Investment Management for Taxable Private Investors

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The chief advantage of buying to sell is simple but often overlooked, explain Barber and Goold, directors of the Ashridge Strategic Management Centre. Once that gain has been realized, private equity firms sell for a maximum return. A corporate acquirer, in contrast, will dilute its return by hanging on to the business after the growth in value tapers off. Public companies that compete in this space can offer investors better returns than private equity firms do.

The latter would give companies an advantage over funds, which must liquidate within a preset time—potentially leaving money on the table. Both options present public companies with challenges, including U. Private equity. The very term continues to evoke admiration, envy, and—in the hearts of many public company CEOs—fear. In recent years, private equity firms have pocketed huge—and controversial—sums, while stalking ever larger acquisition targets.

Their ability to achieve high returns is typically attributed to a number of factors: high-powered incentives both for private equity portfolio managers and for the operating managers of businesses in the portfolio; the aggressive use of debt, which provides financing and tax advantages; a determined focus on cash flow and margin improvement; and freedom from restrictive public company regulations. Public companies—which invariably acquire businesses with the intention of holding on to them and integrating them into their operations—can profitably learn or borrow from this buy-to-sell approach.

To do so, they first need to understand just how private equity firms employ it so effectively. However, as private equity firms have shown, the strategy is ideally suited when, in order to realize a onetime, short- to medium-term value-creation opportunity, buyers must take outright ownership and control.

In those cases, once the changes necessary to achieve the uplift in value have been made—usually over a period of two to six years—it makes sense for the owner to sell the business and move on to new opportunities. Private equity firms raise funds from institutions and wealthy individuals and then invest that money in buying and selling businesses.

After raising a specified amount, a fund will close to new investors; each fund is liquidated, selling all its businesses, within a preset time frame, usually no more than ten years.

Alternative Investments and Fixed Income

A fund management contract may limit, for example, the size of any single business investment. Once money is committed, however, investors—in contrast to shareholders in a public company—have almost no control over management. Typically, private equity firms ask the CEO and other top operating managers of a business in their portfolios to personally invest in it as a way to ensure their commitment and motivation. In return, the operating managers may receive large rewards linked to profits when the business is sold.

In accordance with this model, operating managers in portfolio businesses usually have greater autonomy than unit managers in a public company. With large buyouts, private equity funds typically charge investors a fee of about 1. Fund profits are mostly realized via capital gains on the sale of portfolio businesses.

To ensure they can pay financing costs, they look for stable cash flows, limited capital investment requirements, at least modest future growth, and, above all, the opportunity to enhance performance in the short to medium term. Private equity firms and the funds they manage are typically structured as private partnerships.

In some countries—particularly the United States—that gives them important tax and regulatory advantages over public companies. The benefits of buying to sell in such situations are plain—though, again, often overlooked. For the public company, holding on to the business once the value-creating changes have been made dilutes the final return. In the early years of the current buyout boom, private equity firms prospered mainly by acquiring the noncore business units of large public companies. Under their previous owners, those businesses had often suffered from neglect, unsuitable performance targets, or other constraints.

Even if well managed, such businesses may have lacked an independent track record because the parent company had integrated their operations with those of other units, making the businesses hard to value. More recently, private equity firms—aiming for greater growth—have shifted their attention to the acquisition of entire public companies. In public companies, easily realized improvements in performance often have already been achieved through better corporate governance or the activism of hedge funds.

For example, a hedge fund with a significant stake in a public company can, without having to buy the company outright, pressure the board into making valuable changes such as selling unnecessary assets or spinning off a noncore unit. When KKR and GS Capital Partners, the private equity arm of Goldman Sachs, acquired the Wincor Nixdorf unit from Siemens in , they were able to work with the incumbent management and follow its plan to grow revenues and margins.

Many also predict that financing large buyouts will become much more difficult, at least in the short term, if there is a cyclical rise in interest rates and cheap debt dries up. Even if the current private equity investment wave recedes, though, the distinct advantages of the buy-to-sell approach—and the lessons it offers public companies—will remain.

For one thing, because all businesses in a private equity portfolio will soon be sold, they remain in the spotlight and under constant pressure to perform. In addition, because every investment made by a private equity fund in a business must be liquidated within the life of the fund, it is possible to precisely measure cash returns on those investments.

That makes it easy to create incentives for fund managers and for the executives running the businesses that are directly linked to the cash value received by fund investors. That is not the case with business unit managers or even for corporate managers in a public company. Furthermore, because private equity firms buy only to sell, they are not seduced by the often alluring possibility of finding ways to share costs, capabilities, or customers among their businesses.

Their management is lean and focused, and avoids the waste of time and money that corporate centers, when responsible for a number of loosely related businesses and wishing to justify their retention in the portfolio, often incur in a vain quest for synergy. Finally, the relatively rapid turnover of businesses required by the limited life of a fund means that private equity firms gain know-how fast.

