Taxing private equity

Cite this Article
Larry Ribstein, Taxing private equity, Truth on the Market (May 19, 2010),

The venerable debate over carried interest compensation of private equity managers is heating up again. The NYT’s Andrew Sorkin is predicting Congress will vote to tax it as ordinary income rather than capital gains, which Sorkin thinks is a good thing:

Under their current partnership structure, however, [private equity] general partners * * * receive 20 percent of any profits and they have been treating that as a capital gain even though their own money is not at risk. A lot of people, including me, have been arguing for years that their cut of the winnings is really income, not capital gains. (Of course, profits that executives make by investing their own money in the deals should be considered capital gains.)

But Sorkin says “Wall Street executives are ready”:

If we’ve learned anything from the financial crisis, it seems that new regulations on Wall Street always have a way of breeding another generation of “financial innovation” meant to circumvent them.

These “machinations being whispered about in the industry” include selling the carried interest to a third party and using the cash to invest directly in the deal.  Since the managers would own the interest as investors, they’d be taxed on the interest at the lower capital gains rate.  Or investors would make a loan to the manager, who would then use the loan to buy into the fund, again taxed on the increase as capital gains.  But Sorkin notes that’s specifically ruled out by the latest bill.

Vic Fleischer, whose  “Two and Twenty” paper is a basis for the proposed change, tells Sorkin “[a]ny time there is a new section of the tax code there are going to be lawyers who will try to manipulate the rules.”  Fleischer adds another slippery thing the managers could do:  dismantle the partnership and invest “in companies on behalf of their investors on a deal-by-deal basis,” getting founders’ shares and, again, getting taxed at the capital gains rate.

Sorkin concludes with a warning:  “Whether certain industries get excluded or not, Congress beware: Wall Street will find a loophole.”

I observed three years ago when the idea was first bandied about that it “might have been all along just a tactic to extract campaign contributions.”  Well, Congress got their contributions and now they’re back.

Politics and pejoratives like “loophole” and “machinations” aside, it might be useful to take a deeper look at economic realities.  Three years ago I noted David Weisbach’s paper (since published) that the fund managers are getting paid for the same sort of acumen or luck that underlies any successful stock market investing.  Why should it matter that they happen to be investing through a partnership, essentially borrowing from the investors and paying them interest in the form of the substantial share of the gains the investors get to keep?  From this perspective, “machinations” like loans and founders’ shares really disassemble the transaction back to what it is in reality.

Of course none of these nuances matter if what you really want to do is to punish rich capitalists.  But even then you might consider the effects of the plan.  If carried interest compensation really is just compensation for investing, then there should be a lot of ways to restructure the compensation to accomplish almost the same thing. Congress might try to close one exit (e.g., by explicitly covering loans) but others will remain. At best Congress is just increasing transaction costs.

Even if carried interest compensation is just that, and fundamentally different from investment gains, then you should consider whether, as I’ve argued, it’s an efficient form of compensation that minimizes agency costs between investors and managers and helps make private equity viable.  Indeed, hedge and private equity funds incentive structure arguably helped it avoid the problems that beset ill-managed corporate banks in the meltdown.  It would be ironic if financial “reform” targeted the very firms that least needed reforming.

Another effect of the tax change, as Fleischer told Sorkin, might be to drive the funds offshore. The jurisdictional competition angle is becoming more important as countries get more aggressive in regulating highly mobile capital.

Finally, some influential political oxen will get gored.  The high-powered compensation that Congress is considering attacking is common in venture capital and real estate, two industries whose health is important to any recovery.  Sorkin quotes the National Venture Capital Association as noting the folly of “discouraging investment in new companies at a time when Congress should be doing all it can to support the start-up ecosystem.” They’re seeking exemptions from the tax and they have some significant Congressional support.  If they win their carve-outs, the new tax looks more like Swiss cheese than a return to economic reality.

In general, this whole thing looks a lot more complicated than Sorkin would have us believe.