Carried interest comebacks

July 15, 2011, 5:18 PM UTC
Fortune

Last week I wrote a case for raising taxes on private equity, arguing that PE and VC firm profits should be taxed at ordinary income rates rather than at capital gains rates (as they are today). It was in the context of the (now faltering) debt ceiling negotiations, and it also was included in my daily e-newsletter.

Given that many of my readers would be affected by such a tax change, the inbox overflowed with replies. Some of them were very detailed, so I wanted to publish a bunch of them below. After some, I’ve included my own comments in italics. Enjoy:

MARC
I’d like you ask you what you would think of the following. What of a general partner that pays himself nothing but the carry; their entire compensation is whatever they are able to generate from returns? In that case, should the carry be taxed still as ordinary income in your view or should it be taxed like a capital gain? I am trying to follow your thinking to its natural conclusion in this scenario and I am struggling being confident in how you would respond.

Interesting formulation Marc, and it did give me pause. Ultimately, I still believe such carried interest should be taxed as ordinary income. It’s still a fee for services. You don’t get a tax break for cutting a bad deal.

DAVID
As a former VC/PE investor, I appreciate your willingness to push the issue of carried interest taxation, and I agree with your position. To my mind, either capital is at risk or it isn’t. (I also learned, over the course of the option expensing debate back in 2002-3, that the NVCA, much like its membership, will champion self-interested policies using the most obvious nonsense.)

A couple (possibly clarifying) thoughts.  Have a look below at the investors in Groupon’s various rounds of financing (reformatted from S1).

2_and_20.png

1. Does it make any sense that GPs Battery/Andreesen/KPCB, etc. pay a different tax rate on the same investment compared to GPs at Maverick or Silver Lake? Same security, same terms, same level of participation in the company (i.e., none).

2. If “value addition” were the key criteria for capital gains treatment, why do VCs enjoy the same tax treatment even when not on boards?  The whole argument about value addition is a red herring.  Taxes should be based on substance, not form.  We don’t have to argue about which investment manager adds more value than another, as we can focus on simplifying question of whether GP capital was actually at risk. No risk of loss = ordinary income.

3. As a nation, why would we reward and encourage managing capital equally with investing it? All of the arguments in favor of the present treatment for carried interest — job growth, innovation, etc. — apply doubly were we to index capital gains for entrepreneurs or to eliminate capital gains taxes entirely for small business (to name a few alternatives). There couldn’t be a more indirect way to encourage capital formation than to reward investment managers with no skin in the game.

Anyway, thanks for continuing to push the issue.

DREW
Great posting on carried interest. The reality is you get capital gains treatment on profits if you have your OWN capital at risk. If you are paid to manage other people’s money, you are taxed like income, even on contingent income such as bonuses at IBs and Carried Interest at PE joints.

Taxes are way too high. However, exceptions and special deals in the tax code reduce everyone’s willingness to comply voluntarily, since the perception develops that “others” are getting a special deal. There are waayyy too many special deals, and we need to kill as many of them as possible. You should be able to do your taxes on a postcard, no matter who you are.

However, that starts the argument that we shouldn’t begin the tax reform with VCs, punishing those who create jobs, but that we should do the whole job at once to be fair. We need to do the whole thing, but we also need to fix this special deal now because we can. And the next one, and the next…

LEE
If you advocate for treating carried interest as ordinary income, would you then support making the 15% capital gains rate permanent?  In addition to pushing for ordinary income treatment of carry, the Obama administration has similarly fought for raising the capital gains rate to at least 20% on numerous occasions (and at times even floated the possibility of higher rates).

GPs do put real capital in their funds, often substantially beyond the traditional 1% GP contribution. Again I wouldn’t necessarily advocate for changing the tax treatment of carry, but it seems to me that it would be easier for GPs to swallow if they knew that taxes on hard capital contributions to their funds wouldn’t also be jacked up by this administration.

I know this is going to sound like a cop-out, but I’m largely agnostic on the 15% vs. 20% cap gains rate. Rates were higher in the late 90s, and it was no impediment to VC investing. And the “jacking up” is really just allowing a rate cut to expire (one that didn’t correspond to any major increases in VC investment). Not saying I’m opposed to 15% cap gains rate — although I don’t believe any tax rate can truly be made “permanent” — just that I don’t think it necessarily matters from a macro VC perspective. 

MARSHALL
Dan, you’re just like a politician, throwing out outrageous statements without facts to back them up. Your comment today about general partners not investing: “… is that fund managers don’t actually invest. Don’t actually put anything at risk.” is just such a comment. Have you done any research on how much money general partners invest in their partnerships? The major premise for your argument on capital gain treatment vs. ordinary income treatment for carried interest seem to rest on this notion. When our fund was formed in 2004, my partner and I each put over 20% of our respective net worth into the fund and we didn’t receive a nickel’s worth of carry for 7 years. I know many other general partners that have put a significant amount of capital into their funds, as well. I think it is disingenuous of you as a journalist to make such a misleading blanket statement about general partners’ investments. If you have some facts to back up your premise, I’d be interested to see them.

