Burnham's Beat

Contributors Wanted: M&A & IPO Transaction Lists

The other day I published some lists of M&A and IPO transactions in the Software and Internet industries.  A reader made an excellent suggestion that I should turn those lists into Google Spreadsheets and then allow other people to contribute to and use the lists.  This is exactly what I have done and I am now inviting anyone else that would like to contribute updates/edits to the list to e-mail me (just click the "E-Mail Me" link on the left) and I will add you as a contributor to the list.  In return for becoming a contributor you will get several privileges:

1. You will be able to update, edit, and expand the various transaction lists as you see fit.
2. You will be able to use the transaction lists as you see fit.  This includes republishing them on your own blog or website, turning them into an RSS feed, and manipulating them via Google Spreadsheet's APIs. Go crazy, I don't care.
3. Invite other people to contribute and collaborate with the rest of us.

To contribute you will need a Google ID, if you don't have one you can sign up here.

Hopefully we can harness the power of our collective efforts to provide some pretty useful transactions data that will be useful to a wide variety of people.  BTW, I reserve the right to kick out any "contributors" who are free loading and just trying to pick up good content for their site.

As an aside, it's interesting to think of how projects like this may dis-intermediate some of the data brokers that collect, collate and resell this data (such as Factset).  For example, in the financial services industry there are several services that re-sell transactions data to people.  Those folks had better hope projects like this don't take off!

Carried Interest Debate Cont.: The Death of Sweat Equity?

Fred Wilson has a post up this morning on the carried interest debate in which he advocates taxing all carried interest as ordinary income.  As I mentioned in my own post last week, while I think that the evolution of the investment management business argues that some changes to the tax treatment of carried interest are theoretically justifiable, I do not believe that a wholesale condemnation of carried interest is justified or advisable.

At its heart, the critics of carried interest appear to be unwilling to recognize that it's possible to make an intangible investment.  This is a kind of strange argument to make, especially for VCs, given that the concept of intangible investments is deeply ingrained in the venture capital industry where VCs routinely grant multi-million valuations to start-ups that have little more than some "sweat equity" and "intellectual capital" investment in and while these things don't show up on a balance sheet (or a tax return) they are routinely accorded significant value and in many cases end up producing substantial profits (which in most cases are taxed at a capital gains rate).

The issue most of the "anti-carry" crowd seem to have with VCs is that they either A) aren't willing to concede that VC's make any significant intangible investments in their partnerships or B) are willing to concede that they make intangible investments but believe that the management fees they receive mean that they were already well paid to make those investments, so those contributions shouldn't be viewed as investments, but just part of the job.

As I mentioned in my prior post, I am actually somewhat sympathetic to the arguments underlying B), but those arguments do not hold water across the board spectrum of potential GP/LP scenarios. While it may be hard for people to recognize the value of intangible contributions in the case of a VC or PE professional who is pulling down millions in management fees,  it's pretty easy to see this in the case of a small businessman who is investing their time and expertise (and receiving $0 in management fees) to make a restaurant a success or to renovate an apartment building. And if that person is deserving of capital gains treatment for their sweat equity, then why shouldn’t a VC that agrees to operate under similar terms receive capital gains treatment on any profits produced?

I believe that our tax code must favor not only those who invest straight cash, but also those who take real risk and invest their time and other intangibles.  Without the ability to allocate profits on the basis of both tangible and intangible contributions, a lot of skill rich/cash poor folks will be a significant disadvantage to the rich folks that control all the capital as they will be the only ones to get capital gains treatment.  The real irony of the “anti-carry” crowd’s position is that their logic ends up penalizing labor by reserving beneficial tax treatment only for the providers of capital, something that seems entirely inconsistent with the underlying sentiments of the “anti-carry” crowd.

Finally, I think that the “anti-carry” crowd fails to appreciate that limited partnerships are businesses in which the LPs effectively invest in the GP to help make them money. The LPs invest in the GPs because they want access to their intangibles (sweat equity, connections, intellectual capital, etc.) and they give the GPs a disproportionate share of the profits in direct recognition of the value of these intangible investments. From a theoretical perspective this is basically no different from an investor who buys shares in a corporation at a price above tangible book value.  There is basically zero difference between an Limited Partnership and a Corporation from an operating perspective, yet for some reason the “anti-carry” crowd wants to subject profits from one to a different tax treatment than the other. This makes no sense unless you are either A) intellectually lazy or B) your real intent is to abolish capital gains treatment on all profits regardless of what the legal structure of the entity that produces them is. It is a very slippery slope for anyone who really thinks about this in an intellectually honest way.

