In January 2020, Glenn Youngkin, now the Republican governor of Virginia, got some welcome news. A complex corporate transaction had gone through at the Carlyle Group, the powerful private equity company that Youngkin led as co-chief executive. Under the deal, approved by the Carlyle board and code-named “Project Phoenix,” he began receiving $8.5 million in cash and exchanged his almost $200 million stake in the company for an equal amount of tax-free shares, according to court documents.
The Project Phoenix payout came on top of $54 million in compensation Youngkin had received from Carlyle during the previous two years, regulatory records show. Youngkin retired from Carlyle on Sept. 30, 2020; he won the governor’s election in November 2021.
Youngkin was not alone in receiving the 2020 windfall, according to the court documents. Eight other wealthy Carlyle officials received over $200 million in cash in the deal, paid for by the company. David M. Rubenstein, Carlyle’s billionaire founder and co-chairman, received $70.5 million worth. All of the Carlyle executives exchanged their company holdings into tax-free shares, valued at a combined $4.57 billion, according to figures from the lawsuit and the stock's price at the time.
Now, that transaction is under attack by a Carlyle shareholder in Delaware Chancery Court. The suit, filed last week by the city of Pittsburgh Comprehensive Municipal Pension Trust Fund, says the $344 million deal harmed Carlyle’s stockholders, who received nothing in return when they funded the payday.
Meanwhile, the Carlyle insiders who received the payouts escaped a tax bill that would have exceeded $1 billion, according to the complaint, which accuses Rubenstein, Youngkin and other Carlyle officials of lining their own pockets at the expense of people like police officers and firefighters.
“The kind of impunity that Carlyle’s control group acted with is shocking and unacceptable,” lawyers for the Pittsburgh pension fund said in their complaint.
“The beneficiaries of the city of Pittsburgh Comprehensive Municipal Pension Trust Fund are municipal fire and police personnel serving the city of Pittsburgh. Many are first responders putting their lives on the line every day. They depend on the integrity of the financial markets to provide for their retirement.”
The Carlyle payout exemplifies the private equity industry’s laser focus on avoiding tax bills.
Private equity investors already receive special tax treatment on their earnings, under what is known as the carried interest loophole. Much of their income is taxed at 20%, far below the 37% maximum paid by high-earning salaried workers. Initially, the Inflation Reduction Act of 2022, which just passed the Senate, had narrowed the loophole’s benefits, but the change disappeared at the insistence of Kyrsten Sinema, the holdout Democratic senator from Arizona, according to news reports.
A Sinema spokeswoman told CNBC that she “makes every decision based on one criteria: what’s best for Arizona.”
Carlyle’s 2020 deal cited in the lawsuit is a new twist on a type of contract known as a tax receivable agreement, or TRA. Companies and their founders typically create such agreements in conjunction with initial public offerings of the companies’ shares.
Under normal circumstances, TRA payouts can be a win-win for both a company and its insiders, market participants say, because both parties get something of value — the insiders get stock, and the company gets a tax benefit when they sell it.
But in a highly unusual move that was unfair to Carlyle’s shareholders, lawyers for the Pittsburgh pension fund say, Carlyle paid cash to the insiders and structured its deal as a tax-free exchange of the insiders' holdings, allowing them to avoid huge tax bills on the stock they received in the deal. This meant the transaction generated no tax benefits to the company.
Youngkin, for example, made a tax-free exchange of his 5.7 million units of Carlyle when the deal occurred — worth almost $200 million at the time — and received the same number of shares in the new corporation, the lawsuit says. Under the typical TRA, such exchanges are generally taxable — when the insider sells and pays taxes on the gains, the company receives a tax benefit, the lawsuit and market participants say. But this did not occur in the Carlyle deal, the lawsuit says. The $8.5 million in cash Youngkin received under the deal is subject to taxes, however.
According to the lawsuit, the cash payout and tax-free exchange was “an extreme outlier” among such agreements, designed by the Carlyle insiders “to maximize the benefits for themselves in every possible way, to the detriment of the company and the public stockholders.”
Asked to respond to the lawsuit’s allegations, a spokesperson for Youngkin provided this statement: “When Mr. Youngkin was a member of Carlyle’s leadership, the Carlyle board and an independent special committee retained independent experts and advisors to consider and approve a transaction that had significant benefits for the company and its shareholders. The plaintiff’s allegations are baseless and will be vigorously defended against.”
A Carlyle spokeswoman said in a statement: “Carlyle was the first U.S. private equity firm to convert to a one share one vote, best-in-class governance model creating better alignment with public shareholders who now have a greater vote and voice.”
Rubenstein, through a spokesman, declined to comment.
Lawyers representing the Pittsburgh pension declined to comment further on the suit.
Andy Lee, a New York City-based asset manager who is not involved in the suit, expressed concerns to NBC News about the details it outlined.
“If the allegations are true, we would discourage such behavior on the part of management,” said Lee, the chief investment officer of Parallaxes Capital, a financial firm that buys TRAs. “They are supposed to represent the interests of public shareholders.”
$283 million in cash to Leon Black
The $344 million Carlyle payout sprang from two related events, the lawsuit states. The first was a change in Carlyle’s corporate structure, from a publicly traded partnership to a corporation. The second was the buyout of a tax receivable agreement the insiders had previously struck with the company.
Youngkin was one member of an eight-person committee of high-level Carlyle officials working on the TRA deal, the lawsuit says.
If company founders or early investors are subject to a tax receivable agreement, as they sell their holdings over time they pay taxes on the gains. Under tax rules, those payments create a benefit for the company, known as a tax asset, that the company can use to offset what it owes the IRS when it generates profits.
