I’m planning to attend some of the Buyouts East conference today to learn a little about what’s up in private equityland, and to prepare I’ve been leafing through a friend’s copy of Buyouts magazine. An opinion piece by managing editor Michael Baron caught my eye (it appears to be available online only to Buyouts subscribers). It’s headlined “Gearing Up For One Last Fight On Carry” and includes this paragraph:
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 goalposts midway through the game.
Before I tear into this nonsense, I want to make clear that I’m not criticizing Baron. He’s merely repeating the arguments emanating from the industry that his magazine covers, which is what a trade publication editor is supposed to do. But what vapid arguments! Let’s deflate them:
1. Carried interest shouldn’t be taxed as ordinary income because it “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.” Really? Lump sum payments shouldn’t be taxed as much as regular paychecks? So when my book comes out in June, after years of work and risk on my part, and becomes a big bestseller, I shouldn’t have to pay regular income tax on that. Or—to cite an example closer to the private equity experience—when the CEO of a company who, after years of work and risk, is able to cash in her options stash for $100 million, she shouldn’t have to pay regular income tax on that. Except that … our CEO friend and I do have to pay regular income tax (there’s a limited exception for one kind of stock option, but let’s not get into that). Lumpy or risky income doesn’t get special tax treatment. Carried interest gets special tax treatment.
2. 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. The sweat equity of any hard-working, long-serving employee at any corporation represents just as much of an investment as the money pumped in by outside investors—and doesn’t get special tax treatment. The parallel that I think the private equity guys want you to think of here is that of the founder of a company. But the founder of a company who gets founders’ shares—the gains on which are later taxed as capital gains—is in a much different boat than a general partner at a private equity firm who buys a company using other people’s money, then shares in any subsequent gains.
3. For years, smart investors have migrated to the buyout business … in part because of the favorable tax treatment accorded carried interest. It’s funny, I made this argument once—that the growth of private equity was motivated in large part by tax arbitrage—and The Epicurean Dealmaker swatted it down as delusional. Now here’s a private equity trade publication making it for me. But TED’s point still stands: The actual investors fueling the buyout business—that is, the people who put up the money—don’t get carried interest and aren’t directly affected by this whole taxation debate.
4. The government shouldn’t be allowed to change the goalposts midway through the game. Aww, give me a break. Of course the government is allowed to change the goalposts midway through the game—especially when it turns out somebody had snuck them up to the 10-yard line when no one was looking.
Are these really the only arguments these private equity people have to offer? No, there’s one more: “the law of unintended consequences.” Private equity investing is good for our economy, the reasoning goes, and if you changed the tax treatment bad stuff might happen. This isn’t entirely crazy, although I would think it’s just as likely that if you changed the tax treatment on carried interest good stuff might happen.
The most easily predictable consequence, as outlined by University of Illinois law professor Victor Fleischer in his important paper on the topic, is that private equity firms would restructure their operations so that general partners borrow money from the limited partners (outside investors) to buy stakes in the companies they take over. They would then be taxed at ordinary income rates on any gains up to the value of the loan (that is, the market-rate interest that the limited partners presumably wouldn’t make them pay), and at capital gains rates for any profits above that. (I know, I didn’t explain that very well. If you care, read Victor’s paper.) So mediocrity would be taxed at ordinary rates and excellence at capital gains rates. That doesn’t sound so horrible, does it?