Put another way, let's say there is a VC that does not take any management fees, but still works works hard for 5 years to get a successful outcome on an investment. Can anyone say with a straight face that the VC has not made a substantial investment into that entity even though no cash has changed hands?  I realize that management fees are (or at least should be) the big issue here because they negate in theory and reality both the "risk" and the "investment" nature of the time that the VC spends, however it is very interesting to note that entrepreneurs (and many corporate managers for that matter) not only get sweat equity stock but also get salaries and benefits and yet no one is saying that the capital gains on the sale of their stock should be considered ordinary income. Why should a VC be treated any different? They take the risk of starting a business (an investment management business) and then get investors to agree to a deal in which they get a disproportionate share of the profits relative to the actual capital invested (just like entrepreneurs do). Yes, they get a salary, but so do entrepreneurs and employees at normal companies and yet no one is talking about killing off their cap gains treatment ... at least not yet.

Software and Internet IPO and M&A Lists

Every month I keep a record of all significant public company activity in the sectors I am most interested  in: Software & Internet.   I keep records of all IPOs in those sectors as well as all public company M&A.  I've decided to try out Typepad's relatively new "page" feature by open sourcing these transaction lists.

The links should be good forever and I will try to update the lists each month as I already do this internally.  The lists start in 2004 and are current as of 5/30/07.  Recently announced M&A deals are not listed because they have yet to close.  It's kind of fun to take a walk down memory lane, and see just what has happened over the last few years in each sector.  So without further ado here are the lists:

Internet IPOs
Internet M&A
Software IPOs
Software M&A

If you see anything missing or anything that needs a correction just e-mail me.

Yahoo Buys Rivals From $75M More Than Their 2001 Offer

Yahoo apparently agreed to buy Rivals.com for $100M today and that brought me back down memory lane a bit, so I thought I would share.  In Q1 2001, Rivals was hemorrhaging cash and appeared to be on its last legs.  The site was still attracting a lot of traffic and producing very high quality content, it's just that their cost structure was way to high.  At the time, Yahoo stepped in an offered to buy Rivals for $25M in cash but they proposed a incredibly complex structure designed to somehow keep the near term losses off of their books.  That deal fell through (like so many "rescue attempts" did in 2001) and the company was basically liquidated by the VCs.

Fast forward 6 years later and Yahoo is laying out $100M in cash for a newly revived Rivals.  From what I understand, the founder bought out all the assets in 2001 and restarted the company with a non-bubble cost structure and mentality.  Six years later he is rich man and Yahoo is out an additional $75M because they let a bad cost structure distract them from the reality of a great product.

For me, a deal like Rivals reinforces some great investment lessons:

1)  Even if good products are damaged by bad business decisions, they are still good products.
2)  The time to buy is when everyone else is selling.
3)  You can always reduce expense more.
4)  Don't give up on a good product too soon.

Congrats to any of the original Rivals team for sticking it out.  That's what being a passionate entrepreneur is all about.

The Tax Man Cometh: Carried Interest, Risk, Fees, and Taxes

So there’s a move a foot by some within Congress to tax all carried interest as ordinary income instead of capital gains.  In case you aren’t familiar with the term, carried interest is the share of profits that the general partner within a limited partnership receives. Traditionally, all of the profits generated by a partnership  have been treated as capital gains so long as the investments that generated the profits have been held at least a year.  This means that general partners in VC, Private Equity, or Hedge funds (funds which typically are structured with a carried interest) not only get highly leveraged returns on their own investments, but that any profits produced get very favorable tax treatment (15% vs. 35%).

A Bad Way To Deal With An Admitted Problem
Originally I was going to write a post about how this idea would require a complete rewrite of the tax code and how at its heart it’s a Marxist attack on capitalism, but I figure that A) it would be seen as entirely self serving (which to some degree it is)  B) I don’t think it’s going to happen as currently envisioned given how many feet the government has to step on to make this change happen.

However the more I thought about it, I think it should honestly be said that the proponents of such measures have a few decent points which I think that the entire investment community, in an honest moment of reflection, should probably admit as valid.

Before I do so, let me first state that it would be crazy (and highly impractical/improbable) for the government to enact a blanket change to the tax treatment of the profits generated by the General Partner in a Limited Partnership.  Limited partnerships exist for a very good reason: they are an efficient vehicle for making highly productive capital investments that generate future economic growth and tax revenue.   This growth effect is why Limited Partnership investments and most other forms of capital investment, very sensibly, get favored tax treatment.  In a country with a negative savings rate, we need to do all we can to spur investment.  In addition, while the General Partner’s clearly get great leverage on their investment (usually 20/1 sometimes even 50/1), they are not just risking their own capital, but they are making a substantial investment of “sweat equity” which the limited partners obviously feel is very valuable.  If general partner’s are prepared to take the risk of a 100% loss on not just their money but also their “sweat equity”, there’s really no reason in a capitalist society why their investment shouldn’t be treated like any other capital investment.

