A few weeks ago, we wrote an op-ed piece on our website, PrivateEquityInternational.com, arguing that it was time for the industry to accept that the current tax treatment of carried interest was no longer defensible – that a GP’s share of profits made on investor capital should be taxed as income, not capital gains.
Inevitably, this prompted some strong views. Some in the industry admitted privately that they agreed with us – although none were willing to be quoted on this publicly. Others disagreed, sometimes in the strongest terms; we published two of the most elegantly argued examples (from the US Private Equity Growth Capital Council and the Association for Corporate Growth) on our website.
The counter-arguments were, broadly speaking, as follows. The first was that carried interest is not the same as income: it is entirely contingent on the success of the fund (as opposed to being a guaranteed payment, like salary) and is, in many cases, subject to clawbacks (if a firm fails to hit performance hurdles). So it should not be treated as such in the tax code.
The second was that private equity firms typically do not just invest their own money in creating funds alongside their LPs; they also invest time, energy and expertise to buy and grow companies. Just as the capital gains regime benefits both an inventor, who largely invests time and intellectual property (so-called sweat equity), and an investor, who largely invests money, so GPs as well as LPs should benefit in exactly the same way. Start reducing the post-tax return, defenders say, and it could ultimately stifle any entrepreneurial risk-taking.
In our view, the first of these arguments is not compelling. Bonuses are also contingent, performance-based rewards; they are, increasingly, (as the recent example of Lloyds TSB in UK banking proved) subject to clawbacks. And yet as far as the tax code is concerned, a bonus counts as ordinary income – a reward for services rendered. In this context, carried interest is another form of bonus and should be taxed as such.
The second is a trickier one to counter. In general, we don’t buy ‘slippery slope’ arguments. Carried interest already has a special place in law, courtesy of the various arrangements reached between national associations and tax authorities, so on the face of it there seems no reason why a (well-drafted) law could not apply exclusively to carried interest. Equally, and importantly for those co-opting all things entrepreneurial when defending carry, there seems no reason why a rule change designed to clamp down on private equity would make lawmakers more likely to move onto entrepreneurs. Politically, that’s a very different kettle of fish.
However, it’s undeniably true that when an entrepreneur starts a business, the financial capital they commit is often minimal, a token sum. Any subsequent gains from this ‘founder’s stock’ is, in the event of a sale, treated as capital gains rather than income – and it’s hard to imagine anyone would object to this favourable tax treatment, since it is their ideas and time and energy that make the business a reality. So by analogy, could it not be argued that since private equity firms invest similar time and energy in their portfolio companies, they deserve the same advantages?
The problem won't just go away
Again, we’d argue the answer is no. In an entrepreneurial company, regardless of how the equity split is reached (i.e. the amount of ‘credit’ given to ‘sweat equity’), the parties involved are rewarded proportionate to their equity stake. So if an inventor and an investor own 50 percent of the business each, and the business sells for a certain amount, they will split the rewards 50-50.
In the case of private equity, if (for the sake of simplicity) the GP and LP have a 50-50 split of the fund, the GP doesn’t just get a 50 percent share of the upside; they also get 20 percent of the investors’ share of the upside too. It’s this element that, to us, has more in common with a performance bonus than a capital gain – and as such should be treated as ordinary income.
Perhaps you agree with this. Perhaps you don’t. But arguably, it doesn’t matter now. Recent adjectives used in relation to this discussion are important here: we used ‘futile’ in the heading of our op-ed piece; Joe Dear at CalPERS used ‘indefensible’ when criticising the current tax treatment of carry. Both words reference a markedly different operating environment for private equity today. In a post-Lehman, Euro-crisis-tainted world, people are far less tolerant of well-above-average personal wealth creation that to them seems to originate from financial engineering (read: bankers exploiting other people’s money).
In several countries around the world, pressure is growing for politicians and lawmakers to do something about carried interest – to the extent that it’s hard to imagine them ignoring these calls altogether.
So maybe now is the time for the industry to accept that some sort of change is inevitable, and focus its efforts on trying to mitigate that change. Look at Sweden, where the national association is trying to broker a compromise deal. It must engage, and engage realistically.