Tax experts and private-equity executives say the question is not how he got the money there, but why he wanted to do so in the first place.
You know something is pretty unusual about Mitt Romney's extraordinary $102 million IRA when Steven Rattner, his fellow former private-equity mogul, can go on national television and marvel at just how Romney was able to do it.
Admittedly, Rattner is a somewhat partisan skeptic -- he was Obama's car czar and has been busy reinventing himself as a limousine-liberal pundit since his own bribery scandal forced him out of government -- but as the founder of the soon-to-be-defunct Quadrangle Group in New York (in which I am a small investor), he also has been anything but shy in the past about availing himself of whatever financial perks are available to the tiny cohort of finance executives lucky enough to work in private equity. Rattner has pegged his own net worth -- released as part of his vetting by the Obama Administration -- at between $188 million and $608 million, on a par with Romney's.
But the Romney IRA has him stumped. "If you say to your tax people," Rattner told Fareed Zakaria about Romney in a late JUly edition of GPS, "as he seems to have done: 'I want every trick in the book. I want to push this to the edge,' I will tell you that, as a private-equity guy, I'm familiar with many of the things that he did and I know many people who've done many of the things that he did. I do not know anyone who did everything that he did and some of what he did -- like the IRA -- I've asked fellow private-equity guys, none of us had even known this was a possible 'trick' if you will. So he's pushed the envelope all the way to the edge to his benefit and I think Americans would find that very distasteful."
I have also wondered how Romney did it, and after Rattner remarks, determined once and for all to get to the bottom of this mystery: How can an individual retirement account that was limited by law to annual contributions of at most $30,000 grow into a fund with more than $100 million in it?
This is not something your average American can do, and not only because the average American in not likely to have Romney's investing prowess or his ability to hire people with exceptional investing skills.
The truth about Romney's IRA is that its massive size has very little to do with choosing the right investments and a lot more to do with the alchemy of the private-equity business itself and the opportunities that come out of that insular world for people like Romney, who was the founder and chief executive of Bain Capital for at least 15 years.
If we stipulate that when he was at Bain from 1984 to 1999, Romney put the maximum $30,000 a year into his so-called SEP-IRA, then as a baseline his IRA should have had a value of $450,000 by the time he left to run the Salt Lake City Olympic Games. If he was a talented investor and his IRA grew tenfold -- something not many people can achieve -- his IRA would be have been worth $4.5 million, a far cry indeed from the upper range of $102 million he says it is worth. (The lower range Romney put for disclosure purposes on his IRA was $20 million.)
So how did Romney do it? According to the private-equity executives I talked to, the secret is likely in the compensation arrangement the industry has cut with its well-heeled investors. In private-equity land, the general partners of, say, Bain Capital -- people like Mitt Romney and his cohort of 30 or so well-heeled Harvard MBAs who invest the limited partners' capital -- get what is called "carried interest," or 20 percent of the profits on deals, while putting up only a fraction of the equity needed to do a buyout. It's akin to getting "sweat equity," only with very little sweat. "Your carry is basically buying stock for five cents that other people have paid $1.10 for," explained one partner in a private-equity firm.
Here's how it works: In rough terms, if, say $100 million is needed for the equity account of a $500 million buyout of a company -- a typical buyout ratio of equity-to-debt -- Bain's limited partners -- essentially wealthy investors in its funds -- would put up $99 million of the $100 million. The Bain general partners -- like Romney -- would put up the $1 million balance. In return for that $1 million, instead of getting 1 percent of the equity ownership of the purchased company, they would get 20 percent of the upside. So even though the math would dictate only a 1 percent ownership stake, the Bain guys, like others in the industry, would get a 20 percent stake in deals despite putting up very little money. (Actually, over time, Bain's investors agreed to give the Bain partners 30 percent of the upside in some of their funds, but that's a different story.)
Since Romney was the founder of Bain Capital, it would not be at all unusual for him to take something like a third of the partnership's "carried interest" for himself. So of the 20 percent stake that the Bain partners would keep, it is likely Romney, as the founder, would get at least a third of it -- in every deal during his 15 years at the helm. And this is where the calculus for Romney begins to get very interesting, especially if he used his IRA to invest in these buyouts.
Michele Davis, a Romney campaign aide brought on to defend his record at Bain, declined to get into specifics when asked about the IRA. "Mitt Romney has been scrupulous about observing the requirements of the tax code," she said. "As we have said many times before, Governor and Mrs. Romney's assets are managed on a blind basis. They do not control the investment of these assets, the investment decisions are made by a trustee. The IRA, like all IRAs, is tax deferred and Governor Romney will pay taxes on those funds when they withdraw the funds."
The private equity partners I spoke with laid out what they see as the most probable scenario explaining the growth of his IRA: When it came time for Romney to invest his portion of the $1 million needed (in our hypothetical example) for a Bain leveraged-buyout, instead of using money in his bank account, he used the money -- the $30,000 -- he had put in his IRA. Where once he had $30,000 in cash in his IRA, now he would have had something he valued at $30,000 but that was really his portion of the "carried interest" in the deal; if the deal worked out, the IRA could quickly be worth a lot more than $30,000.
