is the income tax preference for private equity justified? …I don’t think so

simplified preliminaries

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.  

dissecting the fiscal cliff

I’m back home, in the land of electric power and heat, but no internet or TV.  I’m using my phone as a mobile hot spot, but I can’t seem to get a look at the layout of this page.  Sory if the numbers below are hard to see.

Hurricane Sandy humor:

–a runaway Coca-Cola truck knocked down a utility pole on our street on Saturday, splaying live wires all over the place.  Luckily it wasn’t the more important one the big tree knocked down during the storm.  PSEG cleaned up in a matter of hours.

–I called/chatted with Comcast to find out about restoration of internet/TV service.  The two people I spoke with were very nice but said they had no idea.  Both confirmed that Comcast continues to charge customers for service even though there is none.  You have to call them and ask for a refund!!!  Why am I not surprised?

Today’s post:

“Economic Effects of Policies Contributing to Fiscal Tightening in 2013”

On November 8th, the Congressional Budget Office issued an update on its fiscal cliff analysis, titled “Economic Effects…”.  The report makes several points:

1.  “driving over” the fiscal cliff isn’t a good idea

The problem is the domestic economy is still very weak.

The CBO predicts that continuing Washington stalemate would cause a short but sharp recession in the US during the first half of next year.  Growth would resume from the crunch, but from a lower level, in the second half.  But this would be by a small enough amount that real GDP would still end up in the negative column for the full year.

More important, unemployment would spike upward to an estimated 9.1% a year from now, postponing the return to economic normality for the country (meaning reduction in the unemployment rate to 5.5%) until early in the next decade.

2.  the status quo isn’t so hot, either

Continuing the current situation where Washington continually spends more than it takes in will ultimately force interest rates in the US–both for the government and for private borrowers–higher than they would otherwise be.  Maybe a lot higher.  At some point we’ll have a repeat of 1987, when domestic lenders refused to buy any more government debt and the long bond spiked to 10%.  The CBO implies that this is only a remote possibility at present.  But as the debt grows the problem becomes progressively harder to solve.

3.  the long-term solution

(I haven’t seen anyone write about this.)  For the CBO, two moves are important.

–broaden the tax base, don’t raise rates.

–reduce entitlement spending.

4.  in the short term, however…

(short = the next two years)

…postpone part or all of the fiscal cliff elements.  Address the deficit issues in an aggressive way in 2015, when the economy will presumably be healthier and unemployment lower. That way, we have a much better chance to get chronic unemployment under control.  If so, we’re likely to reach full employment in 2018–a time when we can attack the government fiscal mess in a more serious way.

5.  components of the cliff

The numbers are the boosts to real GDP that each would likely provide:

extend expiring income tax provisions for everyone          +1.4%

do so, but omit high-income earners                        +1.3%

extend payroll tax reduction, emergency unemployment benefits             +.7%

eliminate defense spending cuts               +.4%

eliminate non-defense spending cuts          +.4%.

my take

–The CBO analysis doesn’t take anticipatory effects into account.  In other words, it doesn’t address the issue of whether the slowdown in growth we’re now seeing in the US is adjustment in advance to the worst-case (“driving over”) scenario.  If so, the positive economic effects of breaking the logjam in Washington could be greater than the CBO estimates.

We can certainly see effects in the number of M&A deals being done before yearend—DIS/Lucasfilms is a good example.  But there are lots of others.

–Whether income tax rates rise for high-income filers has very little economic significance.  +/- 0.1% in GDP growth amounts to a rounding error.

–From a stock market perspective, the Obama-proposed increase in the tax on dividends is the key possible change that I see.

–Generally, I’m skeptical about arguments that depend on “fairness,” because I think the concept is so perspectival.  In a lot of cases, “fair” equates to just “I get more and you get less.”  Having said that, I think one of the most un-fair things in the tax code is Romney-esque carried interest, whereby high net-worth financiers turn ordinary income into capital gains.  I wonder if that loophole will be closed.

 

 

private equity zombies–very hard to kill

what they are

The Wall Street Journal has been writing recently about private equity “zombie” funds.  These are funds that whose managers refuse to liquidate and return the proceeds to the original investors, even though the typical 8-10-year fund life has already passed.

A given private equity investment is supposed to last around five years.  That gives the managers time to make operating improvements and locate a buyer to sell the now-polished-up company to.  Add a year or so to that, so the managers to find enough good investments to use all the fund’s capital.  Add another, in case recession makes buyers temporarily wary.  That’s how you get to 8-10 years of life for the total fund.

In theory, private equity managers have no interest in keeping client money.  True, they get a recurring yearly management fee of around 1% of the assets under management (based, incidentally, on their own estimate of asset value–another bone of contention).  But their big payoff comes from their “carried interest,”  the 20% or so of the capital gains generated by each project that clients cede to them.  Private equity managers only collect this when the project is sold and proceeds returned to the clients.

The details, including the “sell by” date, are all spelled out in the private equity contracts.

How, then, can “zombies” arise?

The combination of two circumstances keeps them lurching around:

–failed investments, ones with no capital gains possibility, and

–clauses in the early private equity contracts that gave the managers (unlimited) extra time to find a buyer.  The intention was good–to not force the private equity managers to sell at a bad time.  In most cases, however, there was no other provision giving clients a course of action if they disagreed with the managers’ assessment.

The result is hundreds of failed private equity funds that refuse to liquidate, because managers want to continue collecting an annual fee.  They claim they’re looking for buyers, but…  The WSJ thinks that what we’re seeing now is just the tip of the iceberg.

two lessons

1.  Buy in haste, repent at leisure.  In the early days of any new investment fad, buyers rush headlong to be one of the first owners of the new thing.  They rarely look carefully.  If they are alerted about possible pitfalls, like no recourse if the private equity manager refuses to give back remaining money, they ignore the warnings.

2.  In desperate times, almost no one remains honest.  I’m an optimist.  I have great faith in human nature.  But in “zombie” circumstances, this is always a foolish bet.  At the very least, a professional with an obligation to protect clients’ assets shouldn’t rely on the kindness of strangers.

why not let sleeping dogs lie?

Institutional investors appear to be making a big push now to get their dud private equity investments resolved, even by selling them for half nothing (assuming they can find a buyer at all).

Why?

Two reasons:

–for taxable investors, an investment loss has an important tax value.  The present value of the loss deteriorates over time, so the sooner it’s used, the more it’s worth.

–keeping a dud investment on your balance sheet makes you look like an idiot.  Well, when you bought the thing, you were an idiot.  That’s the way it is.

But there’s invariably someone on your board of directors who will ask about it at every meeting.  Prospective clients may even make little gasping sounds if they recognize it on your list of holdings.  The black eye you’ve given yourself will only fully disappear when the investment is sold.  This is especially important if you see more of these coming down the track.

 

what is a carried interest?

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.