The Tax Man Cometh: Carried Interest, Risk, Fees, and Taxes

So there’s a move a foot by some within Congress to tax all carried interest as ordinary income instead of capital gains.  In case you aren’t familiar with the term, carried interest is the share of profits that the general partner within a limited partnership receives. Traditionally, all of the profits generated by a partnership  have been treated as capital gains so long as the investments that generated the profits have been held at least a year.  This means that general partners in VC, Private Equity, or Hedge funds (funds which typically are structured with a carried interest) not only get highly leveraged returns on their own investments, but that any profits produced get very favorable tax treatment (15% vs. 35%).

A Bad Way To Deal With An Admitted Problem
Originally I was going to write a post about how this idea would require a complete rewrite of the tax code and how at its heart it’s a Marxist attack on capitalism, but I figure that A) it would be seen as entirely self serving (which to some degree it is)  B) I don’t think it’s going to happen as currently envisioned given how many feet the government has to step on to make this change happen.

However the more I thought about it, I think it should honestly be said that the proponents of such measures have a few decent points which I think that the entire investment community, in an honest moment of reflection, should probably admit as valid.

Before I do so, let me first state that it would be crazy (and highly impractical/improbable) for the government to enact a blanket change to the tax treatment of the profits generated by the General Partner in a Limited Partnership.  Limited partnerships exist for a very good reason: they are an efficient vehicle for making highly productive capital investments that generate future economic growth and tax revenue.   This growth effect is why Limited Partnership investments and most other forms of capital investment, very sensibly, get favored tax treatment.  In a country with a negative savings rate, we need to do all we can to spur investment.  In addition, while the General Partner’s clearly get great leverage on their investment (usually 20/1 sometimes even 50/1), they are not just risking their own capital, but they are making a substantial investment of “sweat equity” which the limited partners obviously feel is very valuable.  If general partner’s are prepared to take the risk of a 100% loss on not just their money but also their “sweat equity”, there’s really no reason in a capitalist society why their investment shouldn’t be treated like any other capital investment.

Risk Based Investing Without The Risk
That said, as fund sizes have exploded in the last 5 to 10 years, the level of risk that the General Partner is really taking has arguably declined dramatically because the fee income for many funds has become so huge that many of the general partner’s will make a ton of money even if their fund is a total disaster.   After all, it’s hard to claim you are risking a lot of “sweat equity” when you are driving around in an air conditioned Bentley.

For example, in the VC industry if you go back to 1990, according to the NVCA the average firm size was $82M and they had an average of just over 10 “principals” at the firm (10.2 to be precise).  With a 2% management fee, that pencils out to about $164K in management fee revenue per principal, and that’s before all operating expenses.  With fund sizes this small, the general partners were clearly not living high on the hog when it came to management fees.  In fact, if the funds didn’t make a decent profit it would be safe to say that the opportunity costs for most of the partners at the funds would have far outweighed any fund returns.

By 2002, the average firm size had risen to $284M, but the average principals per fund had actually dropped to 9.5.  Five years later I don’t know what the exact figures are, but my guess is that the average is now above $300M and the number of principals has either stayed constant or gone down, but average management fee is now probably closer to 2.5%.  What that means is that at the average firm now generates $789K/year in management fees per principal and many of the top firms (ones in the so-called 3/30 club) have funds under management of well in excess of $1BN, 3% management fees and just 5-10 full partners.  Such funds can and do pay their partners $2-$3M a year before the investors get a single penny back.  Many of these funds also pay the capital contributions of their partners out of management fees meaning that the individual partner’s never even have to write a check into the fund.

Under these circumstances it’s not hard to see how venture capital has become a fairly riskless proposition for many GPs and that it’s pretty hard to argue folks are investing a lot of sweat equity when they are pulling down at least a million dollars a year for getting out of bed in the morning.  Put another way, in a 3/30 $1BN fund, the general partner only has to put up $10M but in return is guaranteed to get at least $150M in fees over just the next 5 years.  With numbers like that, it’s hard to argue that the partner’s are really taking any risk at all and if they aren’t taking any risk then why in the world should they get any favorable tax treatment for their “sweat” equity since they clearly aren’t sweating the risk of a loss.  If they do lose their share of the $10M they can just fly in their private jet to their beach house Maui to console themselves.  The situation is even more pronounced in the private equity world where fund sizes are now racing past $10BN.  At this level, the compensation for partners at many private equity fund’s makes VCs look downright parsimonious.

So while I agree with and strenuously defend the principle of affording capital gains treatment to those general partners that are willing to take the risk of investing their own cash and sweat equity to produce returns, I think the reality is that in a large number of institutional funds today (be they VC, Private Equity or Hedge Funds), the principals are really not risking much if anything and are pretty handsomely compensated for the time and energy they spend on their portfolio investments.

A Modest Proposal
All that said, the solution that government is proposing is, as usual, terribly misguided.   Taxing all income to general partners as ordinary income is a sure way to A) unfairly penalize those limited partnerships where the general partner really is taking a significant risk and investing a lot of sweat equity (which usually are small business partnerships focused on things such as restaurants and apartment buildings) B) reduce the overall level of private investment C) hurt the businesses that depend on this investment capital for growth.  While I think that a blanket change in the tax treatment is bound to have these negative effects, there are some other changes Congress can make which insure that general partners really are taking real risk and investing real sweat equity to help growth the economy such as:

1. For tax purposes, reduce the general partner’s tax basis by the amount of after-tax management fees it pays out to its members.  In other words, if an individual partner invests $1M in the fund, but gets a salary from the fund that generates an after tax income of $1M, then that individual’s basis should be reduced to zero, which effectively means they invested nothing and should therefore have to pay ordinary income taxes.
2. Raise the % of the fund that the general partner needs to contribute to qualify before it qualifies for capital gains treatment from 1% to 5%.   This makes the level of risk for the general partner a lot more meaningful.  One major drawback of this approach though is that general partner’s without a lot of cash will be hard pressed to meet stiffer capital requirement and this might unfairly advantage old rich firms over new upcoming ones.
3. Some combination of 1 and 2.

These changes increase the level of risk and neutralize the risk reducing effects of copious management fees.  Firms can still choose to pay their partners a ton of money, but if they do those people will lose favorable tax treatment on their investments unless they are willing to invest a lot more cash.  This kind of dynamic tension between current income and capital investment risk is exactly what LPs face, so why shouldn’t GPs face the same trade-off?

It's All About the Benjamins
Of course, the real agenda in congress is not fixing the limited partnership incentive structure, but finding an easy way to raise several billion in additional tax dollars, so I really don’t think the Congressmen care that their proposals are likely to backfire and are logically inconsistent with both capitalism and the fundamental philosophy behind our tax code; they are just trying to make a quick buck by alienating a few as people as possible while wrapping the whole exercise in some media-friendly populist pandering.   Might be good politics, but it’s bad policy.