Why plan to change carry tax is misguided

Congress is zeroing in on the extraordinary compensation to private equity managers, with a view to income redistribution and, in the process, balancing the budget by taxing “excess” profits allegedly captured by managers by dint of “tax breaks.”

These thoughts:

First, the effect is likely to be trivial if the only change in the Code is to extend the tax status of publicly traded partnerships by repealing the exception from the PTP rules for “passive-type income.” Since 1986, PTPs have been taxed as corporations rather than as partnerships. If taxed as corporations, not a lot of private equity firms are likely to go public. If the owners of the management company and/or the general partner want to cash out, the ready alternative to an IPO is to sell the entire operation to a multi-national banking institution. .

The danger, of course, is that the tax writers will extend their efforts to impose ordinary income tax on gains in the portfolio allocated to the carried interest enjoyed by fund managers. The carried interest, typically 20% (inherited, incidentally, from the oil industry), is an unpaid-for-profit participation in the gains of a private equity fund—whether venture, buyout or hedge. The theory is that the carry is compensation for services. Therefore, the tax should be at ordinary income rates. Some of the proponents believe that, given the extraordinary profits achieved by private equity funds, the increased revenue will put a dent in our nation’s chronic deficits.

Let’s go offshore

The counter arguments are, first, a tax increase of this nature will simply drive many of the top managers offshore. Indeed, a lot of private equity activity has moved to London, as have other corporate finance assets, according to reports sponsored by Hank Paulson, Mayor Bloomberg and Sen. Schumer. While there is a coincident movement in the U.K. to impose an excess profits tax on private equity, it is likely that Greenwich, England, will wise up and extend an invitation to Greenwich, Conn., meaning a large contingent of successful funds will decamp, taking with them most of our current private equity activity, much as the Eurobond sector moved to London some years ago as a consequence of U.S. inattention.

To be sure, the case made by the above cited reports, keyed off the offshore migration of IPO flotations, may be somewhat overblown. But moving the residence of, say, the 200 managers of the most successful private equity funds will be a cinch. If not London, other offshore jurisdictions can be counted on to extend the welcome mat.

Why it won’t work

Since World War II, the rule makers have understood, first, that venture capital has a vital role to play in our economy and, secondly, given the risk/reward equation, a light touch on the regulatory side is required.”

Joseph W. Bartlett, Of Counsel, Fish & Richardson

Secondly, if the carry is taxed as ordinary income, the increased revenues are likely to be minimized by the funds and their managers, shifting the structure of the carry to a system, for example, which has been employed by selected private equity funds for years. The limited partners agree that the fund may advance to the managers soft loans, perhaps with limited recourse, and at the minimum interest rate required to avoid I.R.C. § 7872 to purchase 20% of each opportunity. (The idea being that the loans will be repaid out of profits.)

Once the structure is refined, the economic result will afford the managers the same after-tax benefits as the carried interest. There will be issues, of course, having to do with whether the notes can be structured as limited recourse without triggering a tax on compensation and whether to ignore the investor partnership forgiving, ad hoc, overdue notes and grossing up for the tax thereby incurred.

That said, experience suggests that ways will be devised (absent an entire overhaul of the Code’s principles on taxation of capital gains) to minimize tax legally, and restore the economics of the current incentives in the bargain. The history of tax “reform” is replete with instances of tax lawyers and accountants taking the static language of a new law and/or regulation and turning it on its head. The guess from this corner is that history will repeat itself, and the result will be not much in the way of new revenue.

Unintended effects

Finally, the more urgent issue in my view is the potential for yet another unintended effect, this time on venture capital. The evidence is compelling: Venture-backed companies are the jewels in the crown of our post WW II economy. Any new rule—however well intentioned—which serves to downsize this critical sector is toxic.

Thus, the typical venture capital fund, although it has expanded significantly in recent years, is not large enough to command the excess management fees which buyout funds are able to bank. With a few billion dollars in commitments to a major buyout fund, the management fee is an extraordinary profit item which (arguably) is unearned. In fact, when first introduced, the management fee was designed to cover, and only cover, partnership expenses, and in venture capital, such is still largely the case. The carrot is the carried interest—the primary (often, in fact, the sole) incentive for managers to undertake the job of investing in emerging growth companies.

Post Enron overregulation has, unfortunately, diminished the rewards for venture managers by cutting off sell-side analytical coverage for venture-backed IPOs with market caps less than, say, $700 million. The ripple effect up the food chain is that venture portfolios lack the opportunity to elevate overall returns by so-called “portfolio makers,” the occasional spectacular IPO which lifts all the boats in the portfolio.

The last nail in the coffin, therefore, for venture activity in the United States could be reduction in the value of the carried interest, thereby driving any number of talented managers to pursue other opportunities.

The history of tax “reform” is replete with instances of tax lawyers and accountants taking the static language of a new law and/or regulation and turning it on its head.”

Joseph W. Bartlett, Of Counsel, Fish & Richardson

To be sure, policy makers at the federal level are sensitive to the necessity of preserving our venture-backed economy. If a tax on the carry is imposed, Congress may attempt to carve out venture funds. See, for example, ill-fated SEC Rule, 203(b)(3)-2, requiring hedge fund advisers to register under the Investment Advisers Act of 1940. The drafters of the rule ostensibly distinguished between hedge funds and private equity and venture funds by borrowing the distinction first announced in The Patriot Act. Interests in the fund were, or were not, “redeemable” within a two year period.

The rule was knocked down in court, but had it survived it would have imposed significant problems for venture managers. Given a number of fact situations (hypothetically) enumerated by commentators in which the exemption did not work at all, venture funds would have been drawn into the ambit of the rule despite the SEC’s intention to carve them out.

Perhaps in response to criticism of the earlier exemption, the SEC has proposed to carve out venture funds in another context—from a rule imposing increased thresholds, measured by the size of an individual’s investment portfolio, for purposes of calculating whether that individual is an exempt investor in a private equity fund within the meaning of § 3(c)1 of the ’40 Act.

The SEC elected to include both hedge and private equity funds within the scope of the rule for this purpose and exempt only venture funds, again borrowing language from another rule/statute, in this case Section 202(a)(22) of the Investment Advisers Act, which defines “business development companies.” However, this exemption has its own warts. A number of venture funds, for example, would be ineligible, and one might well find a number of private equity funds retro-fitting their portfolio strategies to fit within Section 202(a)(22).

The point is that the principle of unintended consequences is a huge concern of long-time practitioners in this area. Venture capital has flourished in the United States because enlightened government action, and particularly benign neglect, has been supportive. Since World War II, the rule makers have understood, first, that venture capital has a vital role to play in our economy and, secondly, given the risk/reward equation, a light touch on the regulatory side is required.

If VCs get tied up in excessive and often counterintuitive regulatory thickets, the venture process could be stunted, with seriously negative impacts on our overall economy.

Joseph W. Bartlett is Of Counsel in the New York office of Fish & Richardson P.C. He is a member of the Corporate and Securities group with practice emphasizing alternative investments, venture capital, emerging companies, initial public offerings, corporate restructurings, private equity finance, and buyouts. He may be reached at bartlett@fr.com.