Populist blather is approaching a high-water mark

Populism is fueling a vitriolic debate around Carried Interest tax ‘reform’, as demonstrated by the comments over at Chris Dixon’s blog. It can feel good to go off on extreme examples like Steve Schwartzman eating $400 crabs, but it’s important to think through what will really happen if this legislation actually becomes law.

Tax policy as it relates to finance and investment activities in the U.S. has as its primary goal the provision of incentives / disincentives based on ‘preferential’ activities. It is about incentivising behavior, not some individualized and debatable construct of fairness. Preferential activities are defined as long-term investments that promote real GDP as opposed to short-term trading with zero-sum outcomes. As a nation we have decided the correct metric is 365.

So, the question is, do we want to revise the incentives, and if so, how? Changing the policy on ‘carried interest’ will, in fact — and with all due respect to my friend Fred Wilson’s hypothesis — impact the flow of commitments into venture capital, private equity, leveraged buyouts, oil & gas, real estate, and just about every other partnership-based investment alternative out there. This will happen at least two ways…

First, these asset classes will be less profitable. Why? Because some of these newly-imposed ‘costs’ will be shared by the limited partners, reducing total returns for them — and their respective asset classes. It is naive to believe that only GP’s will be affected. This will spark an exercise in reallocation analysis, and a flight to ‘perceived’ quality for those dollars that remain committed.

Here’s what you will end up with… Fewer, larger ‘marquis’ firms with more pricing power, synthetic ‘structures’ that echo current LP economics but somewhat divorce term enforcement (more on this below), and tougher deals for entrepreneurs (the mid-range firms with only moderate power will be most at risk, yet it is precisely this group that creates the competitive dynamic that startup companies have enjoyed in recent years).

Second, fund mangers will certainly come up with creative structures (never forget the laws of unintended consequences, Idealism’s frequently-fatal flaw) that traverse legal roadblocks while dissaligning shared incentives within the core investment activity. In other words, ‘carried interest’ will go away, replaced by some form of partner-based ownership (most likely same as common stock) on a deal-by-deal basis. Now, take a moment to think about that… and then think about future financing events, board representation, even deal selection – and the inherent conflicts of interest therein. Turning a performance compensation mechanism into an owned option difficult to claw back will certainly not be in the interests of either startup companies or LP’s (or the pensioners, endowments etc., that comprise them).

In sum, reducing the normalized return differential between common alternative asset classes and ordinary market investing – and thus altering the perceived risk-profile – will have real dollar consequences, make no mistake. Think you dislike hedgies now? Wait until a quarter of alternative assets pour into their coffers.

Moreover, it will significantly alter deal structures creating further chasms between funders and founders. And by the way, at least in the last ten years (as it relates to VC anyway) had this Bill been in effect, your US Gov tax bounty would have rounded to, um, essentially zero.

Couple of other points on this Carried Interest tax question….

1) As for Carried Interest being a ‘fee’, it’s a performance override (and in no way definable as ‘revenue’). Any payment — performance-based or otherwise — is ultimately ‘describable’ as a fee. The question isn’t the nomenclature, it’s in the certainty and timeliness of the payment, and the underlying asset that generated it. If it’s under 365, then it’s short-term. If it’s directly attributable to the increase in value of a long-term asset, that’s materially different than a tip for a job well-done.

2) Every successful VC I know could earn a multiple of their current salaries in other (and not necessarily so different) businesses; they choose to trade off substantially lower current economics (about 5:1 by my calculation) for even higher future earnings potential. But that’s just what it is…. potential. Implicit in this contract is a larger piece of the pie and a cap gains tax-rate on value-creation in exchange for the assumption of this risk. Take away the tax benefit and VC’s will be more risk-averse, not less. It is also ridiculous to suggest that the best people will stay in venture capital ‘because they love it’ despite substantially-diminished economics. Seriously?

3) As has been pointed out by others like Jeff Bussgang, quite a few of us in this business are ourselves entrepreneurs, having built successful, long-term venture capital businesses. We risked our capital, security and futures to chart our own course. But VC firms do not have exit opportunities like the startups in which they invest. We know that going in, so it’s okay as long as alternative paths to wealth creation remain. You can count on two hands the number of firms that have sold or gone public since the dawn of this industry some fifty years ago — and on one hand the number that have actually been successful at it. That’s maybe half a percent; a tiny fraction of the transaction rate startup companies enjoy.

In the end, I prefer a system that rewards long-term value creation over the casino that is Wall Street. And my viewpoint may surprise you, in that I, too, believe that there is a difference between investing a dollar from my own pocket versus a dollar managed that came out of yours. Which is why I think the long-term gains rate should be revised down, to 10% for a principal’s money, 20% for OPM override earned beyond a 12-month period (up from 15% today), and then the rest at short-term rates. This in my view achieves the all-important goal of delivering proper incentives for long-term investment over short while being a ‘fairer’ system. Bear in mind that despite all of the derision around OPM, most all businesses – including most startups – use it to build value. In the end, all of us are ‘stewards’ for someone else’s money, one way or another. The economy doesn’t care from whose actual pocket it’s long term dollars come. Nor do entrepreneurs.

VC-as-bogeyman is a popular meme at the moment, and I can’t say it isn’t somewhat justified. That said, babies and bathwater come to mind, and, unfortunately, heart-felt but unexamined populism rarely leads to better policy. It’s not supposed to; rather, it’s highest and best use is to stir debate. The current carried interest Bill will do little more than hurt the startup ecosystem while raising a de minimis amount of tax revenue.

