peHUB Wire: Friday, May 21, 2010

Several months ago, I promised not to write again about carried interest taxation until relevant legislation either passed or was formally buried. Let me be the first to call me a liar (although perhaps that’s a bit harsh, as I was sincere at the time).

But don’t worry: My goal this morning is not to relitigate the underlying issues. You know where I stand on those. Rather, what follows is to look at where things are at and what might happen once a bill does, indeed, pass.

Where things stand: Last night, Senate and House Democrats said they would new legislation on carried interest taxation, as part of the “American Jobs and Closing Tax Loopholes Act of 2010.” Here is the relevant language, from a bill summary posted online:

The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income. A transition rule would apply prior to January 1, 2013. This proposal is currently being estimated by the Joint Committee on Taxation.

So, 25% of carried interest would continue to be taxed as capital gains, while the remaining 75% would be treated as ordinary income. This would go into effect beginning 2013. The aforementioned “transition rule” for 2011 and 2012 is not spelled out, but I’ve heard that it may be a 50/50 split (i.e., 50% cap gains, 50% ordinary income). 2010 taxes would not be affected.

I pulled out the back of an envelope to do some math, and here’s what I came up with: Let’s assume you made $100 of carried interest. Today you’d be taxed $15 but, with or without the carry tax change, you’d be taxed $20 beginning next year (due to expected rise in cap gains rate). So let’s use $20 as our baseline rate going forward. For 2011 and 2012 – assuming the 50/50 split – your tax bill would rise to $27.50. In 2013 and beyond, it would become $31.25.

That does indeed mean that taxes on 2013 carry would more than double from where they are today, although the jump is 56.25% when the r! evised cap gains rate is taken into account.

Them’s the facts, now let’s move on:

Getting Dodgy: There’s been a lot of talk on both sides of this debate about the issue of “loopholes.” For example, NVCA president Mark Heesen yesterday said: “Referring to the carried interest tax structure as a “tax loophole” is untruthful.The capital gains treatment of carried interest has been a legal part of the tax code for decades.”

Methinks Mark doesn’t understand the definition of a loophole. It doesn’t suggest something illegal. It suggests something legal that should not be, often because it goes against a law’s spirit.

Anyway, the question now isn’t whether or not current carry treatment is a loophole, but rather what loopholes will be found in the revised legislation. For example, I met with a VC yesterday who said (I’m paraphrasing): “This won’t affect us, except that we may need to make one more accounting or legal step – we’ll still pay capit! al gains rates in the end.”

I heard something similar during a recent buyout panel, in which a senior PE firm exec implied that his lawyers already had several contingencies in place.

For example, one idea people have considered for venture capital is moving out of a partnership structure and into a series of one-off co-investments (rather than one blind pool) – in which the VC basically buys founder shares, management “buys” cheap founder stock and LPs put in for preferred stock. It’s kind of how fund economics work anyhow, although it’s far from clear if this is either practical or LP-acceptable.

There also has been lots of talk about domiciling VC/PE funds offshore, particularly after the carry tax issue was first raised in 2007. Since then, however, subsequent legislative language has tried to address the issue via offshore-specific provisions.

Here’s how one PE tax attorney summed it up for me last night: “It’s impossible to say what the solution will be, or if there will be one, until we see the ultimate bill.! We also don’t know how active Congress will be in trying to close new loopholes we discover… but, yes, we’ll be working hard to keep the tax bills for our clients as low as possible.”

Rush for the Exits: Let’s assume that the lawyers don’t come up with a practical solution. Or perhaps that the solution still results in a significantly higher tax bill on carry. What do VC/PE firms do then?

One thing I’m hearing more and more is that firms might accelerate their attempts to exit existing portfolio companies. Remember, the tax bills for 2010 stay status quo, which means any distributions for the next seven months get treated as 15% capital gains.

A few investors have told me that they’ve held board-level meetings to examine the tax implications about selling a company this year as opposed to next year (or beyond). I have not heard that decisions have been made based on those calculations, but people are indeed doing the math.

If this is the! chosen path for certain investments, expect trade sales instead of IP Os – since distributions on the latter would bleed beyond 2010. Will be very interesting if there’s a major Q4 spike in VC/PE-backed M&A…

Political Posturing: Finally, I’m very curious to see how the Levins (Sandy and Carl) pitch their new proposal. These guys have been saying for years that carried interest is ordinary income. Period.

Now, it appears that they’re staking out a middle ground in which carry isn’t quite ordinary income and isn’t quite capital gains (although more the former than the latter). Pretty significant pivot, and perhaps could indicate room for further compromise…

Unrelated: Looking forward to seeing a bunch of you in South Boston tomorrow, as part of the PE/VC Serve-a-Thon team. Sign-up has officially ended, but I’m sure I can get you in. If interested, send me an email. Might also see some of you at tomorrow night’s Celtics game (if the ushers let me near the lower bowl)… Have a great weekend!

Top Three

ABRY Partners has agreed to sell CapRock Communications to Harris Corp. (NYSE: HRS) for $525 million in cash. CapRock is a Houston, Texas-based provider of mission-critical managed satellite communications solutions for the energy, government and maritime industries.

Toyota Motor Corp. has agreed to purchase $50 million worth of common stock in electric car-maker Tesla Motors, following the company’s planned IPO. The investment is part of a larger joint development deal, announced yesterday. Tesla is in registration for a $100 million IPO, and has raised $220 million in VC funding from firms like Draper Fisher Jurvetson, Daimler AG and VantagePoint Venture Partners.

Isaac Ciechanover has joined Kleiner Perkins Caufield & Byers as a partner focused on life sciences investments. He previously was executive director of business development with Celgene Corp.

