PEC testimony before the House Ways and Means Committee
Testimony of Bruce Rosenblum
Chairman of the Board, The Private Equity Council
The Committee on Ways and Means
United States House of Representatives
Mr. Chairman and members of the Committee, I am pleased to appear before you today on behalf of the Private Equity Council to present our views on the taxation of carried interest for partnerships.
I am a partner and managing director of The Carlyle Group, one of the world’s largest private equity investment firms, which originates and manages funds focused across four major investment areas: buyout; venture and growth capital; real estate; and leveraged finance. I also serve as the Chairman of the Board of the Private Equity Council, a relatively new organization comprising 11 of the leading private equity investment firms doing business in the United States. The PEC was formed to foster a better understanding about the positive contributions private equity investment firms make to the U.S. economy.
The Face Of Private Equity
Before addressing the carried interest tax issue, I think it is important to describe private equity investment. Some have a perception that private equity investment is an esoteric form of “black box” finance practiced by a small cadre of sophisticated investors. The truth is that private equity investment is about numerous entrepreneurial firms, large and small, located in all parts of the United States, that are integral to capital formation and liquidity in this country.
Some, like Carlyle, do multi-billion dollar transactions; others may do transactions of $5 million or less, locally or regionally; and, in recent years, spurred by programs like the new markets tax credit and empowerment zones, a new cadre of entrepreneurs have turned to private equity finance to make capital investments in underserved urban and rural communities. Private equity investment is also about benefits provided to tens of millions of Americans through enhanced investment returns delivered to pensions, endowments, foundations and other private equity investors.
And private equity investment is about thousands of thriving companies contributing to the U.S. economy in many positive ways. When you buy coffee in the morning at Dunkin’ Donuts, see a movie produced by MGM Studios, or shop at Toys R Us, J. Crew, Petco, or Auto Zone, to name just a few, you are interacting with private equity companies.
Private Equity Investors
Private equity (PE) investment is driven by private equity firms â€” known as general partners (GPs) or “sponsors” â€” which establish a venture in partnership form (typically referred to as a “fund”). The sponsor invests its own capital in the fund, and raises capital from third-party investors who become limited partners (LPs) in the fund. The sponsor uses the partnership’s capital, along with funds borrowed from banks and other lenders, to buy or invest in companies that it believes could be significantly more successful with the right infusion of capital, talent and strategy.
Private equity has been extremely profitable for the LP investors who receive most of the profits generated by PE funds. Over the 25 years from 1980 to 2005, the top-quartile private equity investment firms generated per annum returns to LP investors of 39.1 percent (net of all fees and expenses). By contrast, the S&P 500 returned 12.3 percent per annum over the same period.
This suggests that $1,000 continuously invested in the top-quartile PE firms during this period would have created $3.8 million in value by 2005. The same amount invested in the public markets would have increased to $18,200. Private Equity Intelligence reports that between 1991-2006, private equity funds distributed $430 billion in profits to their LPs. Clearly, top PE funds have been exceptional investments over the past quarter century, a major reason we are able to continue to attract capital from LPs.
The largest category of investors benefiting from these exceptional returns have been public and private pension funds, leading public and private universities, and major foundations that underwrite worthy causes in communities across the country. The 20 largest public pension funds for which data is available currently have some $111 billion invested in private equity on behalf of 10.5 million beneficiaries.
Let me give you a concrete example of what these numbers mean to real people. The Washington State Investment Board, which is responsible for more than $75 billion in assets in 16 separate retirement funds that benefit more than 440,000 public employees, teachers, school employees, law enforcement officers, firefighters and judges, has been a major private equity investor for 25 years. In that time, the WSIB has realized profits on its private equity investments of $9.71 billion. Annual returns on private equity investments made by the board since 1981 have averaged 15 percent, compared to 10.1 percent for the S&P 500. Put another way, the excess returns generated by private equity investments have fully funded retirement plans for 10,000 WSIB retirees.
Other clear benefits of private equity investment include strengthened university endowments better able to extend financial aid and create greater educational opportunities for students in virtually every state in the country, and strengthened foundations better able to carry out their social and scientific missions.
Private Equity In Practice
The best way to understand private equity ownership is to see it in practice. The PEC has been developing a series of case studies documenting the ways private equity firms grow companies and make them more competitive. I want to share three concrete examples from Carlyle’s experience.
