By generating superior returns over the past decade, the private equity industry has been rewarded with a growing share of institutional investment dollars, and has evolved as a growing force within the economy. But perhaps because of that success, many investors – particularly those that are taxable – have not paid enough attention to the tax aspects of their private equity holdings.

According to an Ernst & Young report, “until a few years ago, tax planning was an afterthought for most private equity firms.” But investors and private equity firms can no longer ignore the fact that sub-optimal tax structures can have a negative impact on portfolio returns. In a true paradigm shift, tax considerations are now increasingly integrated into private equity firms’ investment approach to drive better investment results.

Over the past two decades, private equity has gone mainstream. Private equity was once an asset class that predominantly attracted taxable investors such as high-net worth investors, wealthy individuals and family offices who were able to commit assets for the long-term. Today, however, large tax-exempt financial institutions – pension funds, endowments and foundations – dominate the private equity industry. According to The Wall Street Journal, private equity attracted more than $300 billion in new investor commitments in 2006. Many sophisticated institutions are said to have increased their allocation to "alternative assets" up to a total of 15% to 20%.

As the primary providers of capital to the industry, it is no surprise that tax-exempt investors have ensured that their tax concerns have dictated the structure of most private equity funds.

What has this meant for taxable investors? Unfortunately, until quite recently, it was not widely understood that, for sophisticated taxable investors (family offices, corporations and wealthy individuals), the typical private equity fund is extremely tax-inefficient. Why? Because its legal structure is optimized for its major “customers” – tax-exempt institutions who are averse to generating Unrelated Business Taxable Income (“UBTI”). Income from a flow-through entity such as a limited liability company (LLC), even a passive investment owned through a private equity fund, is considered UBTI, and receiving excessive amounts UBTI can jeopardize a tax-exempt institution’s tax status. Thus most fund documents incorporate provisions essentially prohibiting UBTI generation.

The private equity industry is belatedly beginning to recognize the opportunity offered by adopting new structures that take into consideration taxable investors’ particular tax situation. Specifically, there is a growing awareness that flow-through structures such as LLCs can offer built-in flexibility and significantly reduce tax liabilities for taxable investors, as compared to C-corporation structures. These structural benefits are threefold:

1. Eliminating double taxation on distributions or upon exiting an investment.
2. Building up tax basis over time, which further reduces the investors’ capital gains taxes at exit.
3. Adding incremental enterprise value that is potentially received from the buyer of a portfolio company who is able to benefit from a tax basis step-up.

A recent analysis by Frontenac Company shows that, over the life of a typical portfolio investment, these benefits can result in an incremental return of 0.5 to 2.5x on invested capital. A fund structure favoring the interests of taxable investors can produce an annualized rate of return that is 250-260 basis points higher after tax than one which prohibits generating UBTI.

With this in mind, it is clear that sophisticated taxable investors will increasingly gravitate towards investing in private equity funds that combine the prospect of competitive investment performance with the benefits of a structure that is designed to enhance their long-term after-tax returns. At long last, as Ernst & Young observes, “Tax savvy is becoming something of a differentiator in the private equity space.”