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1 posts from July 2007

July 15, 2007

Cash and Carry

If you at all follow the start-up industry, you have heard the taxing news.  Congress wants to raise taxes on VCs and private equity executives.  Blackstone's IPO and the perceived excessive economics reaped by the firm's principals appears to have been the impetus for the new legislation proposed by representatives Charles Rangel (D-NY) and Barney Frank (D-MA).  As a side note, it is ironic that the sponsoring representatives are from two of the three states (California being the obvious third) whose local economies benefit the most from the private equity industry.  Talk about putting national (albeit populist) politics ahead of local interests!

At any rate, the economic impact involved is quite considerable.  Currently, we VCs get taxed at the long-term capital gains rate - that is, 15% - for our carried interest of 20-30% in a fund.  The new legislation would result in taxing the carry as ordinary income, typically 35%.

Just a reminder, the "carry" in a fund is the portion of the gain that the VC reaps as part of their compensation.  That is, if a $200 million fund returns 2x, or $400 million, a "20% carry" on the $200m gain is $40 million, which goes to the VC managers of the fund.  A 10x performance on a $200 million fund would yield $360 million in carry ($2 billion in returns, $1.8 billion in gains x 20% carry).  The tax difference for these two funds would be 20% points in incremental taxes paid by the principals, or $8 million and $72 million, respectively.

Some entrepreneurs have asked me to justify why VCs should get the capital gains treatment in the first place and I confess to being hard-pressed.  On the one hand, we do put capital to work and it is truly risk capital.  On the other hand, the capital we put to work is either other people’s money (our LPs) or our own money (our “co-invest”), which under any circumstances would be treated as capital gains – that’s not a part of the debate.  The carried interest is a more complicated portion to analyze because the carry isn’t really capital at risk – it’s a share of profits, not unlike what a sales VP or a stock broker might get in commissions, which are taxed at ordinary income rates. 

The industry is obviously aghast at the proposition of paying more in taxes.  The complaints are at both the micro (“you’re going to double my taxes!”) and macro level (“private equity and VC are fundamentally making American business more competitive and critical elements to the economy; increasing their collective tax payments will be deleterious to US growth and global competitive position.”).  Many VCs rightfully argue that the carry can’t be looked at in isolation – it is a single component of a range of components of private equity compensation that the general partners choose to allocate more of their dollars towards as compared to management fees exactly because of the favorable tax treatment.  If that were to change, they would simply raise management fees or increase the carry rate.  Increasing the taxes on VCs and private equity and having these costs passed through to the limited partners in the form of higher fees or carried interest payments will, in turn, lower the asset class returns for American private equity funds and result in capital shifting away from this asset class into other vehicles, likely private equity funds outside the US.

How will all this impact entrepreneurs?  Probably very little in practice.  On the margin, if it pushes a few private equity executives out of the business, the impact will be negligible given the current situation of "too much money chasing too few quality deals".  My observation is that entrepreneurs roll their eyes when they hear their VC friends whining about the topic, and probably rightfully so.

I guess in the end, I personally find myself in the unusual position of being a bit wishy-washy on the topic.  On the one hand, it is galling that Steve Schwarzman’s butler pays a higher tax rate than he does.  On the other hand, raising taxes on such a critical part of corporate America that is so intricately linked to our capital markets, industrial competitiveness and technology innovation clearly isn’t going to help our global competitive advantage.  In practice, my VC friends cynically tell me the whole debate is moot.  If Congress passes the contemplated law, an army of lawyers and accountants will begin advising us on intricate loopholes to structurally avoid the whole thing!