Theater of the Absurd: Capital Gains Now Being Eliminated on Sale of VC/PE Management Companies

According to Bloomberg, there’s a nasty surprise in the bill that eliminates capital gains treatment for carried interest in investment partnerships.  Not only is the government planning on eliminating carried interest on the investment profits generated by a partnership, but they are planning on eliminating capital gains treatment on

“the sale of any firms, including hedge funds, founded by financiers to manage funds that generate carried interest. “

The theory behind this latest twist is that nefarious VC/PE/Hedge fund managers will get around the new carried interest rules by selling stakes in their management companies just prior to realizing capital gains in their investment partnerships.  Because the management companies are typically organized as C Corps or LLCs, these ownership stakes could be sold, like any stock, to get capital gains rather than the partners being forced to book the income as ordinary income/carried interest.

I don’t know where to start criticizing this latest twist but I’ll start with the fact that it makes no sense at all for two key reasons:

1. Many management companies are organized as C Corps and as such don’t realize investment gains or carried interest when a partnership sells an investment interest.  The value of these firms is not tied to investment gains but to management fees. Any profits from those fees are already taxed at ordinary rates.
   
2. In those cases where the management company does in fact receive investment gains, those investment gains are typically spread out of many different investments over the life of many different funds.  It would make no sense at all to sell off a chunk of a management company in advance of one particular investment realization as once you sell a piece of a management company, that piece (and its claim to all future profits) is gone forever, just like stock sale.

In short, for most firms, it makes no sense at all to sell a piece of a company just to get capital gains on a particular deal because most firms don’t even get capital gains to begin with and those that do would be stupid to sell a permanent piece of the returns generated by their company for the returns on a single investment.

Outside of this, it is blatantly discriminatory against one type of company, i.e. a fund management company, vs. every other kind of company.  Look, I can see how people of good faith can argue that investment managers don’t deserve capital gains on their carried interest, but I don’t see how anyone can support this particular provision. 

If a group of people get together to start-up an investment manager/adviser and successfully build that start-up into a real business, they should be able to get capital gains on the sale of an ownership stake in that business just like any other business in this county.  Anyone who doesn’t think so clearly hasn’t tried to create and build their own investment management company.  Believe me, they are as much a start-up as any other kind of business. 

At this rate, the entire US investment industry is just going to decamp to either Hong Kong or Switzerland.