To the Editor:
Many people in America do not understand that carried interest tax treatment was created to benefit pension funds and other investors in venture capital and private equity entities. It protects them from bad managers. Here is why.
Let’s say I meet a person who owns a company which is essentially worth nothing and this individual wants and needs help to fix it. I tell him I will help him grow it, but I don't want a fee or hourly compensation, I want stock because I will make more money through ownership.
He agrees to work with me, as I will only participate in any upside which is created. We structure a deal where he sells me 20% of the most junior equity (common stock) of the company for a nominal amount of money, $2,000. I help him grow the company but take no fees or other income. In five years, my friend sells the company and the common stock proceeds are $10 million. He makes $8 million and I make $2 million, and we are both happy. Since I held my stock for five years, I pay capital gains on my share, as does he.
Several investments later, after similar successes, he asks me to manage a pool of his money—a “fund”—instead of making investments one-by-one. The fund totals $10 million. I agree, I make 10 investments of $1 million each, and I am allowed to buy 20% of the most junior equity of each company for a nominal amount. In five years, he sells all 10 companies.
Unfortunately, I don’t do so well. Five investments increase in value by $1 million each, yielding $10 million (his investment of $1 million each and the gain of $1 million each). However, five companies crater, so he loses his investment of $5 million in those. Thus, in total, the total proceeds of $10 million are equal to his investment in the fund. However, my partner actually only receives $9 million because he has to pay me $1 million as my share of the gains on five successes: 20% times the $1 million increases in value times five successful companies. I have no accountability for the losing deals. Is that fair? Of course not. He lost money on the deal-by-deal structure.
So pension funds, insurance companies, and other large investors worked with the IRS to develop an alternative structure to eliminate such an unintended outcome. That's how carried interest tax treatment was originated. Carried interest simply requires investment managers to add up both the successes and the failures, and then receive their share of the gains. Indeed, they only receive their share after returns exceed a minimum hurdle rate, typically 8% per year, and only after management fees are also taken into account. And it usually takes years of managing the investments before they receive any carried interest at all.
Limited partners such as pension funds, 401(k)s, insurance companies, large corporations and other such investors benefit from this structure. They will be penalized in the future if carried interest is eliminated, as smart hedge fund, PE, and VC managers will likely attempt to return to owning an equity share of each company in which they take a position and not be subject to the downside of the losses. Alternatively, they will, with their attorneys and accountants, design some structure far more expensive and complicated to get around the new rule, which costs will be passed on to limited partners.
Let’s keep a simple, elegant solution in place which has been shown to protect the interests of investors. Carried interest capital gains treatment is best for everyone.
James E. Forrest
Chairman, Shore Capital Partners