Oh Marshall, you really should have read the entire piece. For example, I wrote: “If fund managers really want to align interests, then they should make substantial investments in their own funds (many do). Profits derived from those investments would continue to be treated as capital gains, under every proposal that has come out since 2007.” To be entirely clear: I believe that any carry derived from GP investments should continue to be treated as capital gains, since these are basically LP investments. My argument involves ONLY carried interest derived from third-party commitments.

JON: As you might guess, I strongly believe in the out-sized value the venture capital business system delivers to the US. I’m sure you’ve seen the stats. In order of appearance in your column:

  • “Contingency fee/ordinary income”: These phrases connote income earned in a tax year and taxed as short-term. Obviously carried interest does not meet this definition. As I’m sure you know, depending on the terms we don’t get distributions til our investors profit. I’ve received distributions on investments I originated 8 years earlier. Why should that be taxed on same basis as short-term gains or ordinary income?
  • “…effectively treated as a single entity for tax purposes…”: Where did this come from? Last time I checked, the Limited and General Partnership entities file separate returns, and in turn I file one of my own. On the face of it this statement is nonsensical.
  • “Fund managers don’t actually invest”: Technically false in vc. Traditional terms dictate 1% from the managers. Right now I owe my fund over $100K in notes; that actually is a generous term for us; often managers now want to see the 1% put in alongside the LP’s for cash. Agree it’s not huge relative to fund size but it’s meaningful.
  • “…fund manager loses only his reputation…”: Wrong. If we don’t deliver returns, we get fired by our LP’s when they don’t capitalize a subsequent fund. Or, we have to apply for the same job every time we raise a new fund no matter how well we’re doing. Unfortunately these aspects have been obscured by the vast amounts of capital raised in 1999-2000, which upended our incentive structure as fees became huge and as as our returns plummeted (from too much capital, obvious from law of supply and demand). Only now do I think we’re getting out of that cycle.
  • I do agree with your point about trading Facebook shares. But if the shares are bought and sold within the fund within a year, the fund will have short-term gains passed through to everyone, including the GP’s. This is an anomaly which I hope will pass. We’re not paid to be traders. We’re paid to be investors with a long-term horizon.
  • I’ve never heard the homeowner argument. But the analogy fails. Homes generally (not always) appreciate or depreciate regardless of who owns them.
  • Your “my bonus was taxed as ordinary income” analogy. Inaccurate analogy. You were paid for services in the year you received your bonus. If you had been paid with equity and held for longer than a year, no short term taxes.
  • I do believe that the tax rate is an important incentive to us. While there are obviously some who say they don’t care or don’t know, in my opinion over the long term a reduction in incentives would dilute the talent. Just like if we took away stock options as an employee incentive.
  • Fund creation spike in 1999-2000. Wrong conclusion. Regardless of rates, that was driven by the mania over the internet and institutional investors’ rush into the sector. Obviously a bubble in every respect.
  • “Fund managers…aren’t investors”: I disagree. I get paid to make investment decisions that only prove out over a long period. As such we are incetivized on the same basis as the companies we back. Salary keeps food on the table, the carry promises a payday-but not for a long time.

In summary, the incentive system developed itself to maximize the efficiency of the system itself. It is long-term oriented and rewards private sector investment, fosters job growth, new company formation and other economic boons, as you say at the beginning of your column and meeting the core policy objective of the different tax rate.

GERRY
Back into the thick of it we go… Seriously, you did a very nice job of thoughtfully outlining your position and countering the arguments many of us have on our side of the issue. While I still don’t agree, I respect a well-reasoned discourse. Here are two things that may not (probably will not) change your mind, but at least to think about.

1. Yes, unlike homeowners, we get the 2% management fee. But that is simply a loan. We have to pay it back in full before we get any carried interest. It’s actually somewhat similar to a reverse mortgage – in that for every dollar of management fee we take, we reduce the time to and amount of carried interest we get. I do not believe reverse mortgages are taxed at all. We are taxed on the 2% fee at ordinary income rates. Granted, if we don’t return capital, then it WAS ordinary income. But assuming we do make money in the fund, we paid ordinary income taxes on a loan!

