The private-equity boom has been an enormous driver of economic growth in recent years. As public capital markets have come under increasing strain from excessive litigation and regulation — including Sarbanes-Oxley — private equity has become the crucial source of risk capital for innovative growth companies as well as established businesses with capital needs. In turn, when private-equity firms themselves go public, they fall under even greater public scrutiny while allowing ordinary investors to buy into their growth.
Unfortunately, proposed tax law changes could undermine the incentive for private equity firms to venture into the public realm. A misguided proposal from senators Max Baucus (D., Mont.) and Charles Grassley (R., Iowa) — which could be attached to a fast-moving vehicle like the energy bill as soon as this week — would subject private-equity firms to steeply higher taxes if they choose to go public.
Partners in private-equity firms are typically compensated based on performance. They are paid a percentage of the investment gains they achieve for their investors, often as much as 20 or 25 percent. Investors, usually large pension funds, university endowments, or high net-worth individuals, are willing to pay these performance fees since they give a firm’s partners a strong incentive to perform. And in recent years private-equity returns have been very competitive, even after these fees are paid.
Under current federal law, these performance fees are treated as capital-gains income, since they represent asset appreciation rather than income flow. This tax treatment allows private-equity partnerships to be far more competitive internationally than if they were subject to the steeper corporate or personal income-tax rate of 35 percent (plus state income taxes of about 5 percent). This rate is well above the average world corporate tax rate of 27.1 percent and the European Union average rate of 25.8 percent, according to the latest survey by KPMG.
Current law allows partnerships with passive income to retain their tax treatment when they are publicly traded. Active income, such as management fees, is taxed at the corporate rate. This structure was created in 1987 as a way to allow partnerships sell public stock without being unduly burdened by higher taxes that peers outside of the public markets do not have to pay.
Baucus and Grassley are recklessly referring to this structure as a loophole, and have introduced legislation to specifically carve out private-equity firms. Other partnerships would still be able to be traded publicly without triggering corporate taxes on passive income, but private-equity firms would face the full corporate rate.
The recent high-profile Blackstone public offering has raised the visibility of this so-called loophole. Recent media coverage over the compensation of private-equity executives in general, and Blackstone CEO Steve Schwartzman in particular, has raised the apparent populist appeal of the Baucus-Grassley legislation. But the real impact of Baucus-Grassley is anything but populist.
By requiring private-equity firms to avoid public markets, or instead get whacked by a discriminatory tax hike, the bill would keep private-equity investments available only to institutional investors and the super wealthy. It would lock out ordinary retail investors from the outsized gains made possible by some of the only investment vehicles that have not been overburdened by big government.
In turn, this legislation could spur the consideration of even more destructive policy changes for private equity firms — as well as hedge funds and venture capitalists — such as an effort to tax all performance fees as ordinary income. This would send capital out of the U.S. en masse, along with a good many high-quality financial service jobs. (Senate banking chair Chris Dodd’s home state of Connecticut would be hit especially hard.)
This is a matter of concern for all investors, even if you’ve never invested in a private-equity fund. Private equity has provided a necessary escape hatch in recent stock market corrections, while helping fuel the remarkably sustained stock market rally of today. And when private-equity goes public, such as with the Blackstone IPO, ordinary investors can benefit directly from the private-equity boom.
But Baucus-Grassley would be the kibosh on all this. It is a bad, anti-investor idea that deserves to go nowhere, fast.