📈 More SEC vs Wall Street + JPMorgan Launches Retail PE fund

Private Capital Insider: Weekend Edition

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Equifund: Weekend Edition
October 14, 2023

While the big story this week is most certainly the recent terrorist attack in Israel…

In the world of finance, here’s some of the big stories that are getting buried “below the fold” that we’re paying attention to.

Why should you care about these seemingly unrelated stories? That’s the topic of today’s weekend edition of Private Capital Insider.

-Equifund Publishing

P.S. In case you miss

The American Tax Problem (Part 2)

In the previous weekend edition, we devoted an entire issue to the “rich people don’t pay their fair share of taxes” debate.

At the center of the issue is the Tax Gap – the difference between what is legally owed and what is collected each year.

The gross tax gap in the U.S. accounts for at least $428 billion in lost revenue each year, according to the latest estimate by the Internal Revenue Service, suggesting a voluntary taxpayer compliance rate of 85%.

Don’t worry, it gets worse…

For tax years 2021 and 2020, the latest to receive such IRS estimates, the projected gross "tax gap" soared to $688 billion and $601 billion, respectively.

That marks a significant jump compared to years past — with gross tax gap projections standing at $550 billion for 2017-2019 and $496 billion for 2014-2016.

But before we get into too much teeth-gnashing on the unfairness of it all, let’s talk about the 15% of non-compliant filers.

They can be grouped into three categories:

  • Nonfiling, which means tax not paid on time by those who do not file on time: $77 billion in tax year 2021, up from $41 billion in tax years 2017-2019

  • Underreporting, which reflects tax understated on timely filed returns: $542 billion in tax year 2021, up from $445 billion in tax years 2017-2019

  • Underpayment, or tax that was reported on time, but not paid on time: $68 billion in tax year 2021, up from $64 billion in tax years 2017-2019

The voluntary compliance rate of the U.S. tax system is vitally important for the nation. A one-percentage-point increase in voluntary compliance would bring in about $46 billion in additional tax receipts.

For this reason, the IRS is looking for ways to increase the voluntary compliance rate by making it easier for people to determine how much they owe (and otherwise pay).

But what happens when tax revenue vanishes legally because it simply moves offshore?

How do they do this?

A U.S. company sells its most valuable asset — for a tech company, its intellectual property — to a subsidiary, in a place where the tax rate was extremely low.

Then, that foreign entity charges some sort of “royalty” to the US-based company, that basically sucks out all the profits from that year, and is now recognized as income in the low-tax jurisdiction.

Chances are, you’ve heard about tax havens like the Cayman Islands, Panama, Bermuda, and Switzerland…

But over the past eight years, one country in particular won the global tax game – Ireland.

In the past eight years, the country of five million has watched its corporate tax income triple to the tune of 22.6 billion euros last year, equivalent to almost $24 billion—giving it a budget surplus last year of a comfortable €8 billion euros when many governments are suffering from a post pandemic debt hangover.

Ireland became a hot spot for U.S. companies by slashing its corporate tax rate from 40% to 12.5% starting in the late 90s, and offering a well-educated workforce and a tariff-free way into the European Union.

By last year, there were 950 U.S. businesses operating in the country, employing just under 10% of all Irish workers, according to the American Chamber of Commerce Ireland.

The biggest are Apple, Meta Platforms, Alphabet’s Google, Amazon.com and Pfizer.

But that role has been supercharged since 2015, when changes in international tax rules prompted some U.S. businesses to move hundreds of billions of dollars in intellectual property to the country, such as patents and research.

That allowed some companies, especially tech giants, to register their profits in Ireland even if much of their output or content was made and consumed elsewhere.

When this change was introduced, the influx of U.S. companies to Ireland was so large, it inflated Ireland's GDP by 25% that year.

According to Brad Setser, a senior fellow at the Council on Foreign Relations, last year alone, $10-$15 billion of revenue collected by the Irish government would have been collected by the U.S. in a “sane system.”