12 thoughts on “Populist blather is approaching a high-water mark

  1. jimthat's a well written and articulate set of arguments and i applaud you for putting them out therei come out in a different place and don't share your concerns but i would love to discuss them with you over a beer.fred

  2. TL;DR basically, you're saying your management fee deserves a lower tax rate than management compensation or other professional fees because it's derived from long-term investment activity.I'm skeptical that the tax will make VCs leave the industry, when subpar returns haven't had that effect.But even if one accepts that the tax will change the industry structure, one could argue that concentration in superstar firms is a more efficient allocation of capital, and the current tax benefit encourages marginal firms with dreams of a big, lucky, lightly taxed score, when their services might be more valuable in (horrors!) management or investment banking.

  3. Not at all – management fees are taxed at an individual's marginal tax rate, not capital gains rates. It is the 'carried interest' I am referring to, which is not part of the management fee, but rather an override based on outcomes, often subject to hurdle rates. In short, it only gets paid if a fund's performance – usually over a decade or longer — warrants it.

  4. Jim, Great post. And, I like your suggestion about breaking out the form of capital gains between Principal & OPM. However, that, unfortunately, just further complicates our tax code (although maybe that complexity train has left the station). If the government wants to increase capital gains, then they should, however this business of taxing different industries in different ways only creates value for lawyers & accountants. Charlie

  5. If a public company management meets agreed (possibly arbitrary) long-term targets, should they be able to receive stock at an old reduced cost basis and pay a capital gains tax rate? They're not, so it's hard to see why VC and hedge funds should be any different. (you could argue options serve that purpose in a public company and AFAIK they are taxed as personal income)

  6. Here's what you will end up with… Fewer, larger 'marquis' firms with more pricing power, “Directionally that’s certainly true. Whether it will be a big effect is an empirical question. But I actually suspect that some VC supporters of income tax treatment have this in mind…“'carried interest' will go away, replaced by some form of partner-based ownership (most likely same as common stock, possibly with voting rights) on a deal-by-deal basis.“You say that as if it’s a bad thing… Aligning VCs with common shareholders seems attractive to me. And deal-by-deal carry can be a powerful motivator.“Now, take a moment to think about that… and then think about future financing events, board representation, even deal selection – and the inherent conflicts of interest therein.”There are also conflicts of interest today, it’s just that we’ve gotten used to them. Different is not necessarily worse.“And by the way, at least in the last ten years (as it relates to VC anyway) had this Bill been in effect, your US Gov tax bounty would have rounded to, um, essentially zero.”While this is true, it’s hardly an argument for not making the change. A higher percentage of zero is still zero.“Every successful VC I know could earn a multiple of their current salaries in other (and not necessarily so different) businesses; they choose to trade off substantially lower current economics (about 5:1 by my calculation) for even higher future earnings potential.”Unless you’re referring to some other kind of fund management, I’m incredulous. A VC going into industry to make $1-2m or more in base salary? Even public CEOs don’t make this. “It is also ridiculous to suggest that people will stay in venture capital 'because they love it' despite substantially-diminished economics. Seriously?”They already did for the past decade, by and large.

  7. If there is no risk of a personal capital loss (as a GP) for carried interest how is are your earnings a capital gain rather than a bonus for performance?

  8. Fair enough, Eric!Funny thing about self-interest, though. On the face of it, obviously I'm not looking to have higher tax rates (who is). On the other hand, the impact of the current Bill, by extending it all the way down to small VC's, will in my view harm the tech ecosystem while doing nothing for our nation's coffers. And by 'harm' I mean reduce total funding to the category. That means fewer entrepreneurs get funded, and those that do give up more of their companies. At the same time, I will almost certainly be a beneficiary of work-arounds that closely simulate – one way or another – my current economics. (Any idea how many expensive tax lawyers the hedge fund, lbo & pe communities have? Whatever they come up with will work for me, too).So… reduced VC competition, similar economics, and probable personal, outright ownership in various companies. Which one is better for me? Interestingly, over the course of this multi-day debate, I've received several notes from VC's that oppose the Bill but believe it is not in their interest to do so publicly (and not because they are worried about what a few entrepreneurs might think), asking why I am in this discussion at all. Might be they have a good point…Tell you what: you get a Bill going that says all firms under a reasonable threshold are exempt, figure out how to prevent the game-theorists at the bigger funds from 'qualifying', and then add a clause that says the favorable tax status applies to everyone that looks like – but isn't – Jim Robinson's firm. I'll vote for it.

  9. I'm with Fred on this one. The fundamental problem isn't that we need more VCs and more LP capital deployed toward VC, rather, what we need are more entrepreneurs. Given that, a change in the incentive system is in order…so tax carry as OI and cut cap gains for entrepreneurs…then we'll see a lot of those talented VCs go back to their roots and we'll all be the better for it.

  10. Completely agree that we need tax reform, and I certainly get the desire to soak the fat cats that got us into this mess. Personally, I'm waiting for the perp-walks on Wall Street – like lots of other people. I actually suggest higher taxes in my post – on folks just like me. But if we are going to do it, then let's get real about change. VC is different than any other alternative asset class; it exists on the left side of Schumpeter's Curve (meaning actual asset value creation instead of redistribution of value, or value destruction). This is something I think we want to encourage. As for fairness, try this: how about we alter the AMT to include any amount over some threshold must be taxed at a full rate, no matter the source. While we're at it, I think we should actually return to the 90% tax rates of yore over some amount, as I don't believe anyone should ever reach ten digits, much less pass it down to their offspring. Here's the thing… Are we trying to punish people (in which case, let's punish the right people); are we trying to raise taxes to pay for stuff (then let's actually do that, like with a shift to consumption taxation); or are we trying to define fairness (in which case let's completely redraw the lines). My read of the current Bill is it accomplishes none of these objectives.

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