In 2005, we acquired a company called AxleTech International Holdings, Inc., which designs and manufactures drivetrain components for growing end markets in the military, construction, material handling, agriculture and other commercial sectors. AxleTech was a solid business, but it was focused on the low margin, low growth commercial segment of the market. Under Carlyle’s strategic direction, AxleTech developed a concerted business development initiative to offer its axle and suspension solutions to military vehicle manufacturers in need of heavier drivetrain equipment to support the heavy armored vehicles required to protect American soldiers in Iraq and Afghanistan.
At the same time, AxleTech expanded its product and service offerings in its high margin replacement parts business while continuing to grow its traditional commercial business. The result is that since Carlyle’s acquisition, AxleTech sales have increased 16% annually and employment has increased by 34% from 425 to 568, with new jobs created in AxleTech’s facilities in Troy, MI, Oshkosh, WI, and overseas. Indeed, it is one of the very few US automotive-related companies that are growing in this challenging environment for the industry. And AxleTech’s job growth does not take into account the ripple effects on AxleTech’s suppliers which are experiencing new hiring and increased capital investments.
In 2002, we acquired Rexnord Corporation, a Milwaukee-based provider of power transmission, bearing, aerospace, and specialty components. While healthy, it was a neglected division of a large British conglomerate. After being acquired by Carlyle and its partners, the company refocused its business on lines with the strongest growth prospects, took steps to improve product quality, inventory management, procurement and customer delivery, made key strategic acquisitions, and developed a plan to expand business in the growing China market. Under Carlyle’s ownership, total revenues rose from $722 million in 2003 to $1.08 billion in 2006 and enterprise value doubled from $913 million to $1.8 billion.
Finally, Bain Capital, THL Partners and Carlyle bought Dunkin’ Brands (Dunkin’ Donuts and Baskin-Robbins ice cream shops) in 2006 from a European beverage conglomerate which gave the business low priority and minimal attention. Under private equity ownership, investing in long-term growth is a key business strategy. Jon Luther, CEO of Dunkin’ Brands, recently told the U.S. House of Representatives Financial Services Committee, “The benefits of our new ownership to our company have been enormous. Their financial expertise led to a ground-breaking securitization deal that resulted in very favorable financing at favorable interest rates. This has enabled us to make significant investments in our infrastructure and our growth initiativesâ€¦. They have opened the door to opportunities that were previously beyond our reach.” Today, Dunkin’ Brands is expanding west of the Mississippi, and is on track to establish franchises that will create 250,000 new jobsâ€”with the further benefit of creating a new class of small business entrepreneurs for whom owning multiple Dunkin’ Donuts franchises is a way to achieve personal financial security and success.
Understanding Private Equity Partnerships
In order to understand the issues relating to the taxation of “carried interest,” it is helpful to review the structure of private equity partnerships, how they are formed and owned, and how they operate.
As noted above, private equity investment is typically conducted through a private equity partnership, or “fund.” The fund is formed by a private equity firm, or “sponsor,” which is itself typically a partnership comprised of the founders and other individual owners of the private equity firm. Typically, the sponsor (or one of its affiliates) serves as the GP of the fund and charges an annual management fee to the fund that ranges from one to two percent of the assets under management. In addition, the sponsor (often through contributions by its individual owners) invests its own capital in the fund, which generally constitutes between 3-10% of the partnership’s overall investment capital.
A fund’s partnership agreement establishes the parties’ respective ownership rights and responsibilities from the inception of the fund. Most PE funds are designed to ensure the investors’ right to receive a return of their capital and a minimum level of profit before the sponsor receives any so-called “carried interest.” Thus, under a typical arrangement, when a PE fund sells assets at a profit, the investors are entitled first to their capital back, plus an additional eight to nine percent per annum return on their capital (a so-called “hurdle” rate), as well as reimbursement for any fees paid to the sponsor or its affiliates. Any proceeds remaining after the hurdle is cleared and fees are reimbursed are distributed in accordance with the partnership agreement, typically 80% to the investors and 20% to the sponsor. This allocation of profits to the sponsor is commonly referred to as a “carried interest.”