And from 1998-2018, it’s estimated that U.S. businesses funneled $1.2-$1.4 trillion in profits to low-tax jurisdictions, via a complex international loophole known as the “Double Irish” (which was closed in 2020).

The BEPS 2.0 Framework we touched on in last week's issue is part of a broader effort to end these tax shifting schemes, by enforcing a global minimum tax rate of 15%.

So what does this have to do with the IRS claiming Microsoft owes $28.9 billion in back taxes, plus penalties and interest?

For years, the company has shifted its profits to Puerto Rico (a U.S. Territory) to avoid taxes; KPMG – the company’s tax consultant – persuaded the territory’s government to give Microsoft a tax rate of nearly 0%.

But in 2012, the IRS got tired of seeing the country's largest corporations stashing billions in tax havens, and decided to go after Microsoft.

It was the biggest audit by dollar amount in the history of the IRS, mounting an extremely aggressive offense against the company…

And Microsoft fought back using every tool it could muster – not only to avoid their own problems, but to prevent the emboldened IRS from putting these tactics to work on other tax-dodging corporations.

Business organizations, ranging from the U.S. Chamber of Commerce to tech trade groups, rallied, hiring attorneys to jump into the fray on Microsoft’s side in court and making their case to IRS leadership and lawmakers on Capitol Hill.

Soon, members of Congress, both Republicans and Democrats, were decrying the IRS’ tactics and introducing legislation to stop the IRS from ever taking similar steps again.

The outcome of the audit remains to be seen — the Microsoft case grinds on — but the blowback was effective. [In 2019], the company’s allies succeeded in changing the law, removing or limiting tools the IRS team had used against the company.

The IRS, meanwhile, has become notably less bold. Drained of resources by years of punishing budget cuts, the agency has largely retreated from challenging the largest corporations.

The original 2020 ProPublica article cited above is definitely worth reading if you want to get an inside look at the decade-long fight between the IRS and Microsoft…

But this week, Microsoft revealed, in a securities filing, that they had received Notices of Proposed Adjustment from the IRS for the tax years 2004 to 2013.

However, there will almost certainly be a lengthy appeals process.

The case, in a way, is the last, great vestige of the IRS, before it was gutted by budget cuts over the course of the 2010s and corporate audits plummeted.

While the recent infusion of billions from the Inflation Reduction Act will allow the agency to rebuild itself in the coming years, the Microsoft case shows the fruit of those efforts could take a long, long time to reap.

JPMorgan Joins the Quest for Retail Money

We’ve spent several issues talking about semi-liquid private funds (also called “evergreen funds” or “perpetual funds”) that are specifically designed for the growing demand from retail investors – most notably, Blackstone’s trifecta of products.

Now, the JPMorgan Private Markets Fund (JMPF) is looking to join the fray.

The launch of JPMF aligns with our long-term vision to lead the global democratization of alternatives, building on our offerings across Real Estate, Real Assets, Hedge Funds and Liquid Alternatives.

Private equity has traditionally been difficult for individuals to access, so we're thrilled to deliver our institutional-grade private equity investment expertise to this investor base through JPMF.

According to Ashmi Mehrotra, Co-Head of PEG at J.P. Morgan Asset Management:

We are witnessing increased demand from all investor types to look beyond public markets for access to compelling private company investment opportunities, and the launch of JPMF is an important step in expanding access to the potential long-term return and volatility benefits of private equity.

Investment selection remains critical in small and middle market companies, where private equity ownership can drive transformational business improvements to accelerate growth, without reliance on financial engineering.

Marketing for the fund began in July, and has attracted a variety of institutional investors, such as pensions and insurers.

So far, the fund has brought in ~$100m in commitments. But now the bank is pivoting to the individual market, as have so many other fund sponsors, and talking publicly about the fund and its strategy for the first time.

Why? Pure speculation on my part, but probably because they couldn’t raise more money from institutional sources, and are now forced into the retail channel.

