Arch One Holdings

Hamilton Spinning in his Grave...The Carry Tax 10/8/2007

In July of 1776, within minutes of hearing the Declaration of Independence for the very first time, an angry mob tore down a 2 ton statue of King George III on the Bowling Green in New York. Its bronze was melted into 42,088 bullets which were subsequently used by Revolutionary forces against British Troops. Although a bit long on dramatic effect, this action wasn’t lacking in sincerity either. A legacy of unfair and hegemonic taxation was one of the central themes behind the anger. For the past several months, Congress has been flirting with a policy, a tiny whirlwind named ‘HR 2834’, which is every bit as morally repugnant as the Stamp, Sugar, and Townshend Acts ever were - although perhaps not as well-publicized. At issue is the so-called ‘Carry Tax’.

Private equity firms are compensated through profit distributions with the investors who funded them as well as through annual management fees for their expertise in administering those funds. Annual fees are guaranteed for the firm, but profits, of course, are not. The portion of profits that private equity firms retain after paying returns to their investors is called ‘carried interest’ or ‘carry’. The vast majority of funds pay about 80% of the profits to their ‘limited partners’ (investors) and keep the remaining 20% as carry for themselves, the ‘general partner’. That 20% is distributed among management in the firm. Again, this happens only if the firm turns a profit. If there are no profits, there is no distribution. However, the management fee is a percentage of the committed capital for which they are responsible. This is typically somewhere between 2.0% and 2.5% (with buyout firms on the lower end of the spectrum and venture funds at the higher end)1

Individual managers who run these funds currently pay income tax on their base salary in addition to incurring a 15% capital gains tax rate on their bonus – the portion of the firm’s carry which is allocated to them per their compensation plan. However, a small coalition in Congress wants to tax the carried interest as income - not capital gain -, effectively raising that 15% bar to as high as 35%. Also, the legislative push goes beyond just private equity, to hedge funds and even real estate partnerships. Not only would this policy strike at the core of a critical American industry, but there would also be unintended multiplier impacts on its periphery as well.

#1 – Talent Drain: The more junior analysts and associates in private equity firms typically receive deal closing bonuses and opportunities to co-invest on a deal with their own money. However, carry distributions are generally reserved only for senior associates, VPs and partners. The problem with the Carry Tax will be amplified because it will hurt the mid-level managers the most, just as they are hitting their career stride. These are the professionals who possess the financial acumen of the more junior analysts and most of the negotiation skills and contacts of senior partners. The difference in compensation plans is enough to cause an exodus of mid level management out of private equity, back into investment banking, consulting, etc. before they are too deeply-entrenched in an industry with artificially - and legislatively - low compensation levels. To fill the void, the firms will either have to hire non financial professionals with contacts from outside the industry or prematurely promote from their own junior ranks. Either way, the result is less qualified mid level management at the core of these firms. The inexperience will enable many bad deals to get funded, while many deals that should be done, will be done poorly. The whole condition would almost be laughable if hundreds of billions of dollars of hardworking Americans’ pension funds weren’t on the line.

In the near term, the large private equity firms like Apollo Global Management, Bain Capital Partners, The Carlyle Group, etc. will likely weather the storm because they have strong balance sheets to distribute ‘pre-Carry Tax’ compensation levels to their employees and absorb the shock. Smaller firms have less of a cash cushion and essentially no recourse when talent threatens to walk out the door. In the longer term, all firms will suffer from this malady because the condition of diverting cash out of the balance sheet to accommodate the gap cannot last forever. Herbert Stein, President Nixon’s Chief Economic Advisor, once quipped “If something is unsustainable, it will stop.” He would know.

