U.S. President Joe Biden
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A key tax break for private-equity and hedge-fund managers, which has been targeted for elimination by every president since George W. Bush, has just survived the latest attempt to kill it.
Last week, the House Ways and Means Committee voted to preserve the low tax rate that fund managers enjoy on their biggest paydays: the compensation known as “carried interest.”
President Joe Biden had proposed scrapping the tax-advantaged treatment that managers of alternative investment partnerships enjoy on their performance pay—typically set at 20% of the returns they generate for their investors. Because carried interest is taxed at the 20% capital-gains rate rather than ordinary income rates up to 37%, investment managers pay lower rates than many wage earners. That galls observers.
In August, a bill to completely ban capital-gains treatment for carried interest was introduced by the chairman of the Senate Finance Committee, Ron Wyden (D., Ore.), who claimed it would raise $63 billion over 10 years. “One of the most indefensible loopholes in the tax code allows wealthy private-equity managers to be taxed at lower rates than nurses treating COVID patients and avoid paying any tax year after year after year. This is an issue of fairness,” said Sen. Wyden.
The Biden administration isn’t backing down either. Thursday, it released a study arguing against capital-gains treatment for any wealthy investor’s income.
But the recommendations handed up last week [NOTE: SEPT. 13] by the House Ways and Means Committee would leave the tax break on the books—while restricting its use and raising the rate on all long-term capital gains to 25%.
The private-equity industry is by no means mollified that the carried-interest break has survived. In 2017, the Trump administration and Congress extended the required holding period for carried interest to get capital-gains treatment to three years from one year. The Ways and Means just proposed a five-year holding requirement, with other provisions that the industry says could amount to an eight-year lockup to escape ordinary tax rates. The new holding period won’t apply to individuals with less than $400,000 in taxable income, or to certain real estate partnerships.
“As legislation moves forward, we will continue to make sure members of Congress understand how important private investment has been to their local communities throughout the pandemic,” said Drew Maloney, the CEO of the private-equity industry trade group American Investment Council. ” Instead of moving forward with a 98% tax increase on private investment, Congress should encourage more private capital that supports jobs, small businesses, and pensions across America.
The carried-interest debate is part of a broader argument over a system where the country’s wealthiest get most of their money from capital gains, taxed at lower rates than wages. But hiking the taxes on carried interest also impacts the public companies that manage private equity, hedge funds and real estate. These include Blackstone (ticker: BX), BlackRock (BLK), Brookfield Asset Management (BAM), KKR & Co. (KKR), the CBRE Group (CBRE), Blue Owl Capital (OWL), Boston Properties (BXP), the Carlyle Group (CG), and Apollo Global Management (APO). Their public market capitalizations exceed half a trillion dollars and much of that is a multiple of carried interest profits. Queries to these firms were referred to the American Investment Council trade group.
The performance fees are important to an asset manager’s public shareholders, says Credit-Suisse Securities analyst Andrew Kuske, since carry fees mean that partnership investors realized their return objectives and are likely to commit more dollars to the funds. Assets under management and revenues grow in a virtuous circle.
“Carry generation winds up being a validation of the investment strategy and performance,” Kuske says. “The dollars managed, and the fees generated on the dollars managed, are one of the key driving forces for valuation.”
Performance-based income—including carried interest—is supposed to align the interests of managers with their investors. In the “carry funds” managed by the private equity industry, managers are generally allocated 20% of realized gains in years when the fund has surpassed an annual return hurdle ranging from 4% to 9% (depending on the fund’s investment horizon). After underperforming years, investors get to claw back previously paid fees.
It’s a main source of revenue for the alternative asset industry. One third of Blackstone’s $6.1 billion in 2020 year revenue came from “performance allocations”. Of the $15.6 billion in investments on the firm’s balance sheet at year-end 2020, $6.9 billion came from accrued performance allocations (with some $2.9 billion of that owed to employees).
At BlackRock performance fees were but 7% of its 2020 revenue. But at KKR, carried interest contributed 40% of the firm’s $4.2 billion in 2020 revenue. Unrealized carried interest on the KKR balance sheet at 2020 yearend exceeded $4 billion.
The Ways and Means proposal is far from the finish line that lies beyond the House, Senate and the White House. Treasury regulations must then implement any tax law change: the 2017 law’s tax change for carried interest only got its regulations this year. Alternative investment managers will have plenty of time to huddle with their tax advisors. At any tax rate, the returns of private equity and venture capital should remain attractive to investors.
Write to Bill Alpert at [email protected]
