Time to accept higher taxes?

Stephen Presser, a founding partner at mid-market buyout firm Monomoy Capital Partners, believes private equity firms should prepare to pay more taxes on carried interest. After all, to borrow an oft-repeated phrase from president-elect Barack Obama, change is coming.

“Those of us in private equity should plan for a day when carried interest is treated as ordinary income,” Presser says. “This is entirely fair and appropriate.”

Presser, unlike many general partners in the private equity industry, has no problem with a rule that would treat carried interest as ordinary income – at a tax rate of up to 35 percent – rather than capital gains, which bears a levy of 15 percent.

Industry experts are predicting that the carried interest debate will return to centre stage now that Barack Obama has been elected US president. Obama has already highlighted carried interest as a target for a tax increase.

The private equity industry successfully fought off a proposal to treat carried interest as ordinary income over the summer. However, the industry's position on the issue has been significantly weakened as some big-name firms have benefitted from government bailout money, says Keith Johnson, chairman of law firm Reinhart Boerner Van Deuren's institutional investor services.

“This puts a target on them,” Johnson says. “It'll be difficult for private equity managers to avoid being in the spotlight.”

Cerberus Capital Management reportedly asked the government earlier this month for $10 billion to help fund the merger of its portfolio company Chrysler with General Motors. The Bush administration has so far declined to fund the deal, although many observers say some type of bailout is likely in the near future.

The government also stepped in to help PNC Financial Services buy Corsair Capital-backed National City. PNC is buying National City for $5.2 billion, and the government will take a $7.7 billion stake in the combined company. A Corsair-led consortium purchased a $985 million stake in National City in April and watched as the Cleveland-based bank's market capitalisation shrank rapidly. Corsair has said it will now recoup its original investment on the deal.

Despite the possibility of a tax hike on carry, private equity may not fall completely out of favour with an Obama administration needing all the help it can get to rehabilitate the US financial system.

Johnson, a former legal counsel for the Wisconsin State Investment Board, says the new administration will be open to working with the private equity industry to find ways of restoring health to the financial markets.

“They'll be open to looking at what can be learned from private equity, especially the way private equity firms approach executive compensation,” Johnson says. “Also, private equity's focus is on developing the value of a company, and that's something we're sorely in need of.”

Marco Masotti, an attorney with law firm Paul, Weiss, Rifkind, Wharton & Garrison, agrees that the new administration will need to befriend the private equity industry because of the considerable pools of capital firms have at their fingertips.

Many in the industry believe a tax increase on carried interest would be detrimental to private equity, possibly causing firms to locate elsewhere. The Private Equity Council, a lobbying group for the industry, has maintained that the current tax structure for carried interest is appropriate.

An increase on carried interest is unfair to private equity firms, maintains Stephen Culhane, a partner in the investment management practice at law firm Linklaters. Culhane says he does not believe the carried interest debate will be revived – but he does expect to see an increase in capital gains tax.