I feel like this came out wrong:

The idea that capital gains treatment should only be available to those with money to invest would advance a policy that puts a higher value on financial contributions than vision, hard work and other forms of sweat equity.

That’s from Steve Judge, president of the Private Equity Growth Capital Council, and I think he just said “the idea that capital gains treatment should only be for gains to capital is unfair to people who earn their income from labor,” and, I mean, that’s certainly a position you can have, but … I dunno, that’s not how I’d argue for taxing my labor at a lower rate than other people’s labor?1

It’s from this very funny FT article about the incidence of changes to private-equity taxation. Basically you can just about imagine, if you have an overactive imagination, that a second Obama term would bring changes to the tax treatment of carried interest so that the 20 in private equity’s 2-and-20 would be taxed as ordinary income (35%) instead of capital gains (15%). As with any tax on a business it’s worth asking who actually pays it, and one possible answer is “well, if we amend our partnership agreements to require LPs to gross up managers for any change in the tax code, then the LPs will pay it, won’t they.” That answer turns out to be (1) something that people have actually tried and (2) wrong:

Spurred by the possibility of a change in taxation, five LPs told the Financial Times that many GPs were introducing general clauses into partnership agreements that would give them power to change the terms if there was any change in the tax regime. …

General partners said their investors had shown little interest in their tax rate and have generally declined requests to stand up for the industry when it comes to the tax break, which benefits buyout groups.

One, who said his firm had not made any changes to its fund documents, said he would be surprised if such changes got past large institutional investors. “We have found that our LPs are unsupportive on the issue.”

Perhaps surprisingly, I own an economics textbook and here is a thing it says:

The incidence of a tax depends on the responsiveness of buyers and of sellers to a change in price. When buyers respond to even a small rise in price by leaving this market and buying other things, then they will not be willing to accept a price that is much higher. Similarly, if sellers respond to a small reduction in what they receive by shifting to other areas or going out of business, then they will not be willing to accept a much smaller payment, net of tax.

You can think your thoughts but there seems to be at least some evidence that (1) “investors have become sceptical about the ability of private equity to deliver big returns in the face of ailing public stock markets” and might leave this market and buy other things,2 while (2) most alternative investment managers are unlikely to quit to become touring members of Grizzly Bear. More to the point, we have (somewhat hypothetical) evidence that investors aren’t going to pay it, in the form of them rejecting (somewhat hypothetical but nonetheless) direct requests that they pay it. So that leaves pretty much the managers to pay it.

That’s not really surprising – “General partners said their investors had shown little interest in their tax rate,” and why should they, really? You pay 2 and 20 because your grandfather paid 2 and 20, and his grandfather before him, and you’re not about to pay 2 and 26.153 just because somebody else’s taxes went up. Nor is it that interesting, really, unless you actually think that taxes on carried interest will go up soon, which, I don’t, but what do I know, I had money on Rick Perry being elected president.

What’s interesting is that this sort-of-hypothetical debate does tell you a bit about elasticity in private equity fees. In the face of an external shock to the status quo, managers tried to keep their share the same and take the costs out of investors – and the investors, so far, seem to have pushed back and won. And you could imagine their success in keeping the status quo could embolden them to push managers’ share of the pie even lower. What are the managers gonna do about it – work for a living? That’s so tax inefficient.

Private equity managers fear tax hit [FT]
TPG co-founder warns on returns [FT]

1. For the record, if I were arguing for it, I’d probably take John Carney’s approach, which is one part metaphysical “what is a capital gain anyway?” and one part cynical “we’ll find a way around any changes you might make.” Though I wouldn’t lean too hard on the second part: I suspect his way around the changes would actually founder on the IRS properly determining that it’s not really a loan, and here is the FT again:

The lawyer was also sceptical that private equity groups would be able to avoid new laws designed specifically to end a highly preferential tax break. “Our tax guys would shrug their shoulders, the only way is to raise the carry,” he said.

2. Ooh also in “today in private equity people saying regrettable things to the FT“:

“Returns are trapped by history,” Mr Bonderman added. “When public markets returned 12 per cent and Treasury rates were 600 to 700 basis points higher, private equity returns of 20 per cent made sense.”

Umm:

TBF he was talking in Asia, where things are worse, and even the S&P was flat for 2011, etc. etc. Still!

3. Right? (100% – 15%) x (20%) = (100% – 35%) x (26.15%). Also: you and your ancestors are precocious, reproductively and financially, in that sentence. I understand that there was no “private equity” charging “2 and 20″ in, like, 1880 or whatever.

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Comments (14)

  1. Posted by Guest | October 1, 2012 at 5:15 PM
  2. Posted by Guest | October 1, 2012 at 5:16 PM

    I got your sweat equity right here, jabroni

    -C. Christi

  3. Posted by offset | October 1, 2012 at 6:13 PM

    I'm pretty sure Judge was trying to take on the position VCs have taken and apply it to the carried interest in buyout funds. Not saying I agree, but don't think it's as ridiculous a statement as you purport it to be.