For instance, in the hypothetical $500 million deal, with $100 million of equity, say that company did nicely and Bain sold it for $1 billion after a few years. The $400 million of debt on the company would be paid, leaving $600 million in profit for the Bain investors who put up the $100 million in equity. By the terms of the agreement between the Bain general partners and the Bain limited partners, the Bain general partners would take 20 pecent of that profit, or $120 million, leaving $480 million for the limited partners. By Romney's agreement with the other Bain guys, he would take one-third of the $120 million, or $40 million himself.
And voila, his initial $30,000 in his IRA would now be worth $40 million from one successful deal. The good news is that he could then use the $40 million in the IRA, add $30,000 each year to it, and continue to invest in one Bain Capital deal after another. In short order, his IRA could be crackling with the up to $102 million he says is in it.
The bad news for Romney is that while the contents of an IRA can compound year after year on a tax-deferred basis, money cannot be withdrawn penalty-free from the IRA until the owner of the account is 59 and a half years old. The IRA is required to be withdrawn -- and the long-deferred taxes paid -- on an annual basis starting at age 70.
"Your carry is basically buying stock for five cents that other people have paid a $1.10 for," explained one private-equity partner.
Most private-equity guys like to spend the money they get from investing in deals on toys such as vacation homes, private jets, boats, and mansions. Romney has many of these things, but he obviously had sufficient money from other sources -- inheritance, maybe? -- to pay for them, since he could not use any of the accumulated $102 million in his IRA without suffering a huge penalty. "You wouldn't put your whole investment in unless you were already loaded," one private-equity partner told me.
Worse, other private-equity moguls say -- and this is the thing that has them really scratching their collective heads -- is that when Romney is forced to start taking withdrawals from the IRA in five years, when he reaches 70 years old, he will have to pay ordinary income-tax rates on the withdrawals. (At the moment the federal tax rate is 35 percent; if Obama is reelected it could increase to 39.6 percent). Had Romney used money in his checking account to invest in the Bain deals, instead of using his IRA, he could have simply paid capital-gains rates -- 15 percent -- on the profits, instead of the higher 35 percent rate. Since some huge capital gains are at stake here, that 20-percentage-point differential can add up to huge additional taxes that Romney will have to pay but could have avoided with a more conventional investment strategy. "It's a tremendous bet that you can make more paying 35 percent on it than you would if you just extracted it out and paid 15 percent," said one incredulous private-equity partner.
Added Robert Willens, a well-known tax adviser around Wall Street, "This is very unconventional tax-planning and not something I would recommend doing. Not that he asked me." He said he would never advise anyone who can get capital-gains treatment on an investment to put it in an IRA that is taxed at ordinary-income rates, even if there were enough of a time period of interest compounding tax-free to make it conceivable.
Rattner is not alone in the private-equity world in wondering what would motivate Romney to make this decision. Many in the industry seemed stumped. I spoke to a number of partners of private-equity firms about Romney's IRA and the typical response was something like this, which came from a partner at one of the larger firms after speaking with his internal tax expert: "He doesn't know anyone else who's ever done that, certainly no one here. These tax guys talk to each other. They're all friends. He's not aware of anyone else that would've done that, and frankly, does not understand why he did it. So if he's discovered a loophole, no one else can figure it out."
I spoke with one partner at a private-equity firm -- not a founder -- who has used his IRA to invest in the equity of his firm's deals and then stuck the "carried interest" into the IRA. He doesn't put all of his "carry" into his IRA because then he would not be able to use the money to buy the various toys he and his family like to have. He also realizes it may not be the wisest tax strategy -- given the difference between ordinary-income tax rates and capital-gains tax rates -- but he has done a spreadsheet calculation of the various breakeven points and figured that since he is relatively young and the calculus of the industry allows that something appearing to be worth nothing -- the "carried interest" -- is often worth a huge amount in short order, it made sense for him to try it, even though everyone else at his firm thought he was crazy.
"If you were 70 years old, it would be crazy to be doing it that way, because you're going in the wrong direction," he says. "You're converting capital gains into ordinary income. If you did it when you were in your forties and when you got to age 50 or 55 and you left the private-equity firm, you then had 10 more years of allowing the pile that you'd created to grow even more, tax-deferred. The fact that you were paying no tax on it, even though at the very backend you're taking it out at ordinary-income rates, you've, in theory, over the years, compounded it so many times that it would make up for it." So far so good for him, he says.
But this is not an option available to 99.99 percent of Americans, because the number of people who have access to "carried interest" is tiny. These opportunities exist for people in the private-equity or hedge-fund industries because their investors have agreed up-front to compensate the general partners by giving them their upside in the form of virtually free equity in their deals (in addition to the not-insignificant annual 2 percent fees on the size of the fund, which for a $10 billion fund equals $200 million annually.)
This is a point that Zakaria made eloquently in his July 22 interview with Rattner. Citing something Washington Post (and my fellow BloombergView) columnist Ezra Klein had written, Zakaria said the "larger point at play" worth discussing is "that it shows that people like Mitt Romney and you have access to advice, mechanisms, strategies to build wealth that really ordinary Americans don't have access to. And that when you couple that with his agenda, which is to cut taxes further for those people, it gets to the heart of this idea that there are two Americas, one for the very, very, very rich and one for everyone else."
And on that point, Zakaria and Klein are absolutely right.