The negative externalities spill over to women and minority groups as well. Recently commenting on HR 2834, Willie E. Woods, Jr., Managing Partner of ICV Capital Partners, New York, noted "the present carried interest policy has been essential to attracting top talented minorities and women to the industry as independent firms and fund managers. Its elimination, consequently, would have the unfortunate effect of impeding this great progress." Mr. Woods is also a member of the Access to Capital Coalition (ACC) a consortium of minority and women-run businesses dedicated to opposing the Carry Tax.2

#2 – Bad Deals, Hurt Pensions: The after tax income ‘gap’ will have to be addressed somewhere – if not on the balance sheet through cash dispersals, then through the term sheet vis a vis less competitive dealmaking against similarly-sized foreign firms. Since they are not going to be able to put as much capital to work in an individual deal, many U.S. private equity firms will push for artificially low valuations from the portfolio firms in which they invest. As a ‘trade’ for the lower valuation, those firms will have to make important concessions in other areas of the deal structure. Trading valuation for deal integrity is a quick way to get hurt in this business.

One tradable is liquidation preference. What happens if a portfolio company closes down in a bankruptcy? Liquidation preferences are a tool that enables favorable treatment for preferred shareholders in the event of such a contingency. For example, instead of demanding an immediate 3x return of their original investment in the event of a fire sale, the private equity firm may have to settle for merely getting their purchase price back and then eventually being ratcheted down in the capitalization table like everybody else. But here's the rub. Just getting the purchase price back wouldn’t even cover the cost of capital. That would mean that the millions of beneficiaries of a pension like CalPERS that invests in a (now) impotent private equity firm, could have done better by just keeping that money in a savings account. At least they’d beat inflation.

Another example is registration rights, which are the extent to which preferred vs. common shares will be given preferential treatment during a public offering. For example, if a lead investor in a deal wants to force a registration, the minority shareholders get the opportunity to ‘piggy back’ on a pro rata portion to their ownership. Typically, the minority investors don't have the ability to force a registration. A firm that is burdened with the Carry Tax may have to concede to minority shareholder status and the diminution in competitiveness associated with it. That means less money through fewer and less frequent registrations, less profits for the private equity firm, and less payouts to the pensions.

Finally, consider dividend provisions, which have a major impact on the value of shares over time. These important provisions are what the board of a portfolio firm will live by when issuing dividends. A competitive private equity firm with preferred shares will push for a high percentage on the dividend, a cumulative vs. non cumulative dividend and for the dividend to be dispersed first to preferred shares over common shares. However, in the Carry Tax scenario, all three of these negotiation points could be compromised due to the lower valuations. Again, the pension holders are hurt because the private equity firms are garnishing fewer profits.

Others areas for key concessions under the Carry Tax will include conversion rights, dilution clauses, board composition, information rights, and legal expenses around the offering itself. The list continues…

There has been some debate, offered primarily by Michael Knoll, a law professor at the University of Pennsylvania, that any private equity firms subject to this oppressive tax will simply make their portfolio firms pay for the carry they would normally receive. I would agree with Professor Knoll only to the extent that European and Asian firms will not be subject to the same tax burden and will naturally flock to the very deals in which their American counterparts can no longer compete. Why on Earth would the CEO of an American company in need of financing incur ruinously high fees to cover (what would have been) their financier’s carried interest? That is like paying in cash for a brand new car, then getting a separate invoice for the cost of the sheet metal. No CEO in this country would or should stand for that nonsense. Lets not ask them to do so.

Prior to 1979, large pension funds were practically forbidden from investing in venture funds; the logic being that the risk was just too great for the multitudes of beneficiaries living on fixed incomes throughout the country. That all changed when the guidelines for ERISA (the Employee Retirement Income Security Act) were relaxed that year. The result was a deluge of speculative capital coming into the private equity industry. Between 1978 and 2006, the increase in pension fund capital into private equity has been an astounding 173,338% ($64M in 1978, to $111B in 2006). 3 Today, nearly half of all investors in private equity funds are pension funds. These funds include the California Public Employees Retirement System, the California State Teachers Retirement System, the New York State Common Retirement Fund, and the Florida State Board of Administration. To short-circuit the expertise and returns of the private equity funds will hurt the large pensions investing in them. In turn, the pension funds will eventually have fewer returns to their beneficiaries. Therefore, to unfairly tax the private equity industry is to hurt millions of hardworking Americans.