The carried interest is also typically subject to a “clawback” provision that requires the PE firm (and, thus, the individual partners of that firm) to return distributions to the extent of any subsequent losses in other investments of the fund, so that the sponsor never ends up with more than its designated portion (e.g., 20%) of profits. If the fund generates losses on some investments, the sponsor shares in the downside because any profits from its carry on successful investments are offset by the deals gone sour. If enough deals in a fund do poorly, the sponsor could be left with no carry at all. Thus, the sponsor’s retention of a carried interest in its funds effectively acts as both a risk-sharing mechanism and as an incentive to find the right companies in which to invest, to use its entrepreneurial skills to improve those companies, and ultimately to deliver outstanding returns for LP investors.
Despite the impression you might have, not all profits realized by a private equity sponsor from a fund are taxed at long-term capital gains rates. Those profits may include many elements taxed at higher rates, including rent taxed as ordinary income, interest taxed as ordinary income, and, on occasion, short-term capital gains. The sponsor (like any other partner of a partnership) is taxed on its allocated share of profits based on the underlying character of the income produced at the partnership level. It is only the allocation of what is indisputably long-term capital gains income â€” the profits from the appreciation in value of long-lived capital assets, such as the stock of a corporation â€” that is taxed at “differential” capital gains rates. However, since the core objective of a private equity firm is to acquire businesses, improve their value over the course of many years, and ultimately sell them for a profit, it is typically the case that a large portion of the profits generated by a private equity fund are, in fact, long-term capital gains.
Private Equity Tax Issues
The debate over carried interest taxation has many elements, some of which are technical. I would like to focus my testimony on correcting a series of fundamental mischaracterizations that have emerged as this debate has unfolded. But I have also attached to my testimony a paper prepared for PEC by one of the country’s leading tax professors, David Weisbach of the University of Chicago Law School, which addresses many of the relevant policy and technical tax issues associated with this debate.
A Carried Interest Is Not “the Equivalent” of a Stock Option.
Some have argued that a carried interest is the equivalent of a stock option given to a private equity sponsor in exchange for its “services,” and thus should be taxed as ordinary income. I understand the surface appeal of this argument. But upon analysis, it comes up hollow. While carried interests and stock options are similar in the general sense that they increase in value based on increases in the value of underlying businesses, they differ in many fundamental respects.
First, options arise out of an employer-employee relationship. A stock option is a right granted by a corporation as compensation to an employee. By contrast, a private equity sponsor with a carried interest is not an “employee” of the limited partners, but rather is an owner of the venture from the outset, who maintains control over the management and affairs of the venture. In most cases, the venture would not even exist without the sponsor’s ideas, driving force, and skill.
Thus, a “carried interest” profits interest is an ownership interest in a business enterprise (a fund), created by the founders of that business enterprise in connection with their formation of the venture. In contrast to an option, the general partner need not exercise anything to be considered an owner of the venture and receives allocations and distributions in accordance with the partnership terms from the outset. In these respects, a carried interest has much more in common with “founders stock” in a corporation than a corporate stock option.
Partnership interests with carried interest allocations are also typically subject to terms and restrictions (e.g., minimum return hurdles, clawback provisions) not associated with stock options. Moreover, while stock options are used in private companies (including portfolio companies owned by private equity firms), they are most prevalent in public companies, where (once exercisable) they entitle the holder, at any time of his or her choosing, to acquire a liquid security that can almost immediately be converted into cash. If, subsequently, the value of the corporation decreases and its stockholders suffer losses, there are no consequences for the option holder who has exercised and taken this cash. In contrast, the holder of a carried interest typically remains at risk for the investment returns delivered to limited partners over the entire life of the business enterprise (the fund), has residual risk if the venture fails (as discussed further below), and receives cash with respect to the carried interest only concurrent with the limited partners’ receipt of cash profits. Thus, the “alignment of interests” between limited partners and holders of carried interests is much more complete than that of stockholders and holders of stock options.
Holders of Carried Interests Bear Significant Economic Risks
Proponents of a tax change have also claimed that owners of carried interests bear no risk, and thus should not be entitled to capital gains treatment on their profits. In truth, private equity sponsors bear many types of entrepreneurial risk.
First, sponsors (and their individual partners) contribute substantial capital to their private equity funds. At Carlyle, this can represent hundreds of millions of dollars invested in a single fund. Whatever percentage of total partnership capital this investment represents, it typically represents a very high percentage of the private equity partners’ capital available for investment. This capital is subject to risk of loss, in whole or in part.
