Thursday, June 14, 2007

Tax Breaks for Everyone!

Recriminations are flying across the pond among the private equity pooh-bahs of Old Blighty today after senior officials of the industry public relations arm, the British Venture Capital Association (BVCA), were cut to ribbons on the floor of the House of Commons Tuesday by snarling MPs slavering for blood. Ostensibly primary on the hearing agenda was the MPs' keen interest in having the BVCA explain to them why private equity firms and their partners are subject to only 10% capital gains tax on their earnings, compared to the nominal income tax rate of 40% for high earners. The real agenda, as outlined by FT Alphaville this morning, was rather more political:
Expecting the BVCA to mount a robust, well-argued defence of the indefensible is frankly unreasonable. Expecting them to do so in the full glare of the House of Commons, while being set upon by predatory politicians, well-versed in the art of the sound-bite and salivating at the prospect of glorifying themselves by coming up with the most scathing put-down for the next days papers, is bordering on inhumane. The MPs must be cock-a-hoop. No political downside on this one.

In other words, it was a perfect opportunity for MPs to build a little of their own political capital by beating up the big, nasty private equity beast in the public eye.

Of course, the BVCA walked into this firefight wearing a big, fat target on its ass and carrying a rusty penknife for defense, so unlike Alphaville I cannot feel too sorry for them. Putting aside the issue at hand—for which the BVCA has been pitifully remiss in articulating a coherent, comprehensive, and convincing argument in defense of the current tax treatment—their cause was not helped by Nicholas Ferguson's recent public remark that even he did not understand why private equity partners managed to pay less tax than the ladies who clean their offices. And Mr. Ferguson is one of them, too.

(News flash, via Amanda Palmer at Peter Linthwaite, Chief Executive of the BVCA, has volunteered to fall on his sword and resign, after he cravenly failed to block all incoming cannon fire from the Treasury Select Committee with his own body, as was his assigned task. Leading members of the BVCA are currently debating whether to string up Mr. Linthwaite's body from a gibbet for the sport of Labor MPs, Fleet Street, and other crows or grind him up for fertilizer to feed the plants in senior private equity partners' offices.)

We are experiencing a similar uproar in this country over the preferential capital gains treatment that private equity receives on its 2% management fees and 20% carried interest. I think the hullaboo in Britain has been exacerbated by the outrage many Britons feel that their PE plutocrats pay even lower tax rates than the 15% nominal rate here. The fact that PE bigwigs from the red-in-tooth-and-claw home of Rambo, George W. Bush, and Enron pay more tax than their English peers must drive the historically more egalitarian Brits batty, especially in the redistributive hornets' nest that is New Labor. Never mind that—as Alphaville notes—it has always been easier for rich residents in the UK to avoid almost all tax through the clever use of generous offshore loopholes. There is nothing like the whiff of hypocrisy to make the self-righteous more violent in their vituperations.

Many industry players, commentators, and other kibbitzers from both sides of the Atlantic and all sides of the debate have contributed a great deal more heat than light to this discussion. It has been very hard to hear the arguments over the sound of various axes grinding. Since I do not have a dog in this fight—other than a natural admiration and appreciation for the role that private equity, properly conducted, performs in the economy, and a counterbalancing appreciation that all market participants should contribute some support in the form of taxes to the institutions and structures which enable their daily livelihoods—I thought it might be useful if I introduced some measured considerations on the issue.

* * *

In the US, the basic concept of taxation falls into two buckets: income taxes, based upon monies earned from an individual's labor, and capital gains taxes, based upon returns earned by a person's invested capital. The key concept attached to income taxes is that of "constructive receipt," which means that a person is taxed only when he or she actually receives said income. An illustrative example is compensation in investment banking, which often consists for employees at listed investment banks of cash plus some sort of deferred compensation, restricted shares, options, or whatnot. When Great Big Ugly Universal Bank used to pay Yours Truly my eye-popping bonus at the end of each year, very little of this lucre was actually of the filthy, legal tender variety. Most of it consisted of some useless restricted GBUUB stock which vested over an indefensibly long time period (provided I remained in GBUUB's irksome employ). Quite rightly, the Internal Revenue Service only expected their cut when this crap vested, in other words when I actually received true ownership of the stuff. This is constructive receipt, and I can find little to complain about such treatment.

After these shares vested, I could do with them as I wished. Normally, I would sell them as fast as possible, just to reduce my excessive financial exposure to GBUUB (the trifecta of job security, current income, and personal net worth). If, however, I chose through inattention or otherwise incomprehensible logic to hold onto this stock, my investment in GBUUB looked for tax purposes like any other capital investment. The value of the stock already vested (after the IRS haircut) became the new tax basis for my new/ongoing investment in GBUUB shares, and I became subject to capital gains taxes on the gains (or losses) in excess of the tax basis of my original "investment" when I finally disposed of them. Again, fair enough.

