How the Blackstone Goodwill Write off Really Works

Recently there have been a number of articles about a $1B goodwill write off generated for the Blackstone insiders (i.e. its founders and senior managing directors) in its recent initial public offering (IPO).

Apart from the often either alarmist or apologist nature of the articles, they are, in my opinion, if not inaccurate, so thin on details  (OK I will say it - "dumbed down") as to make it virtually impossible to understand what actually transpired. I saw a blog that  said that some poor fellow read one of these articles 100 times and still could not understand what had happened. It is for those malnourished, intellectually curious souls that I am writing this blog entry.

In my opinion you can't make heads or tails of what happened without an organizational chart of the post IPO Blackstone structure. I have embedded such a chart above. Just click on it to blow it up to legible size and print it out (hopefully you can) to follow this discussion. (For better quality you can also get the chart from the S-1 filings with the SEC on the IPO which are publicly available.)

To start at the top of the chart: pre IPO the insiders (represented by the left oval at the top of the chart) privately owned management companies that managed several investment partnerships - all essentially operating under the "Blackstone" name.  In the IPO the insiders contributed noncontrolling interests in some of these management companies to what is now a public company named Blackstone Group LP (Blackstone Group - the biggest triangle in the middle of the chart) and the insiders (middle oval at the top of the chart) continue to control Blackstone Group through an intermediary LLC (the rectangle above the biggest triangle - there may be two rectangles at this level in a later chart as some type of limited voting LLC was I think also established but that is not relevant to this discussion) which is the general partner which has no economic rights in Blackstone Group or anything anywhere else on the chart.

Still at the top of the chart: limited partnership interests in Blackstone Group were sold in the IPO to outside investors (the oval at the top right of the chart) of which the Chinese government (through I believe the not very imaginatively named "State Investment Company") purchased 40%. The amount raised on the IPO has been reported as $4.75 Billion.

Moving down the chart: Blackstone Group via purchase from the insiders (the left top oval on chart) using IPO proceeds has become the sole general partner of two partnerships (the smaller triangles one tier below Blackstone Group on the chart) and the sole owner of three entities treated as corporations (the 2 rectangles also one tier below Blackstone Group - one of the rectangles contains 2 corporations) through which management fee and carried interest income from the group's investment funds will flow. Think of these two partnerships and three corporations as the middle tier entities.

Moving to the bottom of the chart: the middle tier entities serve as general partners of five fund limited partnerships (the 5 triangles on the lowest tier of the organizational chart) and the middle tier entities have a 22 percent share of each lowest tier fund limited partnership. The insiders (left top oval - sorry you have to jump back up to the top of the chart) retained a 78 percent economic interest in the management and carry fees generated from the lowest tier limited partnerships.

When Blackstone Group (biggest triangle) bought interests in the management companies (middle tier entities) from the insiders (top left oval), the basis in the tangible and intangible assets of those middle tier entities was immediately increased (using something like Section 732 of the Internal Revenue Code or Section 1012 of the Internal Revenue Code, or Sections 743(b) and 754 of the Internal Revenue Code) by the purchase. This, without more, would have entitled Blackstone Group (biggest triangle) to larger deductions for depreciation of tangible assets and amortization of intangible assets, notably goodwill (about $3.7 billion to be written off over 15 years). [Basis can also be increased in the future by the insiders exchange of their 78% economic interests in the fee and carried interest stream from the lowest tier entities (with an Internal Revenue Code 754 election in effect) for interests in Blackstone Group, the public company]. However, for reasons I will next explain, the lion's share of these larger deductions did not flow through to Blackstone Group (again, at risk of hammering the reader, the biggest triangle).

Go back to the middle tier companies: two of these (the left rectangle) are US corporations. This means that they are technically liable for annual income tax (since a corporation's tax income, losses, deduction, and credits do not flow through to its owners, corporations can be thought of as "blocker" entities) which they can reduce by the annual amortization of their share of the goodwill. This future tax reduction benefit is referred to as a "tax receivable".

A corporation's tax receivable can be sold and that is precisely what happened here. The US corporations (the left mid tier rectangle) entered into a tax receivable agreement with the insiders (the upper left hand oval) to pay the insiders 85 percent of the cash savings that the corporations will realize as the result of amortization (the 15 year write off) of increases in tax basis of assets and other tax benefits, including any associated with the tax receivable agreement itself. Some sources have indicated that this savings is expected to be about $1.1 Billion.

Here is the magic: the value of the tax receivable will seemingly be taxed to the insiders as part of the compensation received from the sale but at the infamous (as favoring the wealthy) 15% rates applicable to capital gains. However the tax benefit from the goodwill amortization will save the blocker corporations future taxes at 35% rates, 85% of which savings will get paid to the insiders under the tax receivable agreement. This has been referred to as a "tax low, deduct high" strategy. Moreover, on account of their retained control the insiders may be able to accelerate some of the tax benefits through disposition of blocker corporation assets bearing the goodwill.

A recent New York Times article (July 13, 2007) indicated that the present value of the insiders' share of tax benefit from the tax receivable would outstrip the taxes paid by the insiders on the IPO sale cum tax receivable agreement by $198 Million. That has set off a maelstrom with the pols, the pundits, the businessmen (e.g. Blackstone saying the Times article was "filled with inaccuracies, myths and misrepresentations that give a false impression of Blackstone's tax situation and that of its partners" such as failing to note that the tax benefit of the tax receivable would be taxable to the insiders as paid to them and allegedly lowballing the discount rate in valuing the tax benefit and hence allegedly overstating it) , and John Q. Public all getting in on the fray. Hopefully, this article will, while not resolving the fray, at least have given those who took the time to work their way through it a much more solid understanding of the facts behind it.