Personality Profile: The Professor Who Launched Carried Interest Debate

Name: Victor Fleischer

Title: Professor of Tax Law, University of Illinois Law School

By Jeremy Harrell

Victor Fleischer, a professor of tax law, was only doing what academics do.

In March 2006, he wrote a draft research paper and released it through the normal channels of scholarly distribution. For nearly a year, the world—or at least the part of the world outside a small group of tax lawyers—didn’t pay much attention to the paper, titled “Two and Twenty: Taxing Partnership Profits in Private Equity Funds.”

But in early 2007, as buyout firms snapped up household names and the media put the industry on the front page, lawmakers in Washington, D.C., began paying attention to private equity. In conducting research, a Senate staffer came across Fleischer’s paper, which argues in favor of treating carried interest distributions as ordinary income rather than long-term capital gain. Such a shift threatens to add significantly to the annual tax bill of private equity professionals.

For newly installed Democratic legislators, Fleischer’s proposal presented an appealing one-two punch. By amending the tax code, Congress could undertake the politically unpalatable maneuver of generating more tax revenue without alienating a wide swath of voters. The only victims of the tax shift would be fat-cat private equity pros.

“It’s important for us as academics to get our research out there and tie it to issues when it’s appropriate,” said Fleischer, 35, who this summer moved from the University of Colorado to the faculty of the University of Illinois Law School. “I’ve been interested in this for years. All of the sudden, it became politically interesting.”

So did Fleischer. Although he didn’t actively seek attention from lawmakers, he hasn’t been shy about offering his services once he made it on to the radar. And he’s been a frequent source for the news media. Along the way, he rocketed from academic near-obscurity in March to become a polarizing figure in high finance by June. The Senate Finance Committee’s bi-partisan leaders, Democrat Max Baucus of Montana and Republican Chuck Grassley of Iowa, consulted Fleischer as they drafted the first carried-interest bill, introduced in June. The “Two and Twenty” paper also served as the foundation for a New York Times editorial supporting the change in tax treatment.

On the flip side, Fleischer has been subjected to an unusual amount of derision for a professor. A widely read blog written by a fictitious banker named Percy Walker, for example, featured a photograph of what Walker claimed was a crowd burning Fleischer in effigy.

“The irony is that I’m generally a fan of private equity,” Fleischer said. “It’s an industry that creates real value and can provide real advantages over public companies. Venture capital has also been a huge source of innovation and growth.”

Still, he added, that doesn’t mean that private equity firms should enjoy a tax advantage that public companies don’t have access to. Microsoft and Google, for instance, have also created real value, and they get taxed at a higher rate.

Attorney Turned Professor

Fleischer’s interest in private equity began in the late 1990s, when the Columbia Law School graduate went to work for big-time New York firm Davis, Polk & Wardwell. During his three years there, he got an up-close look at private equity partnerships and the 2-and-20 system of compensation. It’s the typical payment structure in which firms annually collect 2 percent of the amount of each fund they manage, and receive 20 percent of the profit—or carried interest—they generate by investing those funds in portfolio companies.

Fleischer also got a close look at how those partnerships are taxed, and he saw what he considers to be an “anomaly” that allows partners to claim carried interest as long-term capital gains rather than ordinary income. Under the tax code, that means that carry gets taxed at 15 percent rather than 35 percent. “That surprised me when I learned about it,” Fleischer said.

To him, carry is essentially compensation for work, since all but a small slice of the capital in a buyout fund comes from other sources. Yet this fee for service, as he sees it, gets treated as capital gains. It seemed inequitable, he said.

Changing this piece of tax law would also lessen the need for Congress to consider a second piece of proposed legislation that would tax publicly traded private partnerships like a corporation, he said. The proposal, introduced on the eve of the highly publicized public offering of The Blackstone Group, wouldn’t allow a publicly traded partnership to function as a flow-through vehicle for income. Rather, the bill would require the government to tax the partnership as a corporation, subjecting it to a 35 percent rate.

Fleischer called that bill “disappointing,” especially since Congress could correct any imbalance arising from the tax advantages of a partnership by recasting the treatment of carried interest. Meanwhile, treating a publicly traded partnership as a corporation for tax purposes would hurt ordinary investors, he said.

Take the example of Blackstone, whose recent public offering is the subject of a soon-to-be published Fleischer paper. (He explores the structure of Blackstone’s partnership in the paper.) Institutional investors get access to Blackstone’s limited partnership funds, which are considered flow-through vehicles for tax purposes. Retail investors, by contrast, would only have access to Blackstone’s publicly traded general partnership, which would be taxed at a higher corporate rate. That seems fundamentally unfair, he said.

Fleischer’s criticism of that second bill underscores the fact that, although he’s been portrayed as Public Enemy No. 1 of private equity, Fleischer takes a nuanced view of the industry. Indeed, a high-ranking member of the Service Employees International Union, which is waging a public battle against buyout firms, said he’s not sure whether Fleischer is on their side.

And even in his “Two and Twenty” paper, which is still technically in the “working” stage until it’s published by the New York University Law Review next year, Fleischer proposes a remedy. In this workaround, a private equity firm wouldn’t collect a 20 percent carry. Instead the firm would take out a nonrecourse loan equivalent to 20 percent of the capital of a fund and then invest that borrowed money back into the fund. Limited partners, who would technically issue the loan, could waive the interest on the loan, and general partners would pay ordinary-income taxes on the forgiven interest. Assuming the fund made money, the borrowed money would be treated as capital gain. Because it’s a non-recourse loan, GPs wouldn’t be held liable if the investments go south.

“That would be some kind of compromise,” Fleischer said.

Fleischer said that the partnership-tax bill, coupled with the mania that enveloped the entire debate, has left him a little deflated about how things are working out in Washington. “I’m disappointed to see this devolve into partisan politics,” he said. “I’ve gotten my research out there, and we’ll let the political chips fall where they may.” He added: “I’m an academic. I’m not an activist. I’m interested in good tax policy.”