TRAs are becoming increasingly popular among public companies, regulatory documents show. Some 180 companies referred to tax receivable agreements in their Securities and Exchange Commission filings so far this year, according to Sentieo, a provider of a financial analysis and investment research platform. That’s double the 90 companies that mentioned the agreements for all of 2017.
The transactions have received scant attention in the financial press, and few deals have been controversial, because they are disclosed and they deliver a benefit to public shareholders, market participants said.
But a handful of recent TRA transactions involving prosperous private equity firms are coming under scrutiny, Delaware Chancery Court filings show.
In early March 2021, for example, Apollo Global Management, the huge private equity firm co-founded by multibillionaire Leon Black, agreed to buy out tax receivable agreement rights held by a group of the company’s top officials, court documents say. Citing documents received by an Apollo shareholder under a books and records request in Delaware Chancery Court, a filing in the matter last fall says that five Apollo officials received almost $600 million in cash when the company purchased their tax receivable agreement rights under a change in the company’s structure. Together, the five officials conducted a tax-free exchange of company stakes worth $7.5 billion, according to figures from the court filing and the company's stock price at the time.
Black received $283 million in that March 2021 deal, and four other Apollo executives and directors — two of them multibillionaires, according to Forbes magazine — shared in another $295 million, the filing says.
A few weeks after the transaction, Black stepped down from the firm. That January, the company’s law firm had issued a report detailing Black’s long-standing financial relationship with the late Jeffrey Epstein, the financier who died by suicide while awaiting trial on federal sex trafficking charges. It cleared Black of wrongdoing, but he stepped down in March 2021, citing “the relentless public attention” on his Epstein ties.
A spokesman for Black did not respond to an email seeking comment about the TRA deal.
Asked about the Delaware filing, a spokeswoman for Apollo disputed that the payout was made under a TRA. Rather, she said in a statement, it was “to facilitate Apollo’s transition to a single class of common stock, among other corporate governance and structure changes — which benefited all shareholders.”
The company founders “gave up their right to control Apollo and, along with certain other senior Apollo professionals, forfeited a valuable economic asset to which they were legally entitled. In addition, the payments were negotiated solely by a committee of independent directors with independent advisors.”
‘Infected by conflicts of interest’
Tax-free payouts to executives of top private equity firms are notable because the tax code already allows them to pay much lower tax rates on their earnings. The tax treatment has helped propel many top private equity executives to billionaire status in recent years.
Private equity firms use large amounts of debt to buy companies that they hope to sell at a profit in a few years. The firms have taken over large swaths of the U.S. economy, acquiring companies in almost every industry, including health care, fast food, retailers, residential rental properties, nursing homes and pet care.
The firms say they resurrect struggling companies, but academic research shows they can also have a pernicious effect on the companies they buy, including job and benefit cuts, as well as pension depletions.
Three private equity firms benefited in another recent TRA payout, according to a Delaware Chancery Court suit filed in June by an International Brotherhood of Electrical Workers pension plan. Unlike the Carlyle and Apollo deals, the transaction was not tax-free; instead, it was problematic, the lawsuit says, because the payout was far too rich.
The suit is against the board of directors of GoDaddy, a web hosting firm that issued shares to the public in 2015. Early investors in GoDaddy included KKR, Silver Lake Partners and Technology Crossover Ventures, three wealthy private equity firms. None of the firms was named as a defendant.
In July 2020, GoDaddy paid $850 million in a tax receivable agreement generating $201 million to KKR, $212 million to Silver Lake and $92 million to Technology Crossover Ventures, the lawsuit said. The payout was the largest ever by a public company under a tax receivable agreement with pre-IPO owners, the suit noted.
According to the complaint, GoDaddy didn’t have enough cash to make the payment, so it borrowed $750 million for it. Even more troubling, a year before the payout, GoDaddy had valued the TRA at $175 million, based on its independent auditor’s assessment, the lawsuit said.
The pension fund sued GoDaddy’s board, saying the transaction was unfair and that it had been “infected by conflicts of interest.” It alleged the board did not seek approval of the deal from GoDaddy stockholders, for example, and a board committee formed to oversee the transaction decided against hiring a financial adviser to opine on its fairness. On top of that, the board and the special committee “had historical and ongoing financial and professional ties to the founding investors that benefited from the overpayment,” the lawsuit contends.
Representatives of GoDaddy, KKR and Silver Lake Partners declined to comment. Technology Crossover Ventures did not respond to an email seeking comment.
Payments under tax receivable agreements can have significant impacts on companies’ financial results, said Nick Mazing, the director of research at Sentieo. “We have seen examples where the associated TRA liability is a significant percentage of a company’s overall liabilities,” Mazing said, “and where the ongoing TRA payments consume double-digit percent shares of the cash flows generated by operations.”
SEC filings by El Pollo Loco, a restaurant chain, show that for the three years ending in 2019, it made $24.1 million in tax receivable payments. The payments reduced its cash flow from operations by 15% over the period, the filings show.
Given the rise in TRAs and the litigation surrounding them, investors are likely to pay more attention to them, said Jonathan Choi, an associate professor at the University of Minnesota law school and an expert on tax law.
“I think that early on these agreements were drafted without knowing how they would play out,” Choi said. “Going forward, law firms and companies will take more care to specify what will happen in an early termination and be more careful about what was disclosed to shareholders.”
CORRECTION (Aug. 11, 2022, 6:54 p.m. ET): A previous version of this article misstated some of the details of the Carlyle Group deal involving Glenn Youngkin. Youngkin didn’t receive $8.5 million in stock, tax free, from the deal; he in fact received $8.5 million in cash subject to taxes and tax-free status for his almost $200 million stake in the company. The article also misstated what Apollo Global Management executives received in a 2021 deal. Five Apollo executives received almost $600 million in cash subject to taxes and tax-free status for their company stakes worth $7.5 billion at the time.