PE firms brace for tax battle

Private equity firms are again being threatened with higher taxes, as a long-running debate over how to classify their profits again becomes a focus for governments desperate for cash.

But while high-profile buyout firms may seem an easy target, the question is a controversial one. Critics argue that raising the taxes paid by the private equity industry will also hit small partnerships and venture capital, and may not even raise as much revenue as governments hope.

Part of the argument against higher taxes is that they could hinder jobs growth at a time when major economies are struggling with high unemployment rates.

In the United States, there is skepticism that government plans to raise the tax paid on “carried interest,” a major source of earnings for PE executives, will become law anytime soon.

“In its favor it will pick up some taxes,” says Steven Kaplan, a professor of finance at the University of Chicago. “On the other hand, it will hit private equity and particularly venture capital firms, and in this day and age, they’re not the bad guys.”

The long running dispute on the tax was revitalized recently when President Barack Obama once again proposed changing the rate in his budget request.

Carried interest is typically the 20% that private equity executives take from the profit made on their funds, after compensating their investors. The amounts can be large if the funds perform well. Still, it is only payable after a fund generates a performance hurdle, usually 8 percent.

The proposal would tax carried interest as ordinary income, raising the tax rate from 15% to typically the highest income bracket of 35% and raising $24 billion over a decade, the government says.

Obama pitched the idea in his first budget last year, but despite passing the House of Representatives three times, it floundered due to lack of support in the Senate.

It has discombobulated the industry. One private equity executive, who declined to be named, said it was anyone’s guess whether it would get signed into law.

Kaplan handicapped the odds at slightly less than 50-50, but others think it is more likely to succeed.

“I think there’s a groundswell to pass this … its a significant revenue raiser,” says Edward Smith, tax partner in the Boston office of tax services firm BDO Seidman’s Private Equity Practice. “I think because it’s been on the table for so long… it is a high likelihood it will get passed.”

The debate over tax is also bubbling up in the United Kingdom, where there is fear that carried interest, taxed as capital gains at 18%, could go as high as 50%. It could drive people out of London to more transparent and friendlier tax regimes in Europe, observers warn.

“If it means we have to snuggle up to one of the cantons in Switzerland, that’s exactly what we will do,” says a partner at a leading British venture firm, who did not want to be identified talking about the controversial topic.

In Australia, a separate dispute is ongoing, concerning the tax treatment of a profit TPG Capital made through the IPO of a portfolio company.

Critics warn that raising carried interest tax will with one fell swoop hit all kinds of partnerships, not just the huge high profile private equity firms.

“It is being characterized as a tax on giant private equity firms, but the carried interest concept is fundamental to almost all forms of capital formation,” says Bob Profusek, global M&A chair at law firm Jones Day. “People need to realize it will have unintended consequences that would ripple throughout the country.”

Some pointed to the so-called luxury tax introduced two decades ago which slapped a surcharge on sales of expensive items, such as boats and fur, but had the unintended consequence of costing boat manufacturing jobs. It was later repealed on those items.

The 15% tax rate was originally put in place to encourage more private capital investment into companies, with venture capital and private equity investors being compensated for risking their and their investors’ money.

But during the height of the private equity boom in 2007, politicians and union groups argued that buyout firms were paying a lower tax rate than Mom-and-Pop businesses.

At the time of the high profile, $4 billion IPO of The Blackstone Group in June 2007, leaders of the Senate Finance Committee proposed making carried interest taxable at the ordinary income tax rate for private equity firms that had floated.

Hedge fund and private equity managers managed to hold back the effort, but time could be running out.

“These things take a long time to happen and still, there’s a question of how much revenue might be generated by it, but I wouldn’t be surprised for something to happen eventually,” says Josh Lerner, a Harvard Business School professor specializing in private equity. “I think it is probably inevitable.”

Still, some buyout executives are indicating they may be resigned to a tax increase.

“The government is, as it should be, looking for every revenue source,” Apollo Management founder Leon Black said at a recent conference. “It wouldn’t be the worst thing in the world for some adjustment.”

Additional reporting by Simon Meads and Mike Flaherty, Reuters.