Risk Based Investing Without The Risk
That said, as fund sizes have exploded in the last 5 to 10 years, the level of risk that the General Partner is really taking has arguably declined dramatically because the fee income for many funds has become so huge that many of the general partner’s will make a ton of money even if their fund is a total disaster.   After all, it’s hard to claim you are risking a lot of “sweat equity” when you are driving around in an air conditioned Bentley.

For example, in the VC industry if you go back to 1990, according to the NVCA the average firm size was $82M and they had an average of just over 10 “principals” at the firm (10.2 to be precise).  With a 2% management fee, that pencils out to about $164K in management fee revenue per principal, and that’s before all operating expenses.  With fund sizes this small, the general partners were clearly not living high on the hog when it came to management fees.  In fact, if the funds didn’t make a decent profit it would be safe to say that the opportunity costs for most of the partners at the funds would have far outweighed any fund returns.

By 2002, the average firm size had risen to $284M, but the average principals per fund had actually dropped to 9.5.  Five years later I don’t know what the exact figures are, but my guess is that the average is now above $300M and the number of principals has either stayed constant or gone down, but average management fee is now probably closer to 2.5%.  What that means is that at the average firm now generates $789K/year in management fees per principal and many of the top firms (ones in the so-called 3/30 club) have funds under management of well in excess of $1BN, 3% management fees and just 5-10 full partners.  Such funds can and do pay their partners $2-$3M a year before the investors get a single penny back.  Many of these funds also pay the capital contributions of their partners out of management fees meaning that the individual partner’s never even have to write a check into the fund.

Under these circumstances it’s not hard to see how venture capital has become a fairly riskless proposition for many GPs and that it’s pretty hard to argue folks are investing a lot of sweat equity when they are pulling down at least a million dollars a year for getting out of bed in the morning.  Put another way, in a 3/30 $1BN fund, the general partner only has to put up $10M but in return is guaranteed to get at least $150M in fees over just the next 5 years.  With numbers like that, it’s hard to argue that the partner’s are really taking any risk at all and if they aren’t taking any risk then why in the world should they get any favorable tax treatment for their “sweat” equity since they clearly aren’t sweating the risk of a loss.  If they do lose their share of the $10M they can just fly in their private jet to their beach house Maui to console themselves.  The situation is even more pronounced in the private equity world where fund sizes are now racing past $10BN.  At this level, the compensation for partners at many private equity fund’s makes VCs look downright parsimonious.

So while I agree with and strenuously defend the principle of affording capital gains treatment to those general partners that are willing to take the risk of investing their own cash and sweat equity to produce returns, I think the reality is that in a large number of institutional funds today (be they VC, Private Equity or Hedge Funds), the principals are really not risking much if anything and are pretty handsomely compensated for the time and energy they spend on their portfolio investments.

A Modest Proposal
All that said, the solution that government is proposing is, as usual, terribly misguided.   Taxing all income to general partners as ordinary income is a sure way to A) unfairly penalize those limited partnerships where the general partner really is taking a significant risk and investing a lot of sweat equity (which usually are small business partnerships focused on things such as restaurants and apartment buildings) B) reduce the overall level of private investment C) hurt the businesses that depend on this investment capital for growth.  While I think that a blanket change in the tax treatment is bound to have these negative effects, there are some other changes Congress can make which insure that general partners really are taking real risk and investing real sweat equity to help growth the economy such as:

1. For tax purposes, reduce the general partner’s tax basis by the amount of after-tax management fees it pays out to its members.  In other words, if an individual partner invests $1M in the fund, but gets a salary from the fund that generates an after tax income of $1M, then that individual’s basis should be reduced to zero, which effectively means they invested nothing and should therefore have to pay ordinary income taxes.
2. Raise the % of the fund that the general partner needs to contribute to qualify before it qualifies for capital gains treatment from 1% to 5%.   This makes the level of risk for the general partner a lot more meaningful.  One major drawback of this approach though is that general partner’s without a lot of cash will be hard pressed to meet stiffer capital requirement and this might unfairly advantage old rich firms over new upcoming ones.
3. Some combination of 1 and 2.

These changes increase the level of risk and neutralize the risk reducing effects of copious management fees.  Firms can still choose to pay their partners a ton of money, but if they do those people will lose favorable tax treatment on their investments unless they are willing to invest a lot more cash.  This kind of dynamic tension between current income and capital investment risk is exactly what LPs face, so why shouldn’t GPs face the same trade-off?

It's All About the Benjamins
Of course, the real agenda in congress is not fixing the limited partnership incentive structure, but finding an easy way to raise several billion in additional tax dollars, so I really don’t think the Congressmen care that their proposals are likely to backfire and are logically inconsistent with both capitalism and the fundamental philosophy behind our tax code; they are just trying to make a quick buck by alienating a few as people as possible while wrapping the whole exercise in some media-friendly populist pandering.   Might be good politics, but it’s bad policy.