Wednesday, July 11, 2007

The Taxman Cometh

Henry Kravis and his peers are underwhelming me once again.

That bastion of private equity haters The New York Times writes today on the steady stream of Gulfstream Jets and Bentley limousines trundling into the Beltway to man the barricades against restless politicos gunning for private equity tax dollars. While one should ingest the financial reporting of the Gray Lady with several shakers of salt close at hand, a close reading of the piece seems to indicate that the PE bigs are continuing to get their Kiton-clad asses kicked.

I begin to despair of private equity's ability to do anything in public without stumbling over their own appendages. What kind of lobbying strategy are these yokels following? From the looks of it, they have not developed any sort of compelling public campaign at all, but seem to be just showing up on Capitol Hill in their expensive suits with their expensive lobbyists in order to dangle potential campaign contributions in front of the supposedly desperate and stupid members of Congress.

Perhaps they are so convinced of their innate brilliance and suavity that they think they can handle the bumptious rubes charged with filling our nation's coffers just like Jeffrey Skilling did a couple of years ago: just show up and intimidate them with four syllable words. Hmm ... that didn't work out too well for Jeffy Boy, now did it? Whatever you may think of politicians in general, it has been reliably proven by research that businessmen underestimate them as testosterone-addled idiots at their own peril.
Meeting two weeks ago with Representative Sander M. Levin, a senior Democrat who is proposing to more than double the amount of tax that Mr. Kravis now pays, the buyout titan mustered his best arguments. He said that firms like Kohlberg Kravis Roberts play a central role in the economy, participants recalled, citing the example of how his firm had produced many jobs in Mr. Levin’s home state when it turned around a troubled electricity company in Michigan. He asserted that the lower tax rate benefited all Americans. And he said that an increase in tax rates would harm American competitiveness abroad.

Mr. Levin and his staff were unswayed. One aide asked Mr. Kravis to explain whether the measure would hurt workers and middle-income families by lowering the returns for pension funds that invest in Kohlberg Kravis funds, two aides at the meeting recalled. They said Mr. Kravis agreed with an answer by a partner that the proposal would not hurt returns, and the meeting ended soon afterward.

(An adviser to Kohlberg Kravis on Tuesday described the meeting slightly differently and said that Mr. Kravis said he believed the legislation could have an adverse effect on pension fund returns.)

Really? How's that, Hank? Given that the standard 15% capital gains tax rate applicable to KKR's limited partners' return on investment in your funds is not contemplated to change—except perhaps by the lunatic fringe of the AFL-CIO—I find it difficult to understand how their returns would be depressed. Is it your view that being forced to pay standard income taxes like the rest of us working stiffs would chase away all the brilliant minds in the PE industry, leaving Yale University's PE fund allocation in the trembling hands of inexperienced investment managers who would be incapable of delivering the stellar returns you and your brethren have generated for so long? (Where would all of you go? St. Tropez?) Or is it just that KKR would go into a sulk and double the fees and carried interest percentage on their funds to cover your and your partners' increased personal tax bills? I would pay good money to hear what David Swensen would say at that meeting.

Let's be clear here. The people and institutions who put up somewhere around 95% of the actual capital invested in private equity—Yale, pension funds, insurance companies, etc.—benefit from standard capital gains treatment on their investments, like everyone else who actually invests money for longer than a year. While there is nothing written in the firmament saying that preferential tax treatment for returns to capital (versus those to labor; i.e., income) is a given, I happen to believe it is a good policy. At the margin, it has the socially beneficial effect of encouraging saving and investment, which is something this country of profligate consumers desperately needs. You get the 15% long-term capital gains treatment whether you are Yale investing in KKR XXVI or Joe Sixpack investing in Berkshire Hathaway. This is a good thing.

And, notwithstanding the pathetic scaremongering of PE's Gucci Gulch flacks, I have heard no credible reports that Congress is seriously considering eliminating the special tax treatment for all capital gains. What is under threat is the current preferential tax treatment which private equity investment professionals receive for their carried interest in their funds' investment returns. In outline, they contribute somewhere between 0 and 5% of the capital to the fund (often in the form of forgone annual management fees, and sometimes in the additional form of actual spending money), receive 20% of the realized gains, and pay 15% capital gains taxes on the result. While whatever current income they may forgo and real Benjamins they may invest alongside their LPs is truly at risk—PE deals do fail, believe it or not—there is no doubt that on an economic basis the bulk of carried interest returns earned by PE pros is due to their "sweat equity," or labor. Labor taxed like capital. Sweet, huh?

There is a long history to this sweet deal, but the original policy intent was simple and clear. Congress wanted to incentivize the creation of new businesses by giving special tax treatment to the sweat equity of business founders and simultaneously not penalize the moneymen by making them pay taxes on any economic transfer of partnership equity at the start. Okay, fair enough. I could argue that it is still a good policy, given how important start-up businesses and small businesses in general have been and continue to be to the US economy.

But why do we need to maintain this special tax deal for private equity professionals anymore? In case you haven't noticed, PE is almost literally taking over the world. It is a resounding success, and rightfully so. No-one in their right mind can argue with a straight face that PE managers need ongoing tax incentives to join or continue in the business, can they? I mean, the last time I looked, it seemed like 543% of Harvard Business School's graduating MBAs listed "carrying Steve Schwarzman's luggage" as their highest career goal in the next five years. And unless someone can make a coherent and compelling argument that "fairing up" (sorry, Equity Private, the term is apt) the personal income tax treatment of an immensely wealthy, privileged, and tiny fraction of the professional investing community to levels paid by the rest of their peers would have a measureable and sustained negative effect on the returns earned by investors in private equity, you have no case.

In fact, someone might be able to make the opposite argument that raising effective personal tax rates on PE professionals would raise returns to private equity investors. One of the notable features of the recent private equity boom has been the proliferation of hundreds if not thousands of PE firms. As these firms have flooded in, competition for buyout properties has soared, along with prices paid, and average returns to the asset class have been declining steadily from highs a few decades ago. In fact, it seems that the only place you can consistently make PE-like returns from private equity is by investing with the top quartile of fund managers, who consist of the usual suspects. The other three quarters of PE funds apparently struggle to match the returns of the general listed equity market, with much less liquidity and far more volatility. This sounds like a classic case of oversupply to me.

I know! Why don't we raise taxes and chase a few of the latecomers, wannabes, and fat old cats too lazy to work anymore out of the industry. I bet returns would rise nicely.

Oh, and another thing. If any of you PE knuckleheads piss off Congress so much with your lame and pathetic special pleading that they decide to eliminate capital gains tax treatment altogether, you'd better find a deep, dark hole to run and hide in. 'Cause David Swensen and I will be coming for you, and he is much nastier than I am.

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Correction: A helpful reader has reminded me that college endowments and pension funds, which comprise a very large portion of the institutions which invest in private equity, are in fact tax exempt. Therefore, they do not worry about which tax treatment applies to any gains they book from their PE investments. (Not all investors in PE are so favored, however.) Does this fact change my argument in any respect? Hmmm ... let me think ... Nope.

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