Mitt Romney may or may not make it into the White House, but he is destined to have a lasting impact on the private equity industry.
The clamour surrounding the scale of Romney's wealth, its source and how it is taxed has now reached such a pitch that anything other than a reform of the rules on taxing carried interest would be baffling. When the most tax-averse political party in the world starts grumbling, change must be in the air.
And so it should be. Taxing the share of the carry that derives from profits made on investor capital – the lion’s share, in other words – as capital gain and not income cannot be justified. And the industry should be on the front foot, acknowledging that it will accept any reasonable change to its tax status, rather than attacking it. To do otherwise will seem only to confirm to the industry's critics that this is a club of well-fed quasi-bankers greedily trying to keep their troughs filled to the brim.
Private equity is blessed with an enormously attractive compensation model that derives from both management fee and carried interest (‘2-and-20’, or whichever variation thereof pertains to a given fund), and when managers invest well, the rewards accruing to them can be huge. The model’s foundation is a commercial and voluntarily entered contract between the GP and the LP, and anyone not comfortable with the terms can opt to invest elsewhere. In a market-based system (and most economies can still be described as such), there is nothing illegitimate about this.
However, the principle of capital gains tax is based on a notion of investors risking their own money, and there is no reason why private equity should want to try and redefine this rule for its own purposes. It is rare for exceptionalism to be agenda-free, or seen as anything other than self-serving.
By all means, where the GP's own personnel have skin in the game (in other words they've committed their own money – between 1 and 5 percent of the fund’s capital typically), the capital gain principle can apply. But, as PEI has argued in the past, the other part of the carry (15 to 19 percent of the profits, depending) does not meet the personal risk requirement. Any attempt to argue otherwise will provoke the industry’s enemies unnecessarily.
And it’s not like the enemies need any more provoking, do they? Speaking in Davos earlier this week, Carlyle Group co-founder David Rubenstein was right to point out that where private equity is being judged to not be paying enough tax, it isn’t – as some would have it – because it cheats. ‘Change the rules and we will pay more, but we do need the rule change to be able to do it’, was his message. That is as commonsensical as the “all-carry-is-capital-gain” idea is misguided.
The debate around private equity’s alleged merits and demerits is set to continue for some time. For an industry this powerful and large, that is appropriate. It’s the quality of the debate itself that is too often found wanting. Boosters and naysayers can and should do better. The controversy around carried interest illustrates this perfectly.