Permira, one of the largest and most successful European private equity funds, made more than 30 substantial acquisitions and more than 20 disposals of independent businesses from to Few public companies develop this depth of experience in buying, transforming, and selling. As private equity has gone from strength to strength, public companies have shifted their attention away from value-creation acquisitions of the sort private equity makes. They have concentrated instead on synergistic acquisitions.

Global portfolio structuring

Conglomerates that buy unrelated businesses with potential for significant performance improvement, as ITT and Hanson did, have fallen out of fashion. As a result, private equity firms have faced few rivals for acquisitions in their sweet spot. Given the success of private equity, it is time for public companies to consider whether they might compete more directly in this space. Conglomerates that acquire unrelated businesses with potential for significant improvement have fallen out of fashion.

As a result, private equity firms have faced few rivals in their sweet spot. We see two options. The first is to adopt the buy-to-sell model. The second is to take a more flexible approach to the ownership of businesses, in which a willingness to hold on to an acquisition for the long term is balanced by a commitment to sell as soon as corporate management feels that it can no longer add further value.

Companies wishing to try this approach in its pure form face some significant barriers. One is the challenge of overhauling a corporate culture that has a buy-to-keep strategy embedded in it. That requires a company not only to shed deeply held beliefs about the integrity of a corporate portfolio but also to develop new resources and perhaps even dramatically change its skills and structures. In the United States a tax barrier also exists. Whereas private equity funds, organized as private partnerships, pay no corporate tax on capital gains from sales of businesses, public companies are taxed on such gains at the normal corporate rate.

This corporate tax difference is not offset by lower personal taxes for public company investors. Higher taxes greatly reduce the attractiveness of public companies as a vehicle for buying businesses and selling them after increasing their value. Public companies in Europe once faced a similar tax barrier, but in roughly the past five years, it has been eliminated in most European countries.

Note that two tax issues have been the subject of public scrutiny in the United States. The first—whether publicly traded private equity management firms should be treated like private partnerships or like public companies for tax purposes—is closely related to the issue we raise. Despite the hurdles, some public companies have in fact successfully developed a buy-to-sell business model. Those restrictions make such structures unattractive as vehicles for competing with private equity, at least for large buyouts in the United States.

With the removal of the tax disincentives across Europe, a few new publicly quoted buyout players have emerged. The largest are two French companies, Wendel and Eurazeo. Both have achieved strong returns on their buyout investments. In the United States, where private companies can elect, like private partnerships, not to be subject to corporate tax, Platinum Equity has become one of the fastest-growing private companies in the country by competing to buy out subsidiaries of public companies.

The emergence of public companies competing with private equity in the market to buy, transform, and sell businesses could benefit investors substantially. In compensation for these terms, investors should expect a high rate of return.

However, though some private equity firms have achieved excellent returns for their investors, over the long term the average net return fund investors have made on U. Private equity fund managers, meanwhile, have earned extremely attractive rewards, with little up-front investment. Public companies pursuing a buy-to-sell strategy, which are traded daily on the stock market and answerable to stockholders, might provide a better deal for investors. From where might a significant number of publicly traded competitors to private equity emerge? Their investors would be wary. Also, few corporate managers would slip easily into a more investment-management-oriented role.

Private equity partners typically are former investment bankers and like to trade. Most top corporate managers are former business unit heads and like to manage. Account selection: When you review the tax impact of your investments, consider locating and holding investments that generate certain types of taxable distributions within a tax-deferred account rather than a taxable account. That approach may help to maximize the tax treatment of these accounts.

Read Viewpoints on Fidelity. Charitable giving The United States tax code provides incentives for charitable gifts—if you itemize taxes, you can deduct the value of your gift from your taxable income limits apply. These tax-aware strategies can help you maximize giving:. Instead of deferring taxes, you may want to accelerate them by using a Roth account, if eligible—either a Roth IRA contribution or a Roth conversion.

Also, be aware that while your earnings may be subject to taxes and penalties if withdrawn before those conditions are met, your contributions can be withdrawn at any time without tax or penalty. The cost of education for a child may be one of your biggest single expenses. Like retirement, there are no shortcuts when it comes to saving, but there are some options that can help your money grow tax-efficiently. Health savings accounts allow you to save for health expenses in retirement. These accounts have the potential for a triple tax benefit—you may be able to deduct current contributions from your taxable income, your savings can grow tax-deferred, and you may be able to withdraw your savings tax-free, if you use the money for qualified medical expenses.

Your financial strategy involves a lot more than just taxes, but by being strategic about the potential opportunities to manage, defer, and reduce taxes, you could potentially improve your bottom line. Portfolio management designed to help you keep more of what you've earned. Get a weekly email of our pros' current thinking about financial markets, investing strategies, and personal finance. Please enter a valid first name.

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