August 20, 2007
Knoll on Carried Interest
Posted by Victor Fleischer

Michael Knoll has a cool new paper estimating the revenue effects of changing the tax treatment of carried interest.  Depending on various assumptions, he comes up with about $3 Billion a year (see paper at p. 12; if character is changed to ordinary income, then additional tax collected would amount to between 2.4 and 3.4 billion).  I'd previously done a very rough back of the envelope calculation to come up with $4-6 billion a year. 

Among Knoll's key assumptions:

1) $200 Billion a year invested in private equity. Is this too low?  This is a high estimate by historical standards, but low given recent trends.  On the other hand, the recent credit market shakeup may slow fundraising for a while. 

2)  Scope of the change.  Knoll only looks at private equity, but at a minimum the change would also apply to hedge funds.  Hedge funds that make long-term investments might also be affected.  It's also possible that real estate, timber, and oil and gas partnerships might also be affected, depending on how the politics play out in DC.

3)  Volatility.  Knoll uses a Black-Scholes model to value the carry and estimates volatility of the average fund at 20%.  No idea if this is right - average volatility for a portfolio company would be much, much higher, but of course most PE funds have 10 or more companies in the portfolio.  I suspect we could find some historical return data that would help here.  Unfortunately, academics are at a distinct comparative disadvantage here, as the best data sources are proprietary and expensive. 

I'm also not sure what the Black-Scholes model gets you here, i.e., why it's better to use option methodology rather than just looking at historical returns for the sector as a whole. 

Knoll also discusses some possible re-structuring of the carried interest that might take place, and how that might affect revenue.  He notes, for example, that incentive fees might be paid by portfolio companies instead of the funds themselves, which -- if the portfolio company has a high effective tax rate -- generates a valuable tax deduction.  On the other hand, this changes the economics of the deal in ways that the LPs might not like (by measuring carry on a company-by-company basis rather than an aggregate basis), and it's not clear how many portfolio companies have a high effective tax rate.  (Recall that most portfolio companies take on a lot of debt in connection with the buyout.) 

It will be interesting to compare Knoll's paper with government's revenue estimate and methodology. 

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