Private equity investors raise money from institutional investors. Those funds become the equity portion of highly debt-leveraged capital cocktails used to purchase underperforming companies. Once in control of a target company, private equity typically tries to streamline operations. It cuts overhead (including marketing and R&D) and staff, with the intention of selling the made-over and hopefully more profitable project firm, as a whole or in pieces, within five-seven years.
Private equity is paid in two ways: through recurring management fees for its projects, and through a share of the profits when the project company is sold. Applied to private equity, carried interest refers to the practice of having the private equity managers’ compensation structured, either mostly or entirely, as equity–ownership interests in projects. As a result, although the compensation sounds a lot like what hedge funds charge, it is taxed as long-term capital gains rather than ordinary income. This “tax shelter” feature of private equity was highlighted in last year’s presidential campaign, which showed that Mitt Romney’s paid Federal income tax at about a third of the normal salary rate.
most investment professionals pay normal income tax
Last year, Representative Sander Levin of Michigan introduced a bill to close the tax loophole that private equity uses. Mr. Levin has been quoted as saying that it isn’t fair for investment professionals to pay taxes at a lower rate than workers in other industries. I agree. I should point out, though, that Mr. Levin is wrong about one thing. The income of the vast majority of investment professionals–private equity being the only notable exception–is already taxed as ordinary income.
is there reason for a tax preference for private equity managers?
Do private equity managers perform an important economic and social function that would not be accomplished if their compensation were taxed at normal rates?
The two potentially positive arguments that I can see are :
1. that private equity managers are an essential part of the “creative destruction” that continually reinvigorates the US economy. They take idle capital out of the hands of those who use it badly and put those corporate assets into the hands of people who can employ it more effectively. Sounds good. But I haven’t read a single study of the private equity industry that shows conclusively that private equity makes the companies they acquire very much better. Yes, barnacles get scraped off the bottoms. But researchers I’ve read conclude that any supernormal returns generated by private equity projects come from the debt-heavy (read: very risky) financial structure they fashion in their project companies.
2. that they provide counterbidders to trade buyers ( i.e., industrial companies) who would otherwise capture M&A targets too cheaply. That’s probably true. But this doesn’t man any extra social good is created. This is more an issue of into whose pockets the purchase premium goes–the buyers’ or the sellers’. Private equity tilts the field toward the sellers–who, by the way, happen to be the guys who have spawned and tolerated the inefficient entity.
lobbying legislators has been the key to preserving carried interest (no surprise here)
Heavy lobbying by the private equity industry, both in the US and in Europe, has protected the carried interest tax avoidance device so far. Not for long, though, in my opinion. Mitt Romney, a key figure in private equity a generation ago, became a public illustration of how private equity mega-millionaires use the carried interest loophole to make their tax bills from Uncle Sam all but disappear. It didn’t help, either, that Mr. Romney was inarticulate and disorganized during the campaign–and completely blown away organizationally and in the use of technology by Mr. Obama. And Mr. Romney was supposed to be the cream of the private equity crop.