Your humble blogger will endeavor unpack the multi-layered kabuki battle brewing over the indefensible and mislabeled “carried interest” loophole. If you believe the press, Biden is taking aim at it. Since the carried interest abuse had supposedly been an endangered species for at least a decade, yours truly is not about to take the hissing and spitting about its imminent demise seriously until its death really does look, well, imminent.
The posturing and whinging about the fate of the carried interest loophole obscures the fact that money mavens would not find it hard to rearrange their affairs to preserve their economics. But it offends their view of their place in the universe to be told what to do. So bear with us as we pull the signal out of considerable noise.
Tax professional cringe when normies use the term carried interest in the manner that has become pervasive in the fund management industry. What is called carried interest in the US is not actually “carried interest,” which comes about when a participant in a deal borrows money (typically from other principals) to buy his equity stake. Instead, what the press widely calls carried interest is a profits interest that gets preferential tax treatment. As we explained in 2015:
The reason the “carried interest” label is a misnomer relates directly as to why it is also a tax abuse. Money managers like private equity and hedge funds enter into fee arrangements that include what the IRS calls a “profits interest” and a layperson would describe as a profit share. These firms enter into a prototypical “2 and 20” fee structure, meaning a management fee of 2% per annum of the committed capital plus 20% of the profits, usually after a hurdle rate is met.
Due to clever tax structuring, that 20% is taxed at a capital gains rate even though the managers have no or only a token amount of capital at risk (as in the investors generally require that the fund manager invest some of his capital alongside that of the investors, but it is typically in the 1% to 3% range, and in many cases, that amount isn’t actual cash, but instead a deferral of some of that 2% management fee, which by definition is excessive if the manager is in a position to defer it.). In other words, they are being taxed at a preferential capital gains rate on what by any commonsense standard is ordinary income and should be taxed at ordinary income rates.
To underscore the key point: the carried interest loophole allows private equity and hedge fund honchos to have their labor income taxed at more favorable capital gains rates. That preferential treatment is the reason someone going into asset management is twice as likely as someone going into tech to become a billionaire.
Biden Threatens to Slay the Carried Interest Dragon
The Wall Street Journal story, Private Equity and Hedge Funds, Facing a New Tax Burden, Prepare Their Defense, demonstrates that the fight over the carried interest tax break is following a well-established script, save a plot twist. Biden got far more support from private equity firms and hedge funds. Yet here he is, biting the hands that fed him! From the Journal:
Hedge funds and private-equity firms are among those that would be affected by Mr. Biden’s proposal, given his plan would get rid of lower rates on long-term capital gains for high-income households and end what the administration calls the “carried-interest loophole.” The moves would mean investment managers would no longer be allowed to pay a lower rate on a substantial portion of their compensation.
Lobbyists for the private-equity industry responded to the proposal by arguing it might do more harm than good. They said private investment has been beneficial to the U.S. economy, including investing in renewable energy and healthcare, providing jobs and supporting pension plans. The proposed taxes would threaten that investment, they said.
Understand what these lobbyists are asserting, because it’s a howler. They are trying to say, with a straight face, that investment in private equity might shrink because the pay levels for the top dogs might fall from egregious to merely embarrassingly lucrative. Or to paraphrase supermodel Linda Evangelista, “I never get out of bed for less than half a million a day.”
Pray tell, what could these Masters of the Universe possibly do that that would generate anything within hailing distance of what they earn now? Even if lower after-tax pay were a real threat, they’ve got nowhere to go, even before getting to perks like getting to push around investment bankers and top lawyers and fly private class. The fact that men that are unseemly wealthy like Steve Schwarzman and Henry Kravis are still working well into their 70s says it’s not for the money. They really like the job.
Naked Capitalism readers no doubt recognize the second strained claim, that private equity is good for the economy. The lobbyists have the temerity to talk about health care as if private equity’s involvement has been a plus, when it’s been the moving force behind surprise bills, rising ambulance prices, and finding and creating choke points in must-have services, like dialysis, by becoming mini-monopolists in target markets.
The majority of private equity funds go to buyouts, where the “value added” by the private equity funds is provided by leverage and other financial engineering and cost cutting. The industry had a better claim to being good citizens in smaller deals (size $350 million and lower) since private-equity owned firms do sport higher increases in profits than similar-sized companies. But is that because private equity firms managed them well, or simply because they are good at picking “growthier” companies?
The Reality Behind the Posturing: Private Equity Favored Status Not Threatened
The fact is that despite all the whining, private equity isn’t under any real tax threat, even if the private equity loophole is being cut back. As the Journal pointed out:
The 2017 tax law passed under the Trump administration contained a measure that affected the treatment of carried interest by lengthening the period that firms must hold an asset before it is eligible for the long-term capital-gains rate to three years from one. The change generally affected hedge funds more than private-equity firms, which tend to hold assets longer.
Hedge-fund strategies vary widely, but many are active traders with holding periods of less than three years. Still, hedge funds that engage in activism, invest in beaten-down or distressed assets, or invest in long-term plays like biotech companies, for example, can stay in their positions for years and would be hurt by carried interest’s elimination.
In fact, top tax experts have been telling private equity fund managers for many years that the carried interest loophole would be eliminated, it was just a matter of how long it would take. The same experts tell us that getting rid of the carried interest abuse isn’t a serious threat to these money managers’ incomes, because they can use other structures to achieve similar ends. That’s why the CBO scores the income from ending the carried interest tax break at only $14 billion over 10 years.
So why aren’t these funds getting out of the way of the inevitable, particularly since it’s not hard to imagine that the private equity firms’ tax gurus would find ways to cut the cake even more in the fund managers’ favor in the new tax gimmickry? They don’t want to be told what to do.
One top tax pro who has regularly spoken with private equity executives and their tax advisors says that aside from cussedness, the funds are also resisting dropping their carried interest related contractual provisions because as convoluted as they are, the limited partners have gotten comfortable with them (irrespective of whether they understand them or not). If nothing else, the limited partners, if they are doing their jobs (not at all a given), will be difficult as they wrap their minds around new terms.
Getting rid of the preferential treatment of capital gains is the biggest step Biden could take to reduce the income and wealth gap between the rich and the rest of us. That plus imposing a financial transactions tax would have the salutary effect of cutting the economically unproductive asset management business down to size. Sadly we are a long way away from seeing these changes implemented.