2. I may have given you this analogy previously, but here goes:

Imagine you and I decide to form a partnership to buy and fix up an old house here in Oregon. You provide 95% of the capital and I provide 5%. But, because I am on the scene here and you are on the other coast, I offer to do some of the work and oversee the project in return for you offering me 20% of any profit once the house is fixed up and sold, post our respective capital being recovered. I work on the house for many years before it is ready to be put back on the market. We sell the house and make a nice profit (pre-2008 scenario!). Is that 20% of the profit I get based on our partnership agreement taxed as capital gains or do I declare anything above “my 5%” as ordinary income?  I am almost certain it is the former.

Of course, we can arm wrestle on this all day and in the end the Congress will do whatever it decides to do.

First, I had to read up on reverse mortgages. Seems like an apt analogy, except I assume the tax issue relates to the fact that only those 62 and over qualify. And do you suggest paying no taxes on management fees? In general, however, I repeat: My position is not based on the idea that VC/PE pros already are getting paid, so carried interest is gravy. My position is that both management fees and carry are fees for services, and should get treated as such. As for your analogy, it totally depends on if you formed a limited partnership or not. 

BRIAN
I’ve been reading your carried interest arguments for quite some time now but when it comes to venture capital the logic falls apart. It would be great to get your perspective on the following:

Our current fund is $100M in size. Using our fund as an example, assume we originally structured our fund as a C corp where our investors received a participating preferred with a 1x liquidation preference and “management” received 20% of the overall equity in common stock. How is what we do that different from the entrepreneurs except for our legal structure? Most VCs work very hard to create real value in our portfolio companies. I believe the entrepreneurs I work with would say that in many ways I’m an extension of their management team (in a good way). Good VCs think of themselves as company builders, not money managers.

Ironically, if our industry was legally structured just like the companies we back there would be no issue right now. Every investment would be similar to a sub in an operating company and we’d sell them one by one. If the tax laws do in fact change then we may be headed down this path anyway. The only people to gain will be lawyers and accountants.

Any change in the carried interest tax law now puts the entrepreneurs we back one step closer to the same higher tax structure. Nobody wants to see that happen. How long will it be until Congress is seeking even higher tax receipts by using the same logic so they can tax founder’s stock at ordinary income tax rates? I can see a scenario where a VC fund invests $5M into a private company enabling the company to build $100M in value for founders instead of $20M (if they hadn’t taken the investment). The entrepreneur in this scenario is leveraging other people’s money to create a larger equity gain for themselves. This doesn’t seem to different than VC funds leveraging other people’s money to create a larger equity gain for themselves. Also, management in most early stage companies are earning “management fees” (salary/bonus) off of venture money since the vast majority of the companies are unprofitable. Except for at the largest funds many entrepreneurs that are venture-backed are being compensated at similar cash levels as the VCs that back them.

From my viewpoint, I’m a partner with my investors and a partner with my entrepreneurs. All of us bring different things to the table to create what is currently the most powerful innovation machine in the world. You can’t bake a good cake without all of the ingredients and trying to say one ingredient is more important or should be given a different status seems wrong. I think that’s why a lot of entrepreneurs have been very supportive of fighting the tax changes to carried interest. Many of them signed the NVCA petition last year to fight the change.

From a legal perspective, I obviously agree that you may be able to structure VC funds in a way to avoid this type of tax change (were it to occur). And while the founder stock issue is a real thorn in my argument’s side (as discussed here and here), it remains questionable whether taxing such securities at ordinary income rates would really hinder entrepreneurship (does anyone really form a company for the eventual tax benefits?) One big difference between you and an entrepreneur, however, is that you are investing in a portfolio. If one company goes belly-up, it doesn’t mean the end of your potential profits. Not true of your entrepreneurs.

Lawrence
Remember the odd way that for many individuals and trusts, management fees charged by alternative investment managers are not tax deductable.  This is because management fees are treated as a miscellaneous itemized deduction (which they should not be) and there is an exclusion of 2% of adjusted gross income before any miscellaneous itemized deductions are permitted.

Bottom line is that there is a win-win trade here: Tax carried interest at ordinary rates but eliminate the anti-investment tax on management fees.  This would put alternative investments on a level playing field with mutual funds, while today there are outright tax disadvantages to taxable investors in alternatives.

JOSE:
I remember your arguments a few years ago and frankly am disappointed in your resuming to bang the drum of going after the “rich” PE guys. Most LP investment limited partnership are small funds where over 95% are less than $100M and the afforded fees and carried interest (in absolute terms) is OK but not the silly big numbers you seem to focus on from big IPOs. Most deals are in the $2M to $5M that generate 15 to 20% gross that are extremely labor intensive for the small GPs (real estate, oil & gas or PE)

My partners, and all the othe GPs I know, are entrepenuers that make capital commitments that are a substantial percentage of their net worth and are awarded basically an “Out-of-the Money” Option to see if they can create value for LPs. I don’t see how that is unlike every executive (public or private company alike) who are awarded Options and benefit on the up side (a fraction) of what the LPs are awarded.

