Private equity comes in many shapes and sizes, but you can divide most private equity players with a simple question: Do I own the asset, or do I own the asset manager?
Some of the largest players in private equity are Blackstone (NYSE:BX) and Fortress Investment Group (NYSE:FIG). Together, the two manage more than $300 billion, earning fees on every dollar plus incentive payments when they beat their benchmarks.
The difference between "PE" and BDC
Business development companies, like Blackstone and Fortress, are private equity investors. However, they differ in that their shareholders are rewarded directly by private equity investments. When a BDC's portfolio appreciates, the value of each share should also appreciate.
Take, for example, Prospect Capital (NASDAQ:PSEC), a company that is invested heavily in the equity of nonpublic companies. Each increase or decrease in the portfolio value affects net asset value -- the value of assets behind each share of stock. Likewise, Ares Capital (NASDAQ:ARCC) shareholders are rewarded by the performance of its nonpublic debt and equity investments.
Blackstone and Fortress Investment Group shareholders benefit indirectly from portfolio performance, as the bulk of their earnings comes from management fees on other people's money. Good performance brings more assets. Bad performance results in less assets, and lower fee revenue.
Now for the similarities...
BDCs and private equity firms carry one important similarity: they're good at avoiding Uncle Sam.
Business development companies like Prospect Capital and Ares Capital do not pay corporate income taxes so long as they distribute 90% of their income. BDCs and registered investment companies (Prospect Capital and Ares Capital are BDCs and RICs) get favorable tax treatment.
Blackstone and Fortress are not registered investment companies. In fact, they don't want to be because of the requirement that virtually all income has to be paid out to shareholders. Instead, Blackstone and Fortress were formed as partnerships. As partnerships, Blackstone and Fortress also avoid most corporate income taxes earned from fund fees and incentives.
Not all of their income qualifies for favorable partnership treatment, but both have a way around that, too. Income that isn't qualified gets sent to a taxable subsidiary, gets taxed, and then paid out to the parent company. Through the magic of the tax code, these distributions are qualified, and thus, both firms avoid corporate taxes on a majority of their income. That's the simple explanation for Blackstone's and Fortress's controversial tax avoidance.
Thus, in both cases, most of the income flows straight through to shareholders, who pay taxes at the individual level. The only tangible difference is the tax form -- BDC investors get a 1099, while private equity shareholders receive a K-1 form for being a member of a partnership.
Which is better?
It depends. Asset managers like Fortress Investment Group and Blackstone have an advantage in that they can grow earnings much more quickly than a business development company. They're limited only by how much money they manage and the fees they charge to manage assets for investors.
However, on the other hand, BDCs are more "predictable" in a sense. In the past, public shareholders of private equity managers have complained that private-equity companies are run for the employees, not shareholders. It's not uncommon for employee compensation to make up the biggest slice of revenue, or for lavish stock options to be doled out as bonuses at private equity firms. As a shareholder of an externally managed BDC like Ares Capital or Prospect Capital, you know exactly how much you give up to the management, and you don't have to worry about stock dilution. You just have to worry about their ability to find great investments on your behalf.
So, in short, owning a BDC is a bet on a manager's ability to pick great investments with your money. Owning a private equity firm is a bet on its ability to raise assets, and charge fees and incentives to manage other people's money. They're very different business models, but the key ingredient is the same: Both need good investors calling the shots for shareholders to be rewarded in the long haul.
Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.