Carry ‘clock’ proposal could kill continuation fund market – Fall Forum panelists

The list of challenges bearing down on the private equity industry, as enumerated by panelists at the CFOs & COOs Fall Forum on Wednesday, was prodigious.

Perhaps chief among them are the prospects of successful political and regulatory challenges to the industry’s model. “Once again private equity finds itself in the crosshairs, but this time with an opposition that is more well-funded and more well-coordinated,” said one panelist from a large, mid-market-focused firm, who said that there are 13 times more news stories about the industry than there were 10 years ago.

In particular, the panelist noted that a provision of the bill from the US House of Representatives that further limits favorable tax treatment of carried interest took the market completely by surprise. While it was widely known that House Democrats plan to increase the time funds need to hold a given asset in order to qualify for capital gains tax treatment from three to five years, the ‘clock’ on that time period doesn’t start until a fund has invested “substantially all” of its committed capital.

“In Washington speak, that’s typically 80 percent” invested, said the panelist, giving an example: “If you have a fund that owns three [portfolio] companies, bought in 2022, 2023 and 2024, that company you bought in ’22, you actually can’t start the five-year clock until ’24.”

Asked whether the market had seen a peak with regards to managers seeking to reinvest in or extend successful investments on assets they hold or have held — activity that includes continuation funds, for example — the panelist said, “It really depends on what Congress does. [Under] the bill as written, continuation funds wouldn’t work because you would trigger the gain” made on the underlying investment for tax purposes, realizing tax liability on the asset, which would then need to be held in the continuation fund until five years after that fund is “substantially invested”.

Whether the bill passes as written will depend in part on how much of Congress’s budget reconciliation bill ends up being approved, and thus needing funding. A three-to-five-year holding period to qualify for carried interest nets the government about $4 billion, the panelist said. “Changing the clock gets you about $14 billion.”

But the current proposal would significantly impact venture capital and real estate, which politicians are more sensitive about treating punitively, the panelist said.

Rising costs

Other provisions of the proposal, including an increase in capital gains from 20 percent to 25 percent and a graduated increase on corporate tax, as well as as-yet unknown regulatory actions to be taken by the Securities and Exchange Commission around ESG reporting and even OSHA rules on employer obligations for reopening offices, all factor into the bevy of imminent headwinds faced by the industry.

Panelists noted that they are already seeing inflation — if unevenly and in industry-specific situations — in their investments and are beginning to react to it. Labor shortages at the lower-cost employee end of the workforce are causing inflation as costs get passed through to customers. Persistent supply chain issues are also pushing up prices in many areas.

And while a near-term rise in interest rates is far from certain, continuing inflation could force the Federal Reserve’s hand. Asked if rising rates could impinge on some of the highest rates of dealflow ever seen, one senior PE firm partner said deal flow is “not as much economic driven as it is lots of people looking for liquidity events before rates change dramatically.”

But will rising costs themselves rein in activity? “I don’t think so. It will drive profitability… It’s all about whether those businesses can raise prices enough to offset price increases,” the panelist said, adding that their firm’s portfolio companies were already testing out higher prices, and that so far, they were clearing the market.

The recent performance of public markets, leverage availability and flexibility helping to drive valuations into “truly seller’s market” territory, and heavier and heavier competition all suggest performance will come under big pressure in the future. But while an executive at a fund of funds manager agreed performance will inevitably come down, “the top performers are still the top performers, and the returns are still well in excess of what the public markets offer,” they said.

And the expected continued influx of new capital into the industry will be a boon, and one of the panelists said opportunities to drive returns still abound. “I’m very, very bullish about the long-term prospects, even if we pay a lot more in taxes.”