Now, nowhere is it written that this is the only approved way for a government to tax its citizenry. We have elected in the US to make this distinction between returns to labor and returns to capital—and to tax the latter at a lower, more favorable rate—because as a nation we want to stimulate investment in commercial enterprise, on the very sensible assumption that said investment will benefit the entire economy and generate, among other boons, increased tax receipts from businesses and individuals who would otherwise be unemployed. There has been a further bias to stimulate the creation of new businesses, on the similarly sensible assumption that creating healthy, growing, tax-paying entities where none existed before has an even more beneficial effect on the economy and the Treasury's purse. This, as I understand it, is the historical background to the specially favorable treatment of venture capital investments (with their associated carried interest) under the capital gains rules.

Balancing this special treatment of returns to capital is the crucial assumption that in order to receive such favorable tax treatment, the person in question must actually have put some capital at risk. In other words, the investor must have exchanged something of real value for their investment, and there has to be a non-zero chance that the investor could actually lose some or all of it. Here is where we come to the rub with private equity.

The usual arrangement for PE is that limited partners agree to pay the general partner a 2% fee on funds under management and a 20% carried interest in the returns to the fund investments the GP makes. Many GPs have structured arrangements with their LPs to have their management fees credited toward a larger carried interest in the investments, thereby deferring recognition of current income and often converting it into capital at risk in the fund. From what I can tell, this is perfectly in keeping with the current tax regime. (After all, there is nothing illegal about deferring taxes; it is tax avoidance which is frowned upon.) The GP's partners' capital is truly at risk, since nowhere is it written that all or even any private equity investment must be a success, and many PE funds have the GP's carried interest subject to performance hurdles anyway. Likewise, any additional investment by the GP's partners of their own money into these funds should rightly be treated as a normal capital investment subject to the normal capital gains treatment.

Ah, but I can see a couple of weaknesses with private equity's argument that the status quo tax treatment should remain in effect. The first is one of structure and proportionality. In other words, if in fact what GPs do to create value is invest alongside their LPs, why do they get a 20% slice of the profits for investing, say, only 1 or 2% of the actual equity? It is like the GP gets the equivalent of founders stock in an entity that is already well past the founding stage, whereas their limited partners invest at the much higher buyout price. Or, if the value supplied by the GP—who, after all, is not the normal passive, non-insider investor we commonly think of in an investment context—really comes from the sweat of their brow and their constant attention to strategy, execution, and monetization of their portfolio investments, then why is that not properly viewed as the result of income producing labor? After all, this is what private equity firms claim they do. They work their investments; they do not sit idly back and clip coupons.

You can view this argument, correctly, as questioning the entire concept of carried interest and its associated capital gains treatment. In this sense, the argument is moot, since the tax code is clear on this front. However, this point leads directly to the second major weakness I see with the current tax treatment of private equity, which is a thornier issue, and which is harder to argue away.

This is one of intent: is a special tax treatment originally designed to encourage investment in start-ups, small partnerships, and other new businesses really appropriate for leveraged buyouts and take privates of multibillion dollar established enterprises? What are we encouraging: new job creation, improved profitability at portfolio companies, and the resulting higher tax receipts? Sure, but do we really need to give private equity an additional, non-market-based (i.e., tax-based) incentive to pursue this business? Is it really that unattractive or underinvested-in that the US taxpayers need to subsidize private equity? And why—given the fact that we want regular enterprises owned by entities other than PE funds to create jobs, grow profits, and pay taxes as well—are we giving capital providers extra incentives to invest in PE-backed firms which do the same thing?

Actually, when you think about it, we are not even giving the people who invest their cash in private equity—the limited partners and, by extension, their retirees, pensioners, etc.—any break at all. Instead, the American taxpayer is subsidizing the tax bill of private equity professionals. The current tax system is broadcasting loud and clear that we do not have enough investment professionals in private equity at all, and as many Harvard MBAs as possible should jump on the PE tax gravy train, because the US economy is in dire need of more tiny, aggressive, Rod-Stewart-loving squillionaires.

Now, the US tax code is riddled with all kinds of extra-market incentives to economic behaviors that we as a nation have empowered our elected representatives to encourage, some of which are profiled in a recent rant by PE practitioner and apologist Equity Private. But it is a known fact that tax breaks of any kind distort natural market behavior and encourage overinvestment in businesses and asset classes so singled out, whether they be residential housing, oil sands, or solar power. I find it amusing that the strident free-marketeers among private equity's ranks can be so adamant in supporting an existing special tax break which has so clearly been stretched far beyond its original intent and which is so obviously unnecessary in today's brave new world, where PE is in the ascendant.

What's next, private equity support for "green" energy?

© 2007 The Epicurean Dealmaker. All rights reserved.