Side Letter: Carry tax threat returns; PE ponders pricing; LPs target SDGs

Efforts to reform the way carried interest is taxed look closer to fruition after a Wednesday deal among US Senate Democrats. Plus: Uncertainty about pricing is plaguing private equity deals; and LPs are getting specific around the UN SDGs. Here's today's brief, for our valued subscribers only.

Just happened

Keep calm and carry on
The spectre of carried interest taxation reform in the US has returned once more. Earlier drafts of President Joe Biden’s so-called ‘Build Back Better’ legislation included language that would require private equity managers to hold assets for at least five years before they could qualify for a break on their carried interest taxes. That bill had stalled for nearly a year until US Senator Joe Manchin – one of two Dem hold-outs – announced on Wednesday that he and Senate Majority Leader Chuck Schumer had worked out a new deal.

Although precise details have yet to emerge, Schumer and Manchin say their newly christened Inflation Reduction Act will inject billions into the American economy through energy, climate and healthcare investments. It will pay for this by, among other things, raising the corporate minimum tax rate to 15 percent – and gathering $14 billion from changing the way carried interest is taxed. Schumer has promised a vote on the bill by next week.

The bill passing is not a certainty and, if Republicans win the House in November, they might be able to slow, stop or even reverse certain proposals. The impact of carry reform, however, could be significant. In a Private Equity International survey of fund managers and lawyers last year, 81 percent said taxing carried interest as income would negatively affect their firm’s operations. When it came to LP alignment, nearly 70 percent said a higher rate would result in less alignment with their investors.

Perhaps the least helpful potential effect in this competitive hiring landscape: 79 percent said taxing carry higher would hurt PE’s appeal to current and prospective talent. “The industry becomes less attractive to people and that has an impact on who does it and who stays in it,” said a London-based fund of funds manager at the time. Sponsors will no doubt be paying close attention to events in the Senate over the coming days, weeks and months.

The price ain’t right
Uncertainty around precisely where or when volatile markets will level off is stifling PE’s ability to price transactions, a senior deal lawyer told Side Letter in London this week. “Even if you thought the outlook was always going to go down, if you know where it’s going to go, that’s not such a bad thing because you just price for it,” the lawyer notes.

Debt availability (or a lack thereof) is also hindering deal activity: uncertainty around what form new financing will take, what terms it will have and who will provide it are also key questions keeping buyout firms and their advisers occupied. While sponsors are still looking at deals, they are taking longer to convert.

“Before [uncertainty] the process would… be pre-empted; people would equity underwrite, you’d have it done in four… [to] six weeks,” the lawyer adds. “Whereas now, because the debt isn’t available, maybe investment committees are being more cautious, we are probably likely to be going back to what it was in 2019 where people were taking a longer period, having a bigger run up [and] having a proper process.”

For those deals being executed, managers are leaning into their strengths and sector specialisms. As the lawyer notes: “Probably now is not the time to branch out into new areas and have a go.”

They did the math

PE positivity
For all the headwinds facing PE at present, high-net-worth investors remain notably sanguine. According to a survey by London-based investment platform Connection Capital, its clients were more optimistic about the asset class than any other over the next 12 months. Direct PE was considered the most appealing, followed by growth funds and buyout vehicles. Almost three-quarters of respondents already allocate more than 10 percent of their portfolio to alternatives, and a further 40 percent have allocations north of 20 percent. Connection gathered more than 200 responses from its clients in June.


SDG specificity
Institutional investors are planning en masse to create allocations to investments aligned with the UN Sustainable Development Goals, our colleagues at New Private Markets report (registration required). Data gathered by private markets investor LGT Capital Partners from a survey of 230 investors in alternatives (PE, real estate, private debt, infrastructure and hedge funds) found that 40 percent intended to introduce specific allocations to SDG-aligned investments within the next two years. Twenty-two percent of the respondents already have such allocations.

The UN SDGs, a 17-point blueprint for a more sustainable world, are widely viewed by investors as useful in helping the financial industry address environmental and social issues, with many (80 percent, according to the survey) agreeing that they create new investment opportunities. The data chimes with NPM‘s reporting on the LP universe, where various different types of allocator have created buckets – which often cut across asset classes – to deploy capital towards impact, either specific themes such as climate or the broad array of UN SDGs.

Today’s letter was prepared by Alex Lynn with Toby MitchenallCarmela MendozaMadeleine Farman and Bill Myers