings.

"Until a few years ago, tax planning was an afterthought for most private-equity firms," says a report by Ernst & Young. This appears to be changing as alternative-asset investments prove increasingly attractive to taxable investors. But are alternative-investment vehicles set up to accommodate taxable investors' objectives? Do they allow taxable investors to maximize their return on investment?

Look back

Investors and private equity firms can no longer ignore the fact that sub-optimal tax structures can have a negative impact on portfolio returns. In a true paradigm shift, tax considerations are now increasingly integrated into private-equity firms' investment approach to drive better investment results.

To understand the complexity of the issue it's important to look at how the private-equity industry has evolved.

Private equity was once an asset class that primarily attracted taxable investors such as high-net-worth investors, wealthy individuals and family offices able to commit assets for the long-term. Over the past two decades, however, large tax-exempt financial institutions -- pension funds, endowments, foundations -- have become the dominant investors in the private equity industry.

This global trend was driven largely by investors demanding higher returns. Private-equity net returns outperformed the S&P 500 by 9.3% for the 12 months ending September 2006, and by 4.3% over the past 20 years, according to Thomson Financial.

At the same time, private equity has gone mainstream. Private-equity investment options have become more diverse, and innovative investment vehicles are available to make the asset class more accessible to more investors. That said, with institutional investors still the primary providers of capital to the industry, it's no surprise that these tax-exempt investors have ensured that their tax concerns have dictated the structure of most private-equity funds.

New vehicles

What are the implications for taxable investors? Unfortunately, until quite recently, it was not widely understood that for sophisticated taxable investors (family offices, corporations and wealthy individuals) the typical private equity fund is extremely tax-inefficient.

Why? Because its legal structure is optimized for its major "customers" -- tax-exempt institutions that are averse to generating unrelated business taxable income (UBTI). Income from a flow-through entity such as a limited liability company (LLC), even a passive investment owned through a private-equity fund, is considered UBTI, and receiving excessive amounts of UBTI can jeopardize a tax-exempt institution's tax status. Thus most fund documents incorporate provisions essentially prohibiting UBTI generation.

The private-equity industry is belatedly beginning to recognize the opportunity offered by adopting new structures that take into consideration taxable investors' particular tax situation. Specifically, there is a growing awareness that flow-through structures such as LLCs can offer built-in flexibility and significantly reduce tax liabilities for taxable investors, as compared to C corporation structures. These structural benefits are threefold: Eliminating double taxation on distributions or upon exiting an investment. Building up tax basis over time, which further reduces the investors' capital gains taxes at exit. Adding incremental enterprise value that is potentially received from the buyer of a portfolio company who is able to benefit from a tax basis step-up.

Over the life of a typical portfolio investment, these benefits can result in an incremental return of between 0.5 times and 2.5 times on invested capital, according to a recent study by Frontenac, the firm I help run. A fund structure favoring the interests of taxable investors can produce an annualized rate of return that is between 250 basis points and 260 basis points higher after tax than one that prohibits generating UBTI.

Sophisticated taxable investors will increasingly gravitate towards investing in private equity funds that combine the prospect of competitive investment performance with the benefits of a structure that is designed to enhance their long-term after-tax returns. -FWR

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