But for those interested in participating, the fund is organized as something called a “tender offer fund.”

We’ll come back to this in just a moment, but first…

Let’s talk briefly about the difference between “open-ended funds” (which many ETFs and mutual funds are) and “close-ended funds” (like REITs, MLPs, BDCs, and semi-liquid private funds).

The main differences are…

  • Liquidity: Open-ended funds allow investors to redeem their shares from the fund itself on a daily basis. Closed-ended funds issue a fixed number of shares through an IPO, and then trade on an exchange so liquidity depends on the market.

  • Pricing: Open-ended funds are priced daily, based on the value of the underlying assets. Closed-ended funds trade at market prices, which can be at a premium or discount to net asset value.

  • Forced selling: Open-ended funds may need to sell assets to meet redemptions, which can create forced selling pressure. Closed-ended funds are not subject to this issue.

  • Investment flexibility: Closed-ended funds have more flexibility to invest in less liquid assets, like real estate or private equity, since they are not subject to daily redemption requests.

Now, let’s come back to the tender fund structure (and how that compares to something else called an interval fund structure).

Interval funds and tender offer funds are both SEC-registered investment companies that:

  • continuously offer shares,

  • don’t trade on a secondary market, and

  • limit the repurchase of shares to certain thresholds and intervals throughout the year

Fund sponsors are increasingly considering these formats as an alternative to open-ended mutual funds, ETFs, and traditional closed-ended funds.

The recent emergence of tender offer funds, under the Investment Act of 1940, provides individual investors with greater access to private equity, as well as other alternative investments. Lower investment minimums, simplified tax reporting, and potential for liquidity are just some of the key features.

Source: JPMorgan

According to IntervalFunds.org:

For most investors, the differences between interval funds and tender offer funds are so subtle as to be negligible.

However, for those interested in closely monitoring both the liquidity of their portfolios and the value-maximizing capabilities of alternative investments, these distinctions are important.

Both interval funds and tender offer funds sell their shares continuously.

This means that investors can buy shares directly from the fund at any time during the year, and more shares can be created as the fund’s asset pool grows.

The key difference: interval funds have more flexibility in the process of selling shares, while tender offer funds have more flexibility in the process of buying them back.

New SEC Rules on Short Selling

Gary Gensler’s attack on Wall Street continues with the adoption of the new short selling amendment.

In the wake of the 2008 financial crisis, Congress directed the SEC to enhance the transparency of short selling of equity securities.

Today’s adoption will promote greater transparency about short selling both to regulators and the public. This rule addresses Congress’s mandate and improves upon existing sources of short sale-related data in the equity markets.

Given past market events, it’s important for the Commission and the public to know more about short sale activity in the equity markets, especially in times of stress or volatility.

Which past events you ask? The meme stock trading frenzy in 2021, which saw huge surges in certain stocks, like GameStop and AMC, was driven by retail investors coordinating on social media platforms like Reddit.

After two years, the final rules have now been adopted, with the intention of giving traders a broader look at which companies are being targeted by short sellers.

  • The first rule requires institutional money managers with large short positions to file a new SEC form detailing their bets at the end of each month.

    The agency will then aggregate the data and publish it for the market.

    Although the positions and identities of individual short sellers won’t be published, it may provide investors with key information about the actual short interest.

  • The second rule applies to securities lenders, a role often fulfilled by broker-dealers. They will have to tell regulators the terms of each loan they make, including the name and ticker symbol of the security, the amount of the loan, and the fees or rates charged.

    Lenders will also have to identify the type of borrower—such as a broker, customer, bank or custodian. The goal is to help both lenders and borrowers get fair terms, the SEC has said.

Shocker: the industry doesn’t like this, and has “expressed concerns” over the impact this will have on markets.

While this may not have a dramatic impact on our readers in the short term, we continue to applaud the SEC’s efforts to make markets more fair and transparent for retail investors.

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