No pain, no gain

Private equity firms should accept short term tax increases and move on, writes Andy Thomson.

In the UK, Prime Minister David Cameron has repeatedly warned of the 'pain to come' as it becomes evident that increased taxes and public sector spending cuts will be key weapons in the battle to cut an intimidating fiscal deficit down to size.

Part of this pain came in the form of this week’s announcement in the UK budget that capital gains tax (CGT) would rise from 18 percent to 28 percent – though this was less of an increase than many had predicted.        

The word ‘pain’ has also been frequently employed in the US, not least when taxpayer money was being shovelled into bank bailouts.

Welcome, in other words, to the age of austerity.


In this brave new world, everyone is being asked to make sacrifices – and that includes investment fund executives. The UK government has now confirmed that CGT – which applies to carried interest schemes – would climb to 28 percent for top-rate taxpayers. In the US, a more complex formula is being grappled with which involves a percentage of carry being treated as income.

Whatever rates and methods of taxation are finally agreed in the US, it is clear that the wind is blowing in only one direction on both sides of the Atlantic. General partners will no longer enjoy the tax treatment that prevailed at the height of the private equity boom, and which led one seasoned London investment professional to famously proclaim that fund managers paid less tax than their cleaners.

From the hostile responses of industry bodies, it is clear that some in the alternative investment universe believe that – instead of paying less than their cleaners – they are now being taken to the cleaners.

They had argued that the mooted idea of treating capital gains as income would be disproportionate since it would mean a 40 percent or even 50 percent rate being applied and would have made the UK’s capital gains tax regime the harshest in the Western world. This fear has now dissipated but there will probably still be some disappointed at any kind of CGT increase.  

In London, there has been talk of a mass exodus of fund managers to Switzerland or other tax-friendly jurisdictions. Some evidence of this occurring is apparent in the hedge fund world but it may be exaggerated in the context of other types of alternative investment funds due to the need to stay close to portfolio assets.

In the US, the Private Equity Council – which represents large private equity firms – believes data going back 20 years proves that higher taxes mean less private equity investment. And this, in turn, would have a harmful effect on the economy, the recovery and job creation. The council estimates that doubling the tax rate on carried interest would reduce the amount of private equity investment in the US by between $7 billion and $27 billion per year.

On the face of it, this is a forceful argument, though cynics might point to the excesses of the leveraged buyout boom and ask us to consider whether a more subdued level of investment activity is necessarily as harmful a development as the Council invites us to believe. (For example, didn't over-leveraged mega-buyouts ultimately do little to benefit the economy?)

For all the arguments and counter-arguments, alternative investment fund managers are not facing up to reality if they believe the status quo can be maintained when it comes to taxation. To be fair, many industry professionals acknowledge this and some may even privately welcome the changes being planned. They might conclude that making financial sacrifices will hit the pocket but help win valuable plaudits amongst politicians, regulators and – even – the public.

In other words: take the short- term pain for long-term gain.  

“We spend a lot of time with GPs advising them on the most effective positioning within their market sector and identifying the most appropriate investor group for their programmes,” Leykikh said.

Charlesbank closed its seventh fund last year on $1.5 billion, surpassing its $1.25 billion target in just five months. The firm did not use a placement agent, “but looking back at the long hours it took to prepare the materials, a placement could be helpful to some firms in this environment”, Thonis said.

“There wasn’t an hour when we didn’t agonize about how to meet our investors’ needs.” Thonis said. “The amount of work just helping existing investors tripled.”

In today’s tough fundraising environment, even existing investors will look at re-ups as examining first time funds, Thonis said. Due diligence included performance attributes on “every investment we’d done. Had we done well because of EBITDA growth, debt reduction, multiple expansion? We had all that information, but still, when you have to package it all up and make it look right”, that takes a lot of work.