#3 – Expatriation: Not only would the Carry Tax cause a drain of talent out of individual private equity firms, but the firms themselves may relocate offshore or be acquired by foreign private equity firms to avoid the tax. It conjures up memories of the dreaded ‘Bermuda Loophole’ in which firms like Accenture, Ingersoll-Rand, Nabors Industries, Stanley Works and others relocated their corporate headquarters offshore. Contrary to the myth of the loophole, this expatriation did not allow these firms to avoid taxes on U.S. earnings, but it did enable them to avoid taxes from overseas earnings. Yet - even that was enough. The loophole was eventually closed and Congress learned a valuable lesson in aligning motivations. Let’s not unlearn it.

An even more unsettling thought is the possibility of haphazard acquisitions of American private equity firms by their European and Asian counterparts. Foreign funds with foreign investors would not be subject to U.S. capital gains taxes, provided the general partner avoided investing in real estate or firms whose primary assets are in real estate. That means that U.S. based private equity firms could begin to unload their real estate holdings, then offer themselves on the block to foreign firms as a last ditch effort to stay competitive. Why have 77% of American mergers since 1998 been foreign companies acquiring American firms? That is not merely the result of a steadily weakening dollar over the same time period. It is also speculative capital in search of a lower tax burden.4 A similar consolidation could easily happen with private equity.

Further, foreign governments are increasingly acting as investors in private equity firms based in their respective countries. That raises a legitimate national security question, especially with sensitive U.S. technology. For example, the Aerospace and Defense division of the Carlyle Group alone has invested approximately $2.3 billion in 31 aerospace and defense companies over the last 20 years.5 How much of that technology is ‘sensitive’?...The infrared camera technology of Indigo, currently used in the Joint Strike Fighter? Stellex’s sub components for Boeing and Airbus? Missile launchers and combat vehicles made by United Defense? Do we really want a state-sponsored Russian or Chinese private equity firm having information rights and a board seat on one of these companies? The state-sponsored China Investment Corp ('CIC') is funded with $200b of China's $1.4 trillion in foreign exchange reserves and has already taken a $3b equity stake in the Blackstone Group, LP - one of the largest private equity firms in the U.S.6 How long before that 3% becomes 51%? If diplomacy makes for strange bedfellows, obscure tax law makes the relationship even stranger.

Conclusion: All arguments around HR 2834 eventually boil down to less competitiveness and profits for the private equity firms, less profit for the pensions that fund them, fewer returns for the pension holders who depend on them, and artificially low valuations.

It is unreasonable for Congress to demand the private equity industry continue to generate explosive returns, while simultaneously cutting the legs out from under it. It won’t happen immediately after the Carry Tax takes effect, but tens of millions of pension beneficiaries will eventually see steadily diminishing returns in their accounts and demand an answer from someone. Soon afterward will come the political blowback. The irony in this backward piece of legislation is that it could end up hurting the very causes and constituents its champions in Congress are purporting to support – millions of pension holding Americans living on fixed incomes. Yet, the arguments in favor of the Carry Tax continue to echo around the corridors of Capitol Hill.

Matthew Beck, spokesman for the House Ways and Means Committee, recently commented during a hearing on HR 2834 “We are approaching the taxation of carried interest as a basic issue of fairness in our tax code. Why should carried interest—which is compensation for services provided by fund managers, rather than returns on personal investment—receive different and favorable tax treatment compared to the rate other corporate managers and workers pay on their compensation for services?"7

Mr. Beck, carried interest is not income, it is a capital gain – a profit from the sale of a capital asset over its purchase price. A capital loss happens when the sale price of the capital asset is lower than its purchase price. Not only are profits not guaranteed, but a firm can loose its entire principal trying to attain them; thus, the currently favorable tax treatment. You know you are in the presence of a talented money manager when he/she makes profits appear with the regularity of normal income. Indeed, this has been the case for many in the private equity industry. Despite the impressive returns, income and carried interest are absolutely not the same and should have different tax treatment. This is where the confusion lies. The regularity of the profits makes it appear as if they were entitled or contractually obliged – like an hourly rate for a consultant or attorney – but they are not.

