FRONT PAGE CONTRIBUTOR
Why I’m Not Fighting the Tax Treatment of Carried Interest
In regard to the battle over changing the tax treatment of carried interest: I don’t want to see capital gains taxes raised under any circumstances, and in fact I think they should go all the way to zero. But I’m not inclined to fight too hard to keep carried interest taxed as capital gains rather than ordinary income.
For one thing, the carried interest to the general partners of private-equity and venture-capital firms is usually a gain that they made with other people’s money, not their own. They don’t face the downside as their limited partners do, so their participation doesn’t really rise to the level of risk capital. When carried interest is liquefied, it takes the outward form of capital gains, but in economic terms, it’s actually compensation paid by the limiteds to the generals.
For another thing, I don’t buy that PE creates economic growth. Leveraged buyouts are one of the ways that companies fail in our distorted tax system, which double-taxes and sometimes triple-taxes corporate profits. Companies don’t become valuable as they make more money. They become valuable as they grow. That’s because the capital appreciation of a business is taxed far less heavily than its earnings.
So as you’d expect, many businesses aren’t managed to increase earnings, but rather to increase revenues. And that’s not an open-ended process. You can make a steady profit on a stable market position every year for decades (as businesses often did, once upon a time), but you can’t keep getting bigger every year forever. At a certain point, you get too big to keep growing, and your stock multiple drops.
That’s when private-equity firms step in. Assuming your balance sheet is healthy, they borrow as much money as they possibly can and use it to buy the company from the existing shareholders. Or they contrive with management to split the company into parts. (Which makes sense if the pieces that stay publicly-owned can command a higher multiple than the predecessor entity.) Then the cash flow from operations of the newly-private company is used to pay off the debt. Someday, everyone hopes, market conditions will shift and the private entity can again be sold back out to the public or to another public company.
And at the end of that process, assuming all the numbers have worked out right, the PE firm makes big bucks. But they very rarely have created many new jobs in the process. The point of the game is to turn a large, relatively unprofitable business into a smaller, relatively profitable one. This is all about exploiting two basic things: the favorable tax treatment of debt financing as opposed to equity capital; and the stupidity of the general public, who are perennially willing to buy the stock of IPOs at ridiculous valuations.
So I just don’t buy the argument that changing the treatment of carried interest for PE general partners will destroy lots of jobs. Quite the opposite, in fact. PE firms will often cut jobs ruthlessly in their portfolio companies, in order to get their costs down.
Venture capital is different. In theory, it actually does perform an economically useful function. VC feeds capital to the tiny, tiny, tiny sliver of newly-formed companies that actually have a chance to get big. VC manages the extreme risk-adjustments needed in this business through a highly stylized process that looks a lot like putting down small bets on a lot of roulette wheels, and hoping that the few wins outweigh the many losses.
Two problems with allowing the general partners of VC firms to treat their carried interest as capital gains: First, they’re just like PE generals in that they’re risking someone else’s money, not their own. As with PE, they keep earning their management fees even if their limiteds lose money.
And second, although I’ll make enemies with this, most VCs just aren’t any good. Success in VC is all about getting the best deals. (Or put another way, about buying the best management teams at an undervaluation.) The very few VCs at the top of the game get all the good deals. Everyone else fights over the garbage, and doesn’t really make any money, on a risk-adjusted basis.
So I’m not sad to see both VC and PE general partners take a hit to their pay through a reclassification of their income.
A couple of short points in clarification: Hedge funds, which are the third major kind of investment firm that uses the carried-interest structure, will mostly be unaffected by this rule change because their capital-gains are mostly short-term, so they’re already taxed as ordinary income. (VC funds typically run five to seven years; PE funds often 10 years. Those are long-term capital gains.)
And there are plenty of PE and VC general partners who invest their own money in their firms, alongside the money of limited partners. The carried interest that can be allocated to actual capital provided by general partners should NOT be subject to reclassification, because it’s real risk capital with downside exposure.
UPDATE: A good friend has emailed me to point out that I missed something very important. In addition to the big-time PE and VC firms, this rule change will also slug a great many commercial real-estate partnerships around the country. These firms are usually quite small, even though taken together, they own and manage much, perhaps most, of the commercial properties in the country.
And their economics are already tenuous, given the continuing distress in all real-estate markets. If a large new tax is added to these firms, in the form of changing their carried interest from capital gains to ordinary income, many will become economically marginal. That will have a bad impact on the business tenants in the properties. And of all the things we don’t need, it’s more trouble for small businesses.
I’m not an expert in real-estate partnerships, but it seems reasonable to me that, below a certain size, they should be exempted from this rule change.
This story first appeared at The New Ledger.