Klinsky: “The ability to have ‘service partners’ and ‘sweat equity’ … has been fundamental to American entrepreneurialism.”

“Private equity has also been an exceptionally vibrant and dynamic piece of the U.S. economy.”

Today, Real Clear Politics published an op-ed written by Steve Klinsky, former American Investment Council Board Chair and Founder and CEO of New Mountain Capital. Klinsky pushes back against misleading and inaccurate claims that private equity benefits from a so-called “carried interest loophole” as Senate Majority Leader Chuck Schumer (D-NY) and Senator Joe Manchin (D-WV) recently released a legislative agreement that would punitively raise taxes on private equity investments by 85 percent. As the U.S. economy contracts for a second consecutive quarter and fears of a recession rise, the last thing Washington should do is raise taxes on private investors who are helping rebuild the economy, create jobs, and deliver secure retirements for hard working Americans.

There Is No Private Equity Loophole
Real Clear Politics
By Steve Klinsky
August 2nd, 2022

The new version of the Biden administration’s “Build Back Better” bill now backed by Joe Manchin has targeted so-called “carried interest” for private equity firms. Although routinely portrayed in the press, and by Democrats, as a preferential tax “loophole” to help the rich, private equity “carry” is not a loophole and never has been.

Although Chuck Schumer is the driving force in the Senate behind the punitive proposal, the tax plan especially hurts Schumer’s home state of New York and similar states. It would raise long term capital gain taxes for PE professionals who live and pay taxes in New York to as much as 55% (from the current top rate of 38%), while setting taxes for private equity professionals higher than for any other field. This push, seemingly pursued out of populist spite, would not help the economy. PE-backed companies employ 11 million people and account for 6.5% of all GNP. Targeting them with a punitive tax increase could depress investment and growth in the midst of a recession. It would further encourage the biggest taxpayers to leave Democratic Party-controlled “blue” states, where they are most needed, and move to lower-tax Republican states.

It shows the danger of letting demagogic symbolism overrule common sense and simple fairness: In truth, there never was a special rule or “loophole” passed for PE to unwind in the first place.

Take a quick look at how partnership tax has always worked for people outside the private equity world. Assume three friends join together to buy a struggling local donut shop for $10,000. They believe by upgrading the menu and improving the service, they can turn a money-losing operation into a going concern.

One friend puts up the money and is awarded 80% of the future partnership gains after his money is repaid; one is awarded 10% ownership in any future gains because he had the idea; and one will work as the manager of the store with 10% ownership of any future gains, beyond his normal salary. In tax language, the idea guy and the working guy are known as “service partners” since they got their ownership for services, rather than capital.

Under standard partnership tax law for decades, all three owners of the business are taxed the same on their pro rata pieces. This is true for all types of partnerships and all types of industries (private equity-supported or not), and was already true long before the notion of a private equity firm ever existed. There is no tax due on Day One because the existence of any future gains is uncertain. If the donut shop is ultimately successful and later sold at a price beyond the original $10,000 price, then there would be a capital gain. All three partners would receive their pro rata share of the gain and pay their pro rata share of the capital gains taxes: 80% of the gains and taxes to the first, and 10% of the gains and taxes to each of the other two.

Ownership for service partners is commonly known as “sweat equity,” and in private equity, it has been known as “carried interest.” At my firm, New Mountain Capital, we now have a team of over 200 people who help build the businesses we buy, using both our own money and money from our institutional capital partners. The tax rules for service partners in PE were always the same as for service partners in other fields, until recently when the rules were made worse for PE under the Trump administration. One business journalist, Mark Vandevelde of the Financial Times, recently claimed that a 1993 IRS regulation known as Revenue Procedure Ruling 93-27 was the source of private equity’s advantage. But the IRS interpretation merely reaffirmed what the tax law had always been, and it was about service partners in general, not private equity firms specifically.

The ability to have “service partners” and “sweat equity” – to include people into the ownership of partnerships for their ideas and energy, rather than for their money – has been fundamental to American entrepreneurialism. A kid writing software code in his dorm room can have ownership in his software partnership for no dollars at all. A local entrepreneur can borrow his entire starting stake and own 100% of his enterprise with no money of his own at risk at all.

In contrast, an investment banker or employee can work for the safety of a cash fee, but this fee or salary is a deductible expense to the owner of the enterprise who pays it, and it is different from being an owner in the enterprise itself. PE professionals are owners of our businesses, just like any other form of service partner.

Private equity has also been an exceptionally vibrant and dynamic piece of the U.S. economy. Trillions of dollars of gains have been created at PE companies in total, chiefly for the benefit of the retirees of America’s largest pension systems. Many of the best operating managers in the world have been joining a system in which we are free of 90-day public reporting pressures, and can build businesses rationally over a period of years. The best PE professionals have become wealthy by helping to create these gains, but success in itself has never been a legitimate reason for Congress to single out a small group for punitive treatment or symbolic punishment.

My own firm has published a social dashboard on its website each year since 2008. As of the end of 2021, we have added or created over 60,000 jobs at our companies, net of any job losses. We also pay far above the national average. We have spent over $6.8 billion on R&D, software, and capital expenditures. We have never had a PE bankruptcy or missed an interest payment. We have generated over $70 billion of enterprise value gains for all shareholders.

The May-June issue of the Harvard Business Review ran an article on one of our companies, Blue Yonder, which we grew from $600 million in value to over $8 billion (2010-2021), while it became one of the leading software companies in Arizona. Blue Yonder added over 5,000 jobs and many patents under our ownership. It generated many hundreds of millions of dollars of additional tax revenues, and sent billions of dollars of gains to its institutional investors. It would be better for senators to attract growth capital to their own states than to harm the PE-fueled business growth in Arizona and elsewhere.

Steve Klinsky is the founder and CEO of New Mountain Capital, and the former chair of the American Investment Council (2017-2021).