During his press conference on Wednesday, President Obama again raised the issue of changing the tax treatment of carried interest (i.e., private investment firm profits) from capital gains to ordinary income. He couched it in the language of hedge fund managers, but clearly such a move would also hit private equity and VC fund managers (and, arguably, hit them harder).
My first temptation was to once again explain my support for such a change. But then I remembered having promised not to do that until it seemed possible that such legislation could actually become law (remember, this has come up over and over for years, to no avail). So, instead, I grabbed an envelope to figure out how much money such a change could actually mean for the federal government.
The only non-governmental study I’ve seen on this so far was back in 2008 by Michael Knoll, a tax professor at U Penn. He figured it came out to between 1% and 1.5% of capital invested into PE funds per year, which worked out to around $2.5 billion extra per year at the time. Victor Fleischer blogged that alternate math raised it to between $4 billion and $6 billion extra per year, also from the same era.
I readily admit that my statistical skills are non-existent, and that Knoll had a fairly complex calculation that is difficult for me to follow. So I did the following, rudimentary calculation:
- Used Cambridge Associates data on DPI (distributions to paid-in capital multiple), net to LP for 2000-2006 vintage funds (i.e., relatively mature funds).
- Did some reverse engineering to figure out what GP carry on those funds would have been (conservatively assuming 20% per fund).
- Multiplied that carry by the amount of money raised for each vintage.
- Calculated the difference between paying ordinary income (35%) and long-term capital gains (15%) rates on those gains.
I know there are some holes in this, but many of them are on the downside. What I found was that U.S. private equity funds would have paid an extra $22.1 billion in taxes on funds raised during those seven years. U.S. venture capital funds would have paid an extra $7 billion.
To me, the carry issue is about fairness, not revenue. But there still is a bit of revenue to be had. And this doesn’t even include hedge funds, mezzanine funds or oil & gas partnerships. Now feel free to rip apart my math…