VC Deals

Eutechnyx, a UK-based videogame developer, has raised £6 million in VC funding led by Prime Technology Ventures.

TweetDeck, a UK-based maker of free software that helps organize Twitter streams, has raised $3 million in Series B funding. Return backer Betaworks led the round, and was joined by Accelerator Group, Roger Ehrenberg, Howard Lindzon and new investors Ron Conway and Danny Rimer., a Chrome browser extension that allows users to turn the Web into a personal music library, has raised an undisclosed amount of VC funding from Spark Capital, Betaworks, Founder Collective and Dave Morgan.

Buyouts Deals

Charlesbank Capital Partners and H.I.G. Capital have acquired eye care services company TLCVision out of Chapter 11 bankruptcy.

Charlesbank Capital Partners has sponsored a recapitalization of Tulsa-based cedar distributor Cedar Creek, in exchange for a majority ownership position. ClearRidge Capital advised Cedar Creek on the deal. No financial terms were disclosed.

Royal Bank of Scotland reportedly is considering a private sale of health group The Priory, which is previously planned to take public.

Sigma Pharmace! uticals (AX: SIP), a struggling Australian drug-maker, said that it has received an A$707 million takeover offer. It did not identify the suitor.

Terra Firma Capital Partners has acquired Scotland-based Ardrossan Windfarm from Scottish & Southern Energy (LSE) SSE). The deal is valued at £53.8 million, including the assumption of £25.7 million in debt.

PE-Backed IPOs

Accretive Health and ReachLocal both saw their shares rise on the first day of post-IPO trading, by 12.9% and 15.2%, respectively.

PE Exits

C. R. Bard Inc. (NYSE: BCR) has acquired FlowCardia Inc., a Sunnyvale, Calif.-based developer of endovascular devices for coronary and peripheral chronic total occlusion (CTO) recanalization, according to VentureWire. The deal is worth around $80 million. FlowCardia had raised over $42 million in VC funding, from Gilde Healthcare Partners, Life Sciences Partners, H&Q Capital Management, New Science Ventures, Rockport Venture Partners, Gold Hill Capital, Frazier Healthcare Ventures, JPMorgan Partners and Pappas Ventures.

Cisco has agreed to acquire CoreOptics, a San Jose, Calif.-based maker of optical networking subsystems, for approximately $99 million in cash. CoreOptics had raised more than $90 million in VC funding from T-Com Venture Fund, GIMV, Crescendo Ventures, TVM Capital, High Tech Private Equity, Atila Ventures and Quest for Growth.

Google has acquired Simplify Media, a Redwood City, Calif.-based maker of software that lets users stream music from online libraries to other devices. No financial terms were disclosed. Simplify Media had raised VC funding from Sierra Ventures.

Mindspark Interactive Network, a unit of IAC, has acquired a majority stake in DailyBurn, a fitness social network. No financial terms were disclosed. DailyBurn had raised around $525,000 in seed funding from FF Angel LLC, StumbleUpon’s Garrett Camp and author Tim Ferriss. has acquired TravelJigsaw, a UK-based online travel agent specializing in car rental. No financial terms were disclosed. The seller was ISIS Private Equity, which sponsored a £25 million management buyout of TravelJigsaw in 2005. Livingstone managed the sale process.

Rakuten Inc. of Japan has agreed to buy online retailer for $250 million in cash. Sellers include Clearlake Capital Group, which bought a 9% stake in three years ago.

PE-Backed M&A

EN Engineering, a portfolio company of Clearview Capital, has acquired Wheatland Systems Inc., a Lawrence, Kansas-based provider of services to the power and utility industries. No financial terms were disclosed.

The Harvard Drug Group has acquired Spectrum Pharmacy Products, a maker of fine chemicals and laboratory products, from Spectrum Chemical Manufacutring Corp. No financial terms were disclosed. Harvard Drug is a portfolio company of Court Square Capital Partners.

Stant Corp., a portfolio company of H.I.G. Capital, has acquired the assets of Expert Corp., a Romeoville, Ill.-based maker of evaporative emission canisters and front end carriers for the automotive industry.

Zynga has acquired Beijing-based social gaming company XPD Media. No financial terms were disclosed. XPD Media had raised over $2 million from True Ventures and Pilot House Ventures. Zynga has raised around $240 million in total VC funding, from Digital Sky Technologies, Andreessen Horowitz, Tiger Global, Institutional Venture Partners, Kleiner Perkins Caufield & Byers, Union Square Ventures, Foundry Group and Avalon Ventures.

Firms & Funds

The European Bank for Reconstruction and Development said it would invest $50 million into a fund-of-funds focused on Russia, other ex-Soviet states and Turkey. The vehicle aims to raise up to $300 million, and is being managed by Switzerland-based Alpha Associates Group.

Human Resources

Zaid Ashai has joined Point Judith Capital, a Providence, R.I.-based VC firm, as a partner. He previously was with Good Energies and, before that, worked both with HabourVest Partners and Credit Suisse’s tech I-banking group.

Ami Assayag has joined SeventySix Capital, a Philadelphia-based early-stage VC firm, as an entrepreneur-in-residence. Assayag is a serial entrepreneur, having foundedVisualFund andco-founded eHealth Software Solutions.

David Bell, a professor of business and agriculture at Harvard Business School, has joined Paine & Partners as an advisor on the agribusiness and food industry.

Jon Steinberg has agreed to join New York-based content aggregator BuzzFeed as president. He had spent the past seven months as an executive-in-residence with Polaris Venture Partners, before which he was strategic partner development manager for Google’s Small Medium Business Partnerships group.

Joe Wright, the recently-retired CEO of Scientific Games Corp., has joined Providence Equity Partners as a senior advisor.