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.