Moreover, like other entrepreneurs, private equity sponsors (and their individual partners) contribute ideas, expertise, and years of effort to the private equity partnerships they form and own. Like other entrepreneurs, these sponsors (and their individual partners) bear the risk that this investment will not result in any significant value in their ownership interests. Private equity partners forgo other opportunities that provide greater security and guaranteed returns in exchange for the greater upside potential provided by ownership of their interests in private equity partnerships. But it is worth noting that, according to Private Equity Intelligence, 30% of the 578 private equity, venture, and similar funds formed between 1991-97 did not deliver any carried interest proceeds to their GPs. The risk of “coming up empty” is real.
Private equity general partners also have liability for the obligations of the partnership to the extent the partnership is not able to meet such obligations, and they may be asserted to have liability to third parties for certain actions of the partnership. In addition, private equity general partners contribute their goodwill, business relationships and reputations to their funds, and these assets are subject to impairment.
Finally, private equity general partners may be obligated as a business matter (even if not legally obligated) to suffer out of pocket losses on the operations of a sponsored partnership. For example, Carlyle formed a fund in early 2000 to pursue a specified subcategory of private equity investments, and at the time the fund had a high level of demand from limited partners. About two years later, however, there had been a major shift in the prospects for these types of investments, and many of the early investments in the fund were in fact performing badly. At the low point, we valued the capital in these initial investments at less than 40 cents on the dollar.
As a gesture of goodwill to limited partners, Carlyle reduced the level of management fees; refocused the investment objectives of the fund; gave limited partners a one-time option to reduce their unfunded commitments (some actually chose to increase commitments based on the refocused strategy); and, at additional cost to the firm, brought on additional investment professionals to help execute the strategy for prospective fund investments. Carlyle continued to devote considerable attention and expense to this fund, with the objective of at least returning limited partner capital, even though it was highly unlikely that there would ever be sufficient profits in the fund to support any allocation of carried interest profits.
In fact, after several years of effort, it is now clear that the limited partners will receive all of their capital back with a modest profit; there will be no profits allocated to “carried interest” in this fund (since the minimum profitability hurdles will not be cleared); and the fund will be an out-of-pocket loss to Carlyle (i.e., expenses will exceed fees).
Private Equity Funds and Their Partners Own Capital Assets
A third line of argument holds that private equity sponsors are not owners of a capital asset and thus cannot be eligible for a capital gain.
However, it is clear that the underlying economic activity pursued by private equity firms is at its core about the creation of capital gain â€” i.e., ownership and growth in the value of businesses. There can be no question that capital gains are created when these businesses (typically corporations, which pay their own level of corporate taxes) are acquired by a private equity fund, held for the long-term, and sold at a profit.
As discussed above, the carried interest is simply a feature of the sponsor’s ownership interest in the business enterprise (i.e., the fund) that acquires these capital assets. Indeed, it is the sponsor that establishes the private equity fund, sets the investment strategy for the fund and makes the strategic decisions on which businesses to acquire, how to finance the acquisitions and how to run the businesses. It is the sponsor that makes the initial commitment of capital to the private equity fund.
And it is the sponsor that raises capital from the limited partners, who are offered in return a form of “financing partnership interest”â€” an ownership interest that typically entitles them to a return of their capital, the first allocation of profits from that capital until they have received a minimum return or “hurdle,” and 80% of the profits from that capital once the “hurdle” has been satisfied. The sponsor retains an ownership interest that entitles it to a return of its invested capital, the profits attributable to that capital, and 20% of all other profits once the “hurdle” has been satisfied. In sum, a private equity sponsor clearly has “ownership” in the capital assets held by a private equity partnership and, like any other owner, should be taxed at capital gains rates on the profits from the sale of those assets.
Private Equity Sponsors Do Not Benefit From “Loopholes”
A recurring mantra of tax change proponents is that they are simply attempting to “close a loophole” that has been “exploited” by private equity sponsors. Nothing could be further from the truth.
Partnership structures using carried interests, or profits allocations “disproportionate” to invested capital, are pervasive across a broad swath of business sectors. These ownership structures have been used for many years in many contexts, and are commonplace in all forms of partnerships, including real estate, oil and gas, venture capital, small business, and family business partnerships. The flexible partnership structure, in which capital, ideas and strategic management can be provided by different partners, who split profits according to agreement, has been critical to the legacy of entrepreneurship that characterizes the success of American business. And the tax treatment of this ownership structure is well settled. It can hardly be called a “loophole.”