Responsible human beings can have a discussion about the merits and drawbacks of a ‘progressive tax’ vs. ‘flat tax’ - and even the notion of the ‘Fair Tax’. This is part of a fundamental and broad reaching debate on the entire U.S. tax code, which should happen in the appropriate venue. However, the wallets of private equity professionals - padded as they may already be - should not be a proxy battleground for this fight. These people take enormous risk, and they are compensated handsomely for it if their judgment is correct. This is not an issue of fairness. It is an issue of risk and capital mobilization.

There are others, like Dean Baker, at the Center for Economic and Policy Research, who would argue that everyone who is making the same salary should face the same tax rate. On the surface, this notion rings true in a 5 second sound bite such as the following...“Proposals before Congress (bills S. 1624 and H.R. 2834) would make fund managers subject to the same tax rules as everyone else. They would have to pay taxes on their income when they earn it, and it would be taxed at the same rate as normal labor income.”8 This is actually nonsense. Professionals in the private equity industry already pay taxes on their INCOME. However, PROFITS from highly risky capital mobilization should be taxed in a fashion commensurate with that risk.

Perhaps a more appropriate course for Congress would be to take the higher ground and call for a legislated tax credit for private equity firms which voluntarily donate a percentage of carry to worthy charities, particularly those that map to the local communities in which they and their portfolio companies are active. This would keep the oppressive tax burden off the backs of pension holders while still enabling the vital wealth creation the private equity firms provide our economy.

HR 2834 must be defeated because it runs contrary to the fundamental American notions of risk taking, unencumbered capital mobilization, diversity and commerce. Were he alive today, I can only imagine the Bowling Green tongue lashing Alexander Hamilton would have swiftly administered to its proponents in congress...To essentially double the taxes on the greatest risk takers among us? To encumber the very mechanism of capital mobilization that fueled this country’s growth? To inhibit innovation and punish success? In Federalist Paper #35, he wrote “No tax can be laid on land which will not affect the proprietor of millions of acres as well as the proprietor of a single acre.” Its not just the Blackstone Managing Director in his Gulfstream 550 who will feel the pain; it goes all the way to the California Highway Patrol officer riding the beat on a Harley. If it passes, we will all feel the Carry Tax in one way or the other.

- Alexander Daly is Founder and CEO of Arch One Holdings, LLC. -

Sources:

1- www.vcexperts.com http://vcexperts.com/vce/library/encyclopedia/documents_view.asp?document_id=1147

2 - http://www.prnewswire.com/cgi-bin/stories.pl?ACCT=ind_focus.story&STORY=/www/story/09-05-2007/0004656708&EDATE=WED+Sep+05+2007,+09:00+AM

3- Venture Capital and Private Equity: A Casebook, Josh Lerner, pp. 42, John Wiley & Sons, Inc. and the Private Equity Council http://www.privateequitycouncil.org/private-equity-handbook/

4- NewYorkTimes.com http://query.nytimes.com/gst/fullpage.html?res=9501E4D61539F934A25754C0A9649C8B63&sec=&spon=&pagewanted=2

5 - www.wsj.com "Can China Fund Meet Tricky Task? State Firm to Juggle Demand for Returns And Political Worry" By JASON DEAN October 1, 2007; Page A8

6- http://carlylegroup.com/eng/presskitfiles/13%20INDUSTRY%20-%20Aerospace%20Defense.pdf

7- http://www.blackenterprise.com/cms/exclusivesopen.aspx?id=3528

8- http://www.businessweek.com/debateroom/archives/2007/07/kill_the_privat.html