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'Wonderful Time, Wish You Were Here': US Buyout Funds Positioning to Profit from Potential New Tax Breaks

"This is an absolute wonderful time" to be in the private equity business, Blackstone head Stephen Schwarzman has told Bloomberg. Blackstone is currently raking in fees "advising" insurance giant AIG on how to raise cash through selloffs in the wake of the gigantic 2008 bailout.

Blackstone and the other pe funds have been lobbying hard to shape the Obama administration's stimulus package, now headed for the Senate, to extract maximum benefit from possible tax relief provisions on cancelled debt.

The Senate version (different from the one that just passed the House of Representatives) would allow companies which use cash to buy back their debt in 2009 and 2010 to defer tax liabilities on the operation until 2011, and then to pay it back over a number of years. The ultimate cost to US public revenue is estimated at around USD 26 billion.

For US tax accounting purposes, savings on cancelled or reduced debt constitute taxable corporate income - an unwelcome liability at a time when the funds are desperately struggling with their sinking, heavily leveraged portfolio companies. Thus, for example, a pe-owned company which successfully exchanged one million dollars worth of debt for half a million in cash would owe tax on the 500,000 saved, which is treated as income. Taxed as income, it beats paying back interest plus principle, but it isn't easy to pull off, even with investors scrambling to save whatever they can.

In December 2008, for example, the TPG/Apollo-owned Harrah's Entertainment, the world's largest gaming corperation taken private for a premium price at the height of the LBO boom, reduced some of its debt by USD 1 billion. This was accomplished by persuading some bondholders to accept cash or swap existing debt for later maturing new bonds. Altogether, only a relatively small group of bondholders took up the offer. Harrah's continues to lose money and has USD 24 billion in long-term debt on its books, with 710 million due next year and 308 million due in 2011.

Bondholders have not only been reluctant to write off a significant chunk of their claims, some of have been fighting back, adding yet more litigation to the collapsing leveraged finance landscape. Apollo's attempt to refinance over USD 1 billion in debt at sinking real estate broker Realogy.(where interest payments on the buyout deal roughly equal annual revenue) was successfully challenged in the courts by investors holding senior debt (and therefore first to have a go at what's left of assets in the event of bankruptcy). Apollo had sought to exchange over 1 billion in outstanding bonds for new ones worth half as much. The lawsuit contended that the proposed swap would only "delay the inevitable failure of Realogy" and was essentially "fraudulent". The unsecured debt on offer, according to the suit, trading at less than 25% of its nominal value, "is all-but-worthless".