During the past few years, as investors have searched for yield,
private equity provided attractive returns in exchange for illiquidity risk.
Regulations stifling Sales & Trading at big banks, combined with passive
investing outperforming active has driven talented young financiers into
the private equity field in search of riches. Despite the recent financial
deregulation push from the Trump administration – during the 2016 election it
seemed both candidates agreed on getting rid of the “carried
interest loophole” – the holy grail for private equity investors. Is this a
threat to the private equity industry?
The current carried interest tax rate is the same as the capital gains tax rate of 20% (was 15% throughout the 2000s as part of the George W. Bush tax cuts and was increased by 5% in 2013 as part of a broader deal to raise the US debt ceiling)
Theory for carried interest:
Same as theory for a lower tax on capital gains: In exchange for the effort and risk involved in the investment, owners of capital receive their share of profits (if any) at a lower rate.
- Per industry
experts, 75% of PE partners compensation comes from carried interest – The
New Yorker 3/14/16
- Some
PE partners are even able to have their management fee (usually 1-2%)
which is their “labor income” taxed at carried interest
rates
Clearly – an elimination of this tax advantage would reduce the
earnings of PE partners, and hypothetically make employment in the PE industry
less attractive.
Since many in the upper echelon of PE partners are among America’s wealthiest (top 0.1%) the expansion of their taxed earnings from 20% to 39.6%( top tax bracket) is a material amount regarding government revenues
- Estimates on
revenues lost due to carried interest range from $15-25B annually (some
proponents of repealing the tax advantage believe the lost revenues could
be many times more)
- Granular
example: Stephen Schwarzaman, CEO of Blackstone Group
made approximately $700mm dollars in each of the last two years = annual
tax savings of close to $100mm for a single person
Private Equity trends and the coming populist rage:
The regulatory intensity driven by anti-establishment populism is a well-known theme in the finance world during the past few years. The Private Equity industry has largely avoided scrutiny, while their finance contemporaries (Wall Streeters more directly involved in the housing crash, Investment Bankers at the large bulge bracket firms, high-frequency traders) have borne the brunt of public criticism from movements like Occupy Wall Street, the Tea Party and vigilant government officials like Elizabeth Warren, Democrat, MA. However, there are several characteristics of Private Equity that may soon attract public criticism. Disdain for “Elites” in finance is becoming more bipartisan.
The typical business activity that aggravates public sentiment:
- Adding
tax-advantaged debt
- Cost
Cutting (usually facilities and employment),
- Extracting
large fees
Trend of publically held companies turning private (i.e. Dell,
HJ Heinz, Hilton, Kinder Morgan):
Logical Reasons for trend:
- Private
companies can avoid ever increasing regulatory burdens and follies of
“quarterly capitalism”
- Locked in
capital: Often 10 years periods before investors may draw down funds
- Private
firms more insulated from shareholder activists
- Substitute
debt for
Equity = tax optimization & profit maximization
- Benefit of
speed and opportune timing for purchases, sales, and refinancing
Cost of trends:
Direct individual exposure to corporate profits is lost =>
Focuses corporate riches in the hands of privileged few => Disengagement
from capital component of capitalism => Less likely support from public to
support business-friendly government policies
Is Private Equity Truly Private?:
Money within funds is often tied directly to public institutions
(Sovereign Wealth Funds, Municipal Pensions) or tax-exempt private foundations
and school endowments => Implicit tie between allocation of funds,
investments, and the state => Enables corruption and crony
capitalism=>Feeds into populist narrative of self-serving “global elites”
Public Company and Private Equity “Collusion”?:
“[public companies] their inner workings are more open
to inspection and criticism. Sometimes they bring in private equity to do what
they would not. After acquiring Kraft and Heinz in deals that a Brazilian
private-equity firm, 3G Capital, also took part in, Warren Buffett of publicly
traded Berkshire Hathaway explained things like this in his annual report: “We
share with [3G] a passion to buy, build and hold large businesses that satisfy
basic needs and desires. We follow different paths, however, in pursuing this
goal. Their method, at which they have been extraordinarily successful, is to
buy companies that offer an opportunity for eliminating many unnecessary costs
and then—very promptly—to make the moves that will get the job done.”
Berkshire, it appears, with its annual meetings featuring happy shareholders
applauding a jovial peanut-brittle-munching chief executive, outsourced
the hard decisions to a less exposed firm happier to take them.” –
The Economist 10/22/16
Major PE Firms are large employers:
- Carlyle
Group owns 275 companies and employs 725K workers
- KKR owns 115
companies and employs 720K workers
- Both are
larger employers than any listed American company besides Walmart = gives
scope to political scrutiny
Perceived Revolving Door between PE & Government:
High ranking government official retires=>Becomes PE partner at large firm => Firm lobbies Washington to protect carried interest=> Rise, Wash, Repeat
Question: If a wave of intensified political backlash comes to fruition – will the public and vigilant lawmakers simply eliminate carried interest and perceive this issue of equity closed? Or will they demand extreme measures of recourse against the entire PE industry similar to the measures taken against the Big Banks? This risk does not seem priced in.
Additional PE Headwinds
1. Recent performance is weak and competition is growing
2. PE firms are having a tougher time finding profitable
opportunities – evidenced by increasing “dry powder” and increasing % of PE
funds being allocated to less traditional avenues like direct real estate
3. Many new players with access to cheap capital entering the market (Chinese multinationals, Sovereign Wealth Funds, Direct Investing Pension Funds etc) = competition in the buyout market
4. PE funds benefitted during the 30-year bond bull market of being able to refinance their deals at lower rates – with rates at all-time lows, will interest rates turn into a headwind?
5.Fee Pressure
Conclusion: PE industry may soon come under intense public
scrutiny. A Republican house will provide a mitigant to the elimination of
carried interest (many House members have pledged never to raise taxes) but the
issue has become increasingly bipartisan. The carried interest tax advantage
aside, the PE industry may have significant political and regulatory headwinds
in the coming years driven by a global populist backlash.
Sources: The New Yorker, The Economist, The Tax Policy Center, The
American Investment Council
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