Private equity: End of the golden age?

NEW YORK (Fortune) -- The attack that Congress is mounting on private equity may mark an historic inflection point, a grisly finale to what buyout king Henry Kravis lauds as the "golden age." Thursday, top ranking members of the Senate Finance Committee announced legislation aimed at substantially raising the taxes paid by publicly-traded private equity companies.

Their immediate target appeared to be the Blackstone Group, which plans the biggest IPO in five years, an offering that could give Steve Schwarzman's firm a market cap of $40 billion, on a par with Lehman Bros, and almost half the valuations of Goldman Sachs and Morgan Stanley.

At first glance, the proposed legislation looks extremely dangerous to an industry that's reshaping corporate America at dizzying speed. But in reality, it's another proposal, one that would roil this entire privileged world, that's the real potential killer.

First, let's look at the tax proposal on the table, the one that's causing all the angst. Private equity firms make money two ways. First, they charge a 2 percent fee on all the capital they raise from pension funds, university endowments and other institutions.

Second, they pocket 20 percent of the gains they generate from buying companies, fixing their operations, then reselling them through IPOs or sales to corporate buyers or other private equity firms. The big money comes from those gains, known in the trade as "carried interest." And carried interest comes with rich tax benefits. The owners, or general partners, pay capital gains rates of just 15 percent, versus the 35 percent to 45 percent levied on corporate earnings.

As the law stands, private equity can keep those tax benefits as public companies. The reason: They can qualify as partnerships instead of registering as corporations - at least for now. The one shop that's publicly-traded, Fortress Investment Group (Charts), gets an earnings lift from the same low tax rates as private partnerships. But senators on both sides of the aisle complain that publicly-traded private equity firms shouldn't benefit from what amounts to an unfair loophole. They want to put private equity firms that go public on the same footing as other corporations. That move would raise the effective tax rate, simply from going private to public, from 15 percent to between 35 percent and 45 percent. In theory, that change could knock over $600 million off Blackstone's earnings, and cut $10 billion, or 25 percent, from its market cap.

That might not disappoint the big Wall Street firms with private equity arms, notably Goldman Sachs (Charts, Fortune 500) and Merrill Lynch (Charts, Fortune 500). Though private equity does provide them with some tax benefits, it appears that they're stuck paying the regular corporate rate on most of their private equity earnings. That puts them at a competitive disadvantage to the Carlyles, KKRs and Blackstones.

Even as a public company, Blackstone might keep that edge. Why? Because the legislation contains a provision that exempts firms that have already filed for offerings with the SEC from paying the regular tax rate until 2012. It's unclear if Blackstone will qualify for the exemption, but it's fighting to get in before the door slams. Hence, Blackstone could continue keeping a far bigger share of its profits than its Wall Street rivals for five years. Even so, the looming tax increase would shave billions from the market value it would have achieved from a permanent tax break.

It's unlikely that Blackstone will pull its IPO, even if it doesn't qualify for the grace period. The looming legislation, however, could have a chilling effect on rivals that are pondering their own public offerings. Those candidates would have to start paying the big tax rates as soon as they go public.

Many potential followers of Blackstone may reckon that they're better off staying private. Most likely scenario: If intense lobbying can't kill the proposed bill - and the smart money says it can't - the stampede to go public may slow or even stop.

But most private equity is still just that - private. The real potential haymaker for the industry is a proposal, now gaining support in Congress, that would tax the profits private equity reaps on selling companies not at the low cap gains rate, but at the regular income tax rate. That would raise the government's take on carried interest from 15 percent to around 35 percent.

"The real issue is whether carried interest will be taxed as regular income," says Dr. Richard Dietrich, professor of accounting at the Fisher College of Business at Ohio State. "If the partnerships are forced to pay the higher rates, it would be a big blow to private equity."

If taxes do jump for everybody - not just the publicly traded firms - what's the likely outcome? For certain, a lot of the current fun and profit would leave private equity. It's likely that the number of firms would diminish.

It's also likely that they'd pay smaller premiums for their targets, since the potential profits would shrink substantially. And this threat is coming at a time when private equity is showing serious signs of a bubble. Among the warning signals: quick flipping of targets, leverage so immense that cash flows barely cover interest payments, and a proliferation in special dividends that further enrich the sponsors but sap the companies' already meager financial resources.

The issue is particularly fascinating because private equity is all about taxes, and not just the low taxes it currently pays on its profits. Much of the value it extracts from its targets comes from eliminating corporate taxes. Private equity sponsors load companies with debt, frequently wiping out all reported earnings. Hence, the money that used to go to the government suddenly flows to bondholders. That financial legerdemain immediately raises the value of the target by the present value of the tax savings. Presto, the sponsor makes money not by selling more computers or increasing inventories turns but by eliminating taxes. That's a tax break that will stay in place.

Private equity will remain a force to be reckoned with. But if the tax haymaker falls, so will the Golden Age.