    Secondly, I'm not sure that LPs are voting with their feet by not investing in funds generally, but by investing in a mid/large buyout fund with standard terms that does basically the same thing and takes on pretty much the same risks as the mid/large buyout fund that tried to throw a "I can do whatever I want because of Obama" clause into their LP agreement.

    Matt, I really like reading your posts when you stick to what you know.

  4. Posted by guest | October 1, 2012 at 6:42 PM

    matt – ignore the guy above trying to convince himself that his compensation and taxes aren't both about to change for the worse.

  5. Posted by Jeremy | October 1, 2012 at 7:01 PM

    "I suspect his way around the changes would actually founder on the IRS properly determining that it’s not really a loan"

    In fact, if Carney had read the legislation proposed last year (and in 2009 and in 2010, etc), he would have seen that Congress already shut down the nonrecourse loan idea (as well as several other workarounds that so-called smart folks like Carney floated after the first version of the legislation was prepared)

  6. Posted by Guesticle | October 1, 2012 at 7:09 PM

    Okay, Matt. I see where you are going with that bberg snapshot of the SPX. The SPX is up more than 12%, and PE is NOT up the 20% that I said would be achieved in such an environment. At least our returns are way less volatile – - just consult our infrequent portfolio marks.

    -PE Industry

  7. Posted by Guest | October 2, 2012 at 5:20 AM

    Yawn, nothing new here.

    Why in the world would cherrypicking an arbitrary YTD return be considered a representative "proof" that PE returns stink?

    We could just as easily take a 10-yr IRR on the S&P 500 or Russell 2000 and "prove" that public market returns stink.

    Nice strawman.

    Whether GPs are able to get a "gross-up" for the prospective tax change has nothing to do with TTM returns and everything to do with negotiating leverage between LPs and GPs. And this will vary GP by GP, LP by LP.

  8. Posted by Random Dude | October 2, 2012 at 11:20 AM

    Yep. PE might not have the returns it once did, but it isn't meant to be an 8 month hold.

    As for the tax treatment, I understand that if a GP doesn't put any capital in, maybe they shouldn't get the capital gains treatment, but really what is happening is that the LP is agreeing to allocate some of their gains on their money back to the GP. A pool of capital gains has been divided up according to a contract that each partner agreed to. Its not like the government isn't taking almost 35% of their 6-7 figure paychecks every 2 weeks.

    I think the wealthy who have hundred of millions to throw at managers might bring their investment teams in house instead of having 1 or 2 guys. They might reduce their PE allocation a little and do more direct investment, but I don't see this killing the industry.

  9. Posted by PermaGuestII | October 2, 2012 at 11:44 AM

    -"'Returns are trapped by history,' Mr. Bonderman added. 'When public markets returned 12% and Treasury rates were 600 to 700 basis points higher, private equity returns of 20% made sense.'"

    -The S&P was up 13.06% YTD as of yesterday, a 17.98% annualized return.

    -ML found Bonderman's statement odd in light of that fact.

    -You appear to be the one setting up strawmen.

  10. Posted by Negotiation 101 | October 2, 2012 at 1:07 PM

    And you don't think negotiating leverage between LPs and GPs will be influenced at all by how much money GPs have made for LPs over the prior year(s)? Ah, the fabled context-less negotiation…

  11. Posted by Guest | October 2, 2012 at 1:16 PM

    If you / ML can't understand that when Bonderman talks of "history," he means more than the last 8 months of data, I don't know what else to say.

  12. Posted by Negotiation 201 | October 2, 2012 at 1:27 PM

    Perhaps it's time to remember another point of context: that GPs and LPs do not collectively bargain like a union and an employer. Instead GPs negotiate individually with LPs. So GPs can, to a significant degree, control information flows between LPs and the terms on which they invest. LPs always have the option of walking away, but as a previous post pointed out, if a GP has done reasonably well, LPs are unlikely to walk.

  13. Posted by Guest | October 2, 2012 at 1:29 PM

    What about "this will vary GP by GP, LP by LP" didn't you understand?

    I agree with you — Some GPs have stunk up the place and will therefore will have less negotiating leverage over fees come the next fundraising. Some (potentially many) GPs will have zero negotiating leverage for this tax gross up.

    On the other hand, a # of outperforming funds may in fact be able to negotiate something along these lines. Hellman and Friedman would be a good example of a firm who may be able to accomplish this. Some of the big bulge brackets will certainly not.

    The point I'm making is that aggregate stats for some monolithic "PE Industry" painted with broad brushstrokes are good for click-bate / know-nothing journalists, but it obscures real developments in the industry.

    Anyway, I've said my piece.

  14. Posted by Minnie B. Briggs | October 12, 2012 at 5:17 AM

    i’ve seen this but i cant’t point where i did.