Mitt Romney’s taxes

Mitt Romney’s partial disclosure of his tax situation has reopened debate on the issue of how private equity managers and some hedge funds use carried interest as a device to shelter their earnings from tax.

Since Mr. Romney left the private equity business a decade ago, it seems to me that he isn’t currently using carried interest as a tax shelter.  In all likelihood, it’s some combination of itemized deductions, like charitable contributions or state and local taxes paid, and the favorable treatment of long-term gains on investments that’s producing his low tax rate.  But he was a prominent figure in the private equity community, so the press–and his political opponents–have made the connection anyway.

Powerful lobbying efforts by the private equity industry have defeated repeated attempts to close the tax loophole it uses to lower its executives’ tax burden.

I wrote about this topic in mid-2010.  But I haven’t read anything, wither in the current discussion or in the past, that explains exactly what a carried interest is.  Hence this post.

carried interest

A carried interest is a participation in an investment venture where the holder gets a share of the cash generated by the project (profits or cash flow) without having to contribute anything to the venture’s costs.  The holder of such an interest is “carried” in the sense that the other venture participants pick up the burden of his share of project expenses.

Carried interests aren’t just a private equity phenomenon.  They’re very common in the mining industry, which is where I first encountered them thirty years ago.  But they also occur in lots of other industries, particularly those where highly specialized experience or skills, or possession of crucial physical resources are key to a project’s success.  In the extractive industries, holders of mineral rights may be carried.  The fund raisers or organizers of any sort of projects may be carried, as well.  So, too, famous actors or holders of key intellectual property.

variations on the theme

As with everything in practical economic life, there are myriad variations on this basic idea.  For example,

–a party may not be carried for the entire life of the project, but only up to a certain point–say, when cash flow turns positive.

–the other parties may be entitled to recover the “extra” costs they’ve paid to subsidize the carried interest before the carried interest receives a dime (there are also lots of variations on the cost recovery theme), or

–the carried interest may only be paid if the project exceeds specified return criteria.

In plain-vanilla projects, the carried interest receives a portion of the recurring revenue that the venture generates.  This is ordinary income and taxed as such.  The private equity case is different.

private equity and carried interest

Private equity raises equity money from institutions or wealthy individuals, arranges financing of, say, 3x -5x that amount, and uses the assembled war chest to make acquisitions.  It targets mostly badly run companies.  It spruces them up and resells them a few years later.  There’s no conclusive evidence that this process adds any economic value, although it certainly sets the process of “creative destruction” in motion in the affected company–but that’s another issue.

Private equity companies appear to me to act as a blend of business consultants and managers of a highly concentrated (and extremely highly leveraged) equity portfolio.  What’s really unique about them is their pay structure.

Private equity charges its clients a recurring management fee of, say, 2% of the assets under management plus a large performance bonus if the turnaround projects they select are successful.  This bonus is structured as a carried interest (an equity holding) in each individual project.  Because the projects last several years and result in an equity sale, the bonus payments are capital gains, not ordinary income.  This means the private equity executives’ tax bill is much less than half what it would be if the payments were income.

my thoughts

You’ve got to admit that turning investment management income into capital gains is a clever trick.  Should the loophole be closed?  When I first wrote about this I thought so.  I still do.  But I’d prefer to see more comprehensive tax reform that achieves this result rather than specific legislation that targets the private equity industry.  I also find it somewhat disturbing that private equity political contributions and lobbying allow them to “own” this issue in Congress, despite the fact that private equity’s taxation is clearly different from other investment managers’, from management consultants’ and from corporate executives’ for basically the same activities.