Likewise, the principles underlying what is and what is not a capital gain are well settled. Capital gains treatment is not tied to subjective evaluations of the level of “risk” taken by an investor or the “worthiness” of an investment; nor is it dependent on the amount or “proportionality” of capital provided by one investor as compared to another investor; nor is it denied to an investor whose efforts, as well as capital, drive an investment’s profitability. Instead, the rules governing capital gains are simple and straightforward: if you own a capital asset, hold it for more than a year, and sell it for more than you paid for it, you are taxed at long-term capital gains rates.
Thus, the proprietors of a small business may invest very little capital in the business, and may generate most of their ownership value through their personal efforts over many years; when they sell the business, their profit is nonetheless treated as capital gain. An entrepreneur receives capital gain treatment when he or she buys a run-down apartment building at a “fire sale” price, invests years of labor rehabilitating and leasing the building, and sells it at a profit. The founder of a technology company may put very little capital into a business formed to develop his or her ideas. Over the years, as he or she raises equity financing from third parties, his or her ownership share may significantly exceed his or her share of overall capital invested in the business. Nonetheless, the founder will receive capital gains treatment on the sale of his or her stock ownership, even though he or she has provided only a small percentage of the overall capital invested in the business.
“Tax Fairness” Does Not Require Treating Carried Interest Proceeds As Ordinary Income
Perhaps the signature argument advanced by proponents of a tax change is that such a change is needed to restore “fairness” to the tax system.
Tax fairness is an important value. All of us should pay our fair share of taxes. And I believe that the taxation of carried interest ownership interests is fair when understood as part of a tax system which, for many good policy reasons â€” encouraging long-term investment and risk-taking, avoiding “lock-in” (i.e., significant disincentives to selling a capital asset), mitigating the double taxation of corporate-produced returns, and minimizing the tax on “inflationary” returns â€” taxes long-term capital gains at a lower rate than the highest marginal rates applicable to ordinary income.
In each case, the justifications for a differential long-term capital gains rate apply equally well to capital gains derived from carried interests as they do to capital gains derived from other forms of ownership interests. Thus, as long as one believes that taxing long-term capital gains at a lower rate is sound tax policy, something Congress has affirmed repeatedly, there is no “inequity” in the current taxation of capital gains attributable to carried interests. Indeed, I believe that fairness requires that the tax code not single out certain investors for less favorable treatment.
Moreover, it is worth noting that private equity partners do not exclusively receive long-term capital gains, nor do they pay taxes at an “effective tax rate” of 15%. As noted above, profits allocated to carried interests often include elements taxed as ordinary income, and private equity firms receive fees taxable as ordinary income. In addition, many private equity partners receive salary and bonus income that is taxed as such. It is only to the extent that they receive their allocable share of long-term capital gains attributable to their ownership interests that private equity partners are taxed, fairly, at long-term capital gains rates.
In fact, many of the commentators who have raised “fairness” issues about carried interest taxation have also expressed the view that the “bigger problem” is the differential long-term capital gains rate itself, which such commentators say should be abolished altogether. Regardless of whether one agrees with this position (I do not), I believe it is at least more “conceptually coherent” than carving out for “special treatment” the capital gains received by private equity and venture capital firms, as HR 2834 seeks to do. There is no justification for treating capital gains allocated to private equity sponsors less favorably than other capital gains â€” including those earned by other successful investors and businessmen, whether they be Warren Buffett, Bill Gates, or persons of more modest means who have successfully invested in the stock market or a small family business.
Nor is it accurate to describe carried interest taxation, as some have, as a “tax break” that helps the “rich get richer.” If anything, the history of the carried interest is that of the “not particularly rich” â€” and the “not rich at all” â€” getting richer. There are numerous examples of private equity, real estate and oil and gas entrepreneurs from modest backgrounds building wealth through value-creating enterprises that included carried interests as part of their ownership structure. The relentless media and political focus on a handful of highly successful founders of large private equity firms ignores the fact that these individuals (like many other successful business founders) were not necessarily “rich” when they started their businesses.
Also ignored are the many thousands of business founders who employ carried interest ownership structures in small to medium size enterprises, or in “start up” businesses that are still struggling to get themselves off the ground.
Ironically, H.R. 2834 and similar proposals would create more of a “rich get richer” environment, by providing that capital gains generated in certain types of partnerships will be respected as such only to the extent allocated to partners “in proportion” to invested capital. Thus, only those who are in a position to provide significant risk capital â€” and not those who build these businesses through their ideas, vision and effort â€” will be in a position to derive significant benefit from differential long-term capital gains rates.
