Private Equity and Carried Interest – House
Raising Taxes on Private Equity:
Anti-Growth, Anti-Competitive, Anti-Capital
Legislation approved November 9, 2007 by the House of Representatives would impose a 130% tax increase on private equity funds, real estate partnerships, venture capital funds, and other investors. The bill will hinder entrepreneurial risk-taking, create disincentives for private equity firms to acquire and enhance the competitiveness of underperforming or undervalued companies, and potentially reduce returns flowing to pension funds, foundations, and university endowments that provide the bulk of the capital for private equity.
Private Equity Benefits the Economy and Investors
• Private equity is a positive force in the U.S. economy. Private equity firms make long-term investments in companies to help them grow their businesses, including increasing R&D spending, developing new products and business strategies, hiring superior management, and increasing capital spending. This growth-orientation often results in jobs created or saved, and additional tax revenues by healthier, more profitable companies.
• Eighty percent of the profits from private equity investments go to the investors. In the last 15 years, private equity firms worldwide have distributed more than $430 billion in profits to these investors who use these superior returns to carry out their important social value missions. That translates into stronger public and private pension funds, educational endowments and charitable foundations.
• Raising taxes by more than 130% on any taxpayer — corporate, partnership, or individual — can change incentives and behavior. Given the benefits of private equity to business, the economy, US competitiveness, and investors, Congress should be very careful of the unintended consequences likely to occur by enacting HR 2834.
Carried Interest Rewards Entrepreneurial Risk Taking
• Capital gains treatment for so-called carried interest is not limited to private equity. In fact, it has been enshrined in tax law for decades. It is based on the uniquely American principle that we reward those who take entrepreneurial risk, whether that risk involves investing capital or it involves years of time, effort, and vision. All agree that those who invest capital deserve capital gains tax rates; the carried interest rules allow those who invest their hearts and souls in an enterprise to also be rewarded for taking the risk of creating something. Changing this policy will discourage exactly the kind of risk taking so central to the growth of the American economy.
• Profits earned by private equity firms today are taxed the same way and at the same rate as those of any other investor or owner that takes entrepreneurial risk, and expends time, energy and effort to increase the value of an asset over time and then earns a profit. In short, this is not a private equity “tax break.”
• Earning carried interest is not guaranteed. It is directly tied to the performance of each fund and is 100% risk based. If the fund managers are successful in identifying good investment opportunities and growing them, then the partners make a profit. If they do not, they make nothing — just like any other capital investment, whether it is a stock purchase or real estate investment.
• In fact, PE partners receive no carried interest at all until and unless they first pay their investors 8-10% of the profits. If they fail to meet this hurdle rate, they have no carried interest. To further illustrate the fact that the carried interest is at risk, it is worth noting that in cases where PE managers take a carried interest from profitable investments but then subsequent investments lose money, the private equity fund must return its profits to the other investors.
• Carried interest is not analogous with an employee performing services or stock options. The tax law makes a fundamental distinction between an employee performing services and an entrepreneur creating or increasing the value of its business. A sponsor of a private equity fund is more like an entrepreneur than an employee. The sponsor is the driving force, the individual with the ideas and the skill to make a project happen. As general partner, the sponsor bears all of the fund’s residual risk. This is not the case for an employee or CEO with stock options.
Sending the Wrong Message
• At a time when our economic competitors are doing everything they can to emulate the success of US capital markets, this proposal plays right into their hands by eliminating some of the very features of our tax system that has encouraged entrepreneurial risk taking.
• Our nation needs to be investing more in innovation and making our companies more competitive, but this tax increase could have exactly the opposite effect.
• America is the leader in global capital creation. Changing the tax treatment of PE may adversely impact that dominance. Faced with a choice of locating in the US or other international cities , where carried interest is treated as a capital gain, the “best and brightest” financial innovators of the next generation will go to the most hospitable climate. If there is a gradual migration of firms to other markets, that carries the risk that the capital they invest flows away from the US as well.