Gearing Up For One Last Fight On Carry

It’s the 24 billion dollar question. Is the Treasury Department’s expected windfall by taxing carried interest as ordinary income from 2010-2019, a teardrop compared with a sea of bailout money, enough to risk the unintended and potentially negative consequences?

The answer from buyout professionals is a resounding no, of course. They are dead-set against the plan, part of the federal budget proposed late last month by President Barack Obama, to boost the tax rate on carried interest to nearly 40 percent, up from today’s 15 percent capital-gains levy. (One way or the other, the tax is almost certain to go up, as the federal budget also calls for a boost in the tax rate on capital gains to 20 percent.)

“It’s shortsighted,” said Erik Kreiger, managing partner with Portland, Ore.-based Riverlake Partners, a mid-market firm concentrating on control-stake investments in manufacturing and services businesses, said of the plan. “We put in a lot of work on portfolio companies over long periods of time. There’s no way to predict how a change like this, which strikes directly at the motivation behind long-term investing, will impact the industry as a whole.”

Kreiger has already drafted a letter expressing his opposition to the plan to Ron Wyden, a U.S. Senator from Oregon who sits on the Senate Budget Committee. In the letter Kreiger details what he sees as the parallels between carried interest and founders’ stock, which also gets capital gains treatment. In addition, Kreiger plans to urge his limited partners and managers of his portfolio companies to send similar letters.

On the surface, the argument against taxing carried interest as ordinary income is pretty simple. The 20 percent of profits that comprise carried interest bears little resemblance to ordinary income. The payout doesn’t arrive in a check every two weeks. It shows up in a lump sum, after years of work and risk, if it shows up at all. Buyout professionals have long argued that their sweat equity represents just as much an investment as the money pumped into their funds by limited partners. Beyond that, there’s the question of fairness. For years, smart investors have migrated to the buyout business, many of them setting up their own shops, and creating jobs along the way, in part because of the favorable tax treatment accorded carried interest. The government shouldn’t be allowed to change the goal posts midway through the game.

There’s also the law of unintended consequences to consider. Kreiger believes that the higher tax could shorten up the typical holding period for an investment and lead to more of a trading mentality among buyout shops. That attitude would likely deter firms from pursuing strategies with distant benefits, such as expansion into new geographic regions or investment in expensive capital equipment. Instead, cut-and-run tactics, such as eliminating jobs to immediately enhance profitability, may become predominant and produce a negative impact on the overall economy that far outweighs the short-term bump in tax revenue. Buyout professionals “are smart, and they’ll make changes in reaction to this,” Kreiger said. “But the view from the government seems to be to get something now, damn the consequences.”

Indeed, if the tax change does erode the long-term nature of investment in alternative assets, it would have repercussions throughout the financial system, as investments in buyout funds, and other partnerships like venture capital and hedge funds, will no longer provide the same diversity and balance for institutional investors seeking to spread different types of risk throughout their portfolios. “This should be a call to arms for the whole alternative assets universe,” Kreiger said.

Such widespread opposition from industry participants could set the stage for a compromise. Possible scenarios include setting a threshold for when a higher tax rate on carried interest kicks in, or coming up with a separate designation that properly defines carried interest and its attendant tax rate, taking into account both the long-term nature of the investment as well as the fact that GPs are piggy-backing to some extent on the capital supplied by others.

But if there is to be a compromise buyout professionals will have to find a way to counter the popular view of the wealthy as greedy people who have abused the system. The government clearly espouses this attitude within the document detailing the provisions of the budget and what it’s trying to accomplish. Although buyout professionals and other alternative asset managers aren’t specifically cited, they’re clearly being referenced in spots, lumped in with the other popular villains of the recession, such as bank CEOs and Wall Street traders.

“While middle-class families have been playing by the rules, living up to their responsibilities as neighbors and citizens, those at the commanding heights of our economy have not,” the document states. It adds, at a later point: “With loosened oversight and weak enforcement from Washington, too many cut corners as they racked up record profits and paid themselves millions of dollars in compensation and bonuses. There’s nothing wrong with making money, but there is something wrong when we allow the playing field to be tilted so far in the favor of so few.”

It’s ironic that the proposal to tax carried interest as ordinary income should come when the government is looking to partner with the private sector to provide a remedy for the toxic assets languishing on the balance sheets of so many financial institutions. To hear Treasury Secretary Timothy Geithner tell it, there’s a big role for buyout professionals to play in getting the country back on solid footing. Buyout professionals may be reluctant to accept one hand in partnership if the other is simultaneously reaching into their pockets.