This is one reason why the newly formed Access To Capital Coalition, which represents many African-American and women entrepreneurs and investment firms, has said that “Carried interest has played a vital role in attracting highly talented and committed risk-taking minority and women entrepreneurs to the investment capital industries. It also has served, and has the capacity to serve to even greater degrees, as a mechanism for increasing minority and women entrepreneurs’ access to investment capital and capital investments in underserved urban and rural communities.
“We believe that because of its direct impact on minority- and women-owned firms, and its broader impact on the investment capital industries as a whole, the legislation could impose a significant financial burden on minority- and women-owned investment capital firms, both with respect to their profitability and maintaining and improving their access to investment capital, vertically and horizontally. These developments could threaten the viability and stifle the growth of many minority- and women-owned firms and managers in the industries. Also, because of its larger effect, the legislation has the potential to significantly curtail access to investment capital for minority and women entrepreneurs and many of the communities that they serve.”
The Law Of Unintended Consequences
Finally, proponents of the proposed legislation claim there is no risk that it will create adverse consequences for long-term investment or the economy. I wonder how they can be so sure. I have been careful not to declare that the sky will fall or that private equity investment will disappear if these changes are enacted.
Quite the contrary, private equity firms â€” at least those, like Carlyle, that have become large and well established â€” will survive. But predicting how markets will respond to such a huge change in the economic structure of private equity investment â€” or assuming that such activity will go on as if nothing happened â€” is naÃ¯ve, especially during a time of considerable market sensitivity to external events.
I cannot predict what actions Carlyle or any other PE firm will take in response to a tax change. And no one can predict the consequences of a tax change with absolute certainty. Tax costs are but one of many variables affecting private equity investment activity.
Other factors, including interest rates, access to capital, market liquidity, and sector and macro economic trends are all relevant. But a change in carried interest taxation is clearly a relevant variable in the extent to which such activity will be pursued. And it is worth noting that since capital gains rates were lowered, the pace of private equity investment activity has increased significantly. I think it is reasonable to believe that a dramatic tax increase will indeed have a negative impact on private equity investment.
Of course private equity sponsors will continue to meet their responsibilities to their limited partners, even if the “rules of play” are changed in the middle of the game. And, of course, we will pay taxes on whatever basis is determined by Congress. But over time, investment structures will change; incentives for new fund formation (or formation of new PE firms) will be diminished; and there will inevitably be less activity in the sector, at least by U.S. firms with U.S. owners.
I believe Congress ought to proceed very carefully before risking an adverse impact on a form of investment that has been a major and positive force in strengthening U.S. competitiveness, giving struggling or failing businesses a new lease on life, and pumping critically needed capital into the economy.
In addition to the general economic harm that could occur from diminished private equity investment activity, let me cite three specific potential consequences which should cause concern.
Lower Returns For Investors: It may be that sponsors can develop new financing models that ensure the same level of return to PE firm partners and our LP investors â€” although, if we do, it is likely that these new structures would significantly reduce any anticipated tax revenue expected from this change. But alternatively, PE sponsors may look at ways to offset the higher tax burden through changes in economic terms that will adversely impact their LPs.
A likely result would be the eventual reduction in the returns of pension funds, endowments, foundations, and other investors who rely on these returns to carry out important social missions. This is exactly why Pensions and Investments Magazine, the leading trade journal for many such investors, recently said in an editorial that “pension funds, endowments, and foundations, even though they are tax-exempt institutions, might end up paying the increased taxes Congress is considering imposing on the general partners of hedge funds and private equity firms.â€¦ The result: lower returns for the pension funds, endowments, and foundations.”
Loss of Competitiveness: Another possible consequence is that U.S. firms will become less competitive with foreign PE firms, and even foreign governments with huge investment war chests. The Wall Street Journal noted in a recent article that the world’s capital is going global, reporting that many sovereign governments are actively seeking investment opportunities worldwide. They, and the major foreign PE firms with whom we compete, will not be as constrained by taxes, and will be in a more competitive position to acquire companies than U.S. PE firms with a higher “cost of capital.”
The U.S. is the dominant capital market in the world, and this Committee has been very supportive of protecting that status. But it is odd that, as governments the world over are striving to make their tax systems more competitive to attract foreign capital and challenge U.S. dominance, this Congress is considering a proposal that would go in the opposite direction.
