May 05, 2007
I'm off to DC to present Two and Twenty at Monday's closed-door briefing of the Senate Finance Committee (i.e. mostly staff from Senate, House, JCT, and also some practitioners and other academics). I don't have any special insight on where the politics of the issue are headed, but I'm pleased that the staff indeed seems to be in fact-finding mode, as this Reuters story suggests:
Senate Finance Committee Chairman Max Baucus, a Montana Democrat, said the world has changed since tax rules for private equity funds were written and acknowledged that the committee is looking into the tax issue.
Baucus declined to say whether the committee's review would eventually result in legislation changing the tax treatment of carried interest in private equity ventures.
"We're trying to do what is right here," Baucus told reporters.
Worth noting that the interest is bipartisan. Senator Grassley (R) was the first to pipe up on this issue.
Probably the simplest fix is to just change the tax treatment of carry into ordinary income. But it's also possible, as a policy matter, that we might be better off with my "cost of capital" method or some blended rate that provides more of an entrepreneurial risk subsidy, similar to an 83(b) election for common stock.
It's also unclear whether a legislative proposal should be targeted to hit only private equity, or should also cover hedge funds, real estate, venture capital, and other investment funds. (It's hard to see how or why one would single out only private equity; a subsidy for venture capital could be justified, although there are probably better ways to target a subsidy than through the tax treatment of carry.)
Lastly, while it's clear that raising the tax rate on fund managers would increase the marginal incentive to move overseas, it's not clear how we should estimate or account for that effect.
It's not crystal clear what the right thing to do is. But it's nice to see a wide range of tax policy options being considered, with an emphasis on getting the policy answer right before worrying about the lobbying brigade (which in this case includes, among other groups, the SEIU, the Private Equity Council, and venture capital and real estate groups). The staff's sensible approach reminds me of Showdown at Gucci Gulch, which of course is the best tax-related book ever.
I'll report more next week as time permits.
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1. Posted by 2L on May 6, 2007 @ 15:16 | Permalink
Any distinction of treating carry for PE shops vs. treating carry for investment partnerships investing in public securities (i.e., a long-only, equity-only HF)?
I'm thinking of something like ESL Investments where long equity positions have an anticipated holding period of 5+ years and Lampert himself is carrying a substantial portion of his cut every year.
I'm curious why this is only characterized as a PE tax issue when it affects other investment partnerships who generate carried interest while focused only on public securities.
2. Posted by Jake on May 6, 2007 @ 16:16 | Permalink
Vic, please make the most of this opportunity, and good luck. Sol Diamond was correctly decided.
The breadth of any resulting legislation is a concern, as you suggest. So please keep us readers informed.
3. Posted by Vic on May 6, 2007 @ 20:16 | Permalink
Thanks, Jake.
2L is right that any legislative response would likely have to affect, at a minimum, all investment partnerships, including hedge funds that take long-term strategic positions in portfolio companies. It's usually characterized as a PE issue because most HFs don't hold positions for very long, and generate either ordinary income or cap gain. But I should note that deferral issues related to HF compensation appear to be of interest to the staff as well.
4. Posted by andy on May 7, 2007 @ 9:35 | Permalink
is Congress actually going to do anything about this, or, seeing that the subject was the topic of a few newspaper articles, did some enterprising representatives just decide this would be a good way to attract some attention to themselves?
5. Posted by 2L on May 7, 2007 @ 13:26 | Permalink
Ahh, I guess I assumed that their was a normative goal of promoting long-term investing in the public markets--that was separate from (and overrode) issues relating to PE compensation.
Of possible note, the Trader Daily 100 (http://www.traderdaily.com/news/item/5585.html) is populated by those incurring short-term capital gains. For instance, I'd venture that of the 100, less than 10 made the list due to a strategy earning long-term (likely unrealized, such as Lampert) gains.
On a small-business note, small HFs (under $100MM in AUM) are likely to employ a long-term time horizon investment strategy. To engage in substantial hedging strategies, paired trades, derivatives investing, swaps, etc. requires quite the setup (not to mention a prime broker). Would seem perverse to change tax treatment across all investment partnerships without consideration of other policy goals that certain investment partnerships may meet while others flatly do not.
6. Posted by Vic on May 7, 2007 @ 17:56 | Permalink
Andy - this was a closed-door briefing, no press and no members, so it hardly seems like Senators are looking for headlines here. I think they really are trying to figure out what's right.
2L - no one except the NYT has suggested doing away with the capital gains preference for investors. The question is whether, as under current law, the preference should be extended to service partners.
7. Posted by Jake on May 8, 2007 @ 19:00 | Permalink
One hopes Vic might post a draft of what he thinks a practical amendment to Subchapter K might look like.
