A taxing negotiation

Of all the uncertainties facing the private equity industry in 2013, one of the most significant is whether the US government will introduce legislation to change the tax treatment of carried interest from capital gains to ordinary income (which is taxed as high as 35 percent)
In anticipation of such a change, some general partners are now requesting terms that would allow them to renegotiate limited partner agreements in the event carry loses its capital gains status. Though still uncommon, the development indicates that some fund managers are already bracing themselves for a potentially difficult transition if taxes do go up.
GPs actually started discussing such terms a few years ago, sources say, shortly after Congress first began to consider changing carry’s tax treatment.
“This carry tax thing has been around for a while, and there was one point a few years back when my law firm was saying: ‘There are ways you can structure around it [though] you might have to tweak the LP agreement to do that.’ But we never got into the specifics of it,” says one mid-market GP.
For those who did explore the option, some negotiated very aggressive language allowing them to amend the agreement to minimise any impact from tax law changes on their economics, according to Michael Harrell, partner at Debevoise & Plimpton. 
However, he adds: “Most provisions soften that language by adding that no change can be made if it would adversely affect the LPs.”
Prior to its initial public offering in April, The Carlyle Group included language in the firm’s offering memorandum cautioning investors about the potential impact of legislation related to carried interest. 
“If any similar legislation were to be enacted and apply to us, the after-tax income and gain related to our business, as well as our distributions to you and the market price of our common units, could be reduced,” the firm said.
But if GPs are trying to change the terms of their LPAs in a way that adversely affects LPs, sophisticated investors are unlikely to grant such a request. 
“Like the rest of us, they have to deal with the taxes as they come,” says one public pension official. “I don’t think those would be terms that investors who have the downtown lawyers would go for.”
And until there’s more clarity about what any tax change would involve, don’t expect LPs to allow any renegotiation on terms, says Kathy Jeramaz-Larson, executive director of the Institutional Limited Partners Association. 
“LPs really are unable to include a term like that in their documents because it’s negotiating a hypothetical, and that’s impossible to do,” she said.
One 2010 proposal to tax up to 75 percent of carried interest as regular income was dropped from a US Senate bill. Other proposals have been even more extreme, taxing carry as income in its entirety, though none have managed to make it through both houses of Congress. 
President Barack Obama’ has been very clear in his last two federal budget proposals about his intention to close the carried interest ‘loophole’. Republicans have successfully opposed those measures so far, although Presidential candidate Mitt Romney has not yet clarified his position. 
The situation may become clearer after the election. But some GPs seem unwilling to wait that long. ?