The Bigger Significance of CalPERS’ Private Equity Carry Fee Release: Another Nail in the Carried Interest Tax Loophole Coffin

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.

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  1. Jim A.

    You said 700 Billion in the third paragraph, but the fourth paragraph seems to indicate that you meant 700 million.

    1. Yves Smith Post author

      We refer to the amount that is taxed at more favorable capital gains rate; the JCT number is what they estimate the tax revenue increase would be at the Federal level if the loophole were closed.

  2. JerryDenim

    “So a rough estimate for total carry fees per annum is on the order of $125 to $150 billion”

    That’s a very significant amount of money. So if we just use a round number for calculations and call the estimated carry fees per annum 140 billion that would mean hedgies are paying capital gains on those fees at 15%, netting the federal government 210 million in tax revenue, yes? But if the 140 billion in fees were taxed at the top personal income tax rate of 39.6% the government’s take would be over 554 million? Is my math correct here? The carried interest loophole is a 344 million give-away each tax year?

    1. John Zelnicker

      @JerryDenim – Your numbers are off by 2 decimal places. 15% of $140 billion is $21 billion and 39.6% is $55.4 billion, so the tax break is worth about $34.4 billion. For context, IIRC the federal deficit is running in the $400 billion range annually (and it should be much bigger).

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