Migration Of Capital Activity: A third possible consequence is that private equity activity will increasingly move overseas. There has been considerable misunderstanding about this risk, with some dismissing the prospect of major U.S. PE firms relocating. However, the concern is not that PEC members or other well-established U.S. private equity firms will relocate their U.S. operations â€” indeed, I think this is not highly likely.
Rather, the question is whether the U.S. will be the home for the next generation of PE entrepreneurs, who will have discretion to start their businesses wherever the climate is most favorable. Will the “center of gravity” migrate to Europe, Asia, the Middle East, or Eastern Europe, where firms will tend to seek first investment opportunities in their own regions? Will the U.S. see growth capital now invested to strengthen American companies shifting to help foreign firms better compete against U.S. businesses? And are the perceived benefits of this change in tax policy worth taking that risk?
Tax Treatment of Publicly-Traded Partnerships
I do want to address an issue that has received considerable attention recently. Although the focus of this hearing is not on the tax treatment of publicly traded partnerships, I would like to provide the committee with a few observations regarding legislation which would deny partnership treatment to certain publicly-traded partnerships that derive income (directly or indirectly) from services provided as an investment advisor or from asset management services provided by an investment advisor.
We oppose the bill on several grounds. It inappropriately singles out our industry for exclusion from the general rules for qualification as a PTP. In doing so, it will discourage private equity firms from going public in the U.S., impeding potential benefits both to such firms and the U.S. capital markets. Those PE firms which do go public will be subject to a “triple taxation” regime, with the same income potentially taxed at the portfolio company level, at the public entity level, and at the investor level. And, despite all of this dislocation, the incremental tax revenue produced by the change is unlikely to be meaningful.
Virtually all private equity firms are organized as partnerships or other “flow through” entities today. Thus, going public as a PTP simply preserves the status quo for tax purposes. There is no abuse or tax evasion involved. In fact, public PE firms would generally conduct a portion of their operations through a corporation, thus subjecting to corporate taxation income which is not subject to such tax under private ownership.
Under the current law, there is a general standard for PTP qualification: 90% of income must be qualified income, such as dividends, interest and capital gains. The private equity industry is not seeking “special treatment” but simply the ability to use a structure that is made available to, and used by, other sectors, such as oil and gas. There is no justification for singling out PE firms for adverse treatment.
Indeed, exclusion of PE firms is particularly inappropriate given that their activities center around investments in corporations that are themselves taxable entities.
Thus, income earned by these firms would be subjected to three levels of taxation: (i) the first level of corporate tax would be paid by the investment funds’ portfolio companies on their operating income; (ii) the second level of corporate tax would be paid by the PE sponsor on its share of the gain from the sale of the portfolio companies or on distributions received from such companies; and (iii) the third level of tax would be paid by the public owners of the PE sponsor when they sell their shares.
Because of the overall structure, the dividends-received-deductions would generally not be available to ameliorate the three levels of tax. Thus, the PTP bill appears to impose a penalty on publicly-traded PE firms that corporate enterprises in foreign jurisdictions do not bear, and which most other corporate enterprises in the U.S. do not bear (by virtue of consolidation or the dividends-received-deduction).
This penalty will constrain the ability of mature private equity firms to raise capital in the U.S. public markets that may be required to compete in an intense and increasingly global business. In turn, U.S. public market investors may be deprived of an opportunity to participate in the next phase of growth of this sector, and the competitiveness of the U.S. capital markets will suffer.
We understand that the bill was driven at least in part by a concern over erosion of the corporate tax base. However, as noted above, conversion by private equity firms to PTPs would simply preserve the status quo. Other financial firms organized as C corporations have not shown an inclination to organize as PTPs despite the opportunity to do so. Financial corporations contemplating a change to PTP status generally would face significant corporate taxes upon conversion, which will often be prohibitive.
Finally, the transition to public ownership may be important in succession planning and allowing a mature PE firm to survive beyond its founders. By discouraging and possibly precluding such steps, the bill imposes unfair limits on the ability of these firms to fully realize their potential.
I would like to thank Chairman Rangel and Ranking Member McCrery again for the opportunity to present our views on these important issues. We look forward to working with you and the other Members of the Committee in the weeks ahead. I would be happy to answer any questions you might have regarding these issues.