Experts on the tax beat have recently been saying, as incredible as it may seem, that the days of the billionaire-creating carried interest loophole are numbered. The release by CalPERS of carry fee information across its portfolio yesterday may well move its sell-by date forward.
First, as we’ve discussed, whenever CalPERS has taken a step forward on transparency in private equity, the rest of the industry has eventually followed. For instance, CalSTRS’ foot-dragging on gathering and disclosing carry fee information will become increasingly untenable.
Second, CalPERS’ disclosure provides a basis for making a back-of-the envelope estimate of how much general partner income gets this preferential tax treatment. CalPERS is roughly 1% of the limited partner universe in private equity. It is so large that experts have argued that it can be regarded as an index fund (indeed, it has been used as an industry proxy in a 2013 paper by professor Tim Jenkinson and other Oxford academics). It reported $700 million in carry fee payments for its 2014-2015 fiscal year.
Even though CaLPERS invests in private equity funds that target foreign markets, the overwhelming majority are run by US managers like KKR and Carlyle. So it’s not unreasonable to simply gross up the $700 million to $70 billion in overall private equity carry fees. Assume that the hedge fund industry is of roughly the same size, but gets somewhat less in carry due to the fact that its high water mark system is less favorable to the investment manager then the private equity hurdle rates (see our companion post today for a further discussion). So assume that the carry fees on hedge funds are a bit lower, say $60 billion. But there are other funds that also have managers receiving carry fees, like infrastructure funds. So a rough estimate for total carry fees per annum is on the order of $125 to $150 billion.
Yet the Joint Committee on Taxation (“JCT”) has said that increase in tax receipts, were the carried interest loophole to be abolished, would be only $15.6 billion, or roughly 10% of the gross amount. The JCT refuses to disclose its methodology for coming up with this estimate. They do consider changes in behavior, and they no doubt assume that many of these investors would try to achieve a similar tax outcome by turning what the IRS calls a profits interest into a true carried interest, in which they borrowed money so they could take an actual 20% stake in the fund (or whatever percentage participation they chose to have). But borrowing would expose the investor to the possibility of losing money. Would all that many make the change?
The bigger issue is that CalPERS’ disclosure puts academics and experts on a path to having better data so they can make more informed estimates. That may put pressure on the JCT if these experts find its assumptions of increased tax receipts to be unduly low. And that in turn could accelerate the allegedly-inevitable demise of the carried interest loophole.