Dan, sadly you beating the drum sounds solely as a philosophical perspective and without understanding the “unintended consequences” on the smaller GPs and making the risk-reward basically ridculous in absolute terms at the maximum tax rate (in California means 50%). I would suggest that you get to the real dollar economics on the typical fund vintage 2005 to 2007 with a gross 15 to 20% return (check the Prequin numbers the last 10 years and the gross returns are below these) and then apply a 50% tax rate. The quality GPs would basically find something else to do in life and the lousy ones could not raise money creating market inefficiencies at the small to middle market at the worst time when “as a matter of Government policy should interested in encouraging the formation of new quality GPs that put capital at risk and dedicate their careers to building companies.” The basic economics and math do not support your case, seriously!!

Your bullying pulpit could be helpful as an informed voice but I believe you only help advance the Post Keynesian argument that increased Government spending and stimlus, hence requiring higher taxes from the “rich,” to re-distrbute wealth is the way to recovery for the economy. Thank you for motivating debate on other important issues but on the taxing Carried Interest I think you are off base.

As I wrote in my story, I simply do not believe that changing the tax treatment would significantly affect the number of private equity pros. I keep asking for someone to say, on the record, that they would quit — and have heard crickets. And, even if some were to quit, it wouldn’t be the end of capitalism as we know it (judging by how many prospective GPs are unable to raise funds in the first place). As for your last point, I’ve began banging this drum before the Great Recession even began. It is not a federal revenue issue for me. It is a fairness issue. 

GORDON
Great piece on the tax treatment of carried interest. There is simply no justification for the present tax treatment – it’s work that’s being
paid for, not investment, and it should be (and always should have been) taxed accordingly……….. Those who argue to maintain the present tax treatment simply have an indefensible position, regardless of the argument they choose to put forward on their own behalf. Bravo.

THOMAS
Thanks for providing the detail on your case for change. The core of your argument seems to be that fund managers aren’t investors, and therefore shouldn’t be taxed as such. Please take a few minutes to read this e-mail. My hope is that you’ll better understand why there are those of us out there who so strongly disagree with your position on this issue.

My firm focuses on micro-cap buyouts, which we define as companies with $5 to $50 million of revenue and less than $3 million of EBITDA. We look for true re-cap scenarios, where the founder/CEO is willing to retain equity and continue in his or her operating role. We are a small firm, with only two professionals and are more active than passive in working with our portfolio companies. Our equity checks have ranged from $1 to $3 million and we want to have 2-3 active investments at any given time. Due to our size and approach, it has never made sense for us to raise a fund. Even if we had a $20 million fund, we couldn’t put the money to work without staffing up dramatically and/or changing our investment strategy.

We are fortunate to have solid relationships with a few deep pocket, sophisticated LPs who understand PE and like our model.  For each of our deals, we have gone to those LPs and sourced 85-90% of the equity for that specific investment. The balance of the equity (10-15% in each deal) is provided by my partner and me. The two of us put the deal together, perform all of the due diligence, source and arrange any debt, and subsequently work with a management team over the next 3-5 years to grow the business. On each deal, we negotiate a carry with our LPs, which is typically less than 20% and only comes into play if we exceed a preferred return hurdle. We do not earn an asset management fee from our LPs. To cover our overhead and pay our modest salaries, we take monthly management fees from our portfolio companies, and those fees have never exceeded $10,000 per month, per investment.

We live and die by the success of our investments. The only way that my partner and I make real $ is if our companies grow and we generate a big return on our equity. It’s also worth noting that the 10-15% equity my partner and I put into each deal is more meaningful to us as a % of our net worth than the 85-90% is to our LPs. We are absolutely at risk in everything we do, not just for reputation but for hard dollars.

My question to you is this: For our situation, is the capital gains treatment of carried interest really that offensive to you?

Yes, although it seems mean to say I’m “offended” when you were so polite. As I said before, none of what you said changes the fact that your carry is a fee for services (save for the carry based on your own personal investment). As for “living and dying,” it sounds like your firm should generate about $25k per month in management fee income (based on having 2.5 deals at any one time, at $10k monthly per deal). Subtract 20% for non-salary overhead, and that means you and your partner each make over $120k per year before carry. I honestly am not a class warfare guy, and think it’s great when people earn good salaries (and like to earn one myself). But it’s hard for me to see $120k as “dying.” It’s obviously not the riches of high finance, but if you are good enough at your job to generate carry… 

MIKE
Shut the eff up about carried interest already! We know your position and we know our baby is ugly – but we don’t need you to constantly remind us of that. I assure you that the many other news sources we utilize provide a much less biased update on the carried interest issue so we don’t need your blog for this.

Duly noted