Carried Interest Debate Cont.: The Death of Sweat Equity?

Fred Wilson has a post up this morning on the carried interest debate in which he advocates taxing all carried interest as ordinary income.  As I mentioned in my own post last week, while I think that the evolution of the investment management business argues that some changes to the tax treatment of carried interest are theoretically justifiable, I do not believe that a wholesale condemnation of carried interest is justified or advisable.

At its heart, the critics of carried interest appear to be unwilling to recognize that it's possible to make an intangible investment.  This is a kind of strange argument to make, especially for VCs, given that the concept of intangible investments is deeply ingrained in the venture capital industry where VCs routinely grant multi-million valuations to start-ups that have little more than some "sweat equity" and "intellectual capital" investment in and while these things don't show up on a balance sheet (or a tax return) they are routinely accorded significant value and in many cases end up producing substantial profits (which in most cases are taxed at a capital gains rate).

The issue most of the "anti-carry" crowd seem to have with VCs is that they either A) aren't willing to concede that VC's make any significant intangible investments in their partnerships or B) are willing to concede that they make intangible investments but believe that the management fees they receive mean that they were already well paid to make those investments, so those contributions shouldn't be viewed as investments, but just part of the job.

As I mentioned in my prior post, I am actually somewhat sympathetic to the arguments underlying B), but those arguments do not hold water across the board spectrum of potential GP/LP scenarios. While it may be hard for people to recognize the value of intangible contributions in the case of a VC or PE professional who is pulling down millions in management fees,  it's pretty easy to see this in the case of a small businessman who is investing their time and expertise (and receiving $0 in management fees) to make a restaurant a success or to renovate an apartment building. And if that person is deserving of capital gains treatment for their sweat equity, then why shouldn’t a VC that agrees to operate under similar terms receive capital gains treatment on any profits produced?

I believe that our tax code must favor not only those who invest straight cash, but also those who take real risk and invest their time and other intangibles.  Without the ability to allocate profits on the basis of both tangible and intangible contributions, a lot of skill rich/cash poor folks will be a significant disadvantage to the rich folks that control all the capital as they will be the only ones to get capital gains treatment.  The real irony of the “anti-carry” crowd’s position is that their logic ends up penalizing labor by reserving beneficial tax treatment only for the providers of capital, something that seems entirely inconsistent with the underlying sentiments of the “anti-carry” crowd.

Finally, I think that the “anti-carry” crowd fails to appreciate that limited partnerships are businesses in which the LPs effectively invest in the GP to help make them money. The LPs invest in the GPs because they want access to their intangibles (sweat equity, connections, intellectual capital, etc.) and they give the GPs a disproportionate share of the profits in direct recognition of the value of these intangible investments. From a theoretical perspective this is basically no different from an investor who buys shares in a corporation at a price above tangible book value.  There is basically zero difference between an Limited Partnership and a Corporation from an operating perspective, yet for some reason the “anti-carry” crowd wants to subject profits from one to a different tax treatment than the other. This makes no sense unless you are either A) intellectually lazy or B) your real intent is to abolish capital gains treatment on all profits regardless of what the legal structure of the entity that produces them is. It is a very slippery slope for anyone who really thinks about this in an intellectually honest way.

Put another way, let's say there is a VC that does not take any management fees, but still works works hard for 5 years to get a successful outcome on an investment. Can anyone say with a straight face that the VC has not made a substantial investment into that entity even though no cash has changed hands?  I realize that management fees are (or at least should be) the big issue here because they negate in theory and reality both the "risk" and the "investment" nature of the time that the VC spends, however it is very interesting to note that entrepreneurs (and many corporate managers for that matter) not only get sweat equity stock but also get salaries and benefits and yet no one is saying that the capital gains on the sale of their stock should be considered ordinary income. Why should a VC be treated any different? They take the risk of starting a business (an investment management business) and then get investors to agree to a deal in which they get a disproportionate share of the profits relative to the actual capital invested (just like entrepreneurs do). Yes, they get a salary, but so do entrepreneurs and employees at normal companies and yet no one is talking about killing off their cap gains treatment ... at least not yet.