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Private funds might have to give up a bigger share of their profits

Politicians on both sides of the Atlantic who have long argued that the government should carve a larger slice out of private equity and venture capital profits could be closer to getting their way.

Politicians on both sides of the Atlantic who have long argued that the government should carve a larger slice out of private equity and venture capital profits could be closer to getting their way.

The end result could not only eat into private equity profits but could even undermine an important tool for aligning the interests of fund managers and their investors.

In the US, Democratic lawmakers have floated a proposal that could not only increase tax rates on so-called carried-interest profits but also extend the length of time general partners must hold an asset before they can benefit from a favorable tax rate.

Carried interest is the cut (typically 20%) that GPs get on the money returned to investors after a liquidity event. In principle, it gives managers incentives in a way that benefits limited partner investors like pensions and endowments. Alongside the management fee, a 2% annual fee on capital managed by a fund, carried interest is an important component of the “2 and 20" fee structure that underpins private funds. It also represents a lot of potential tax revenue.

Under the current system, carried interest earned is treated as capital gains. This means managers typically only pay a federal tax rate of 23.8%, which comprises the 20% net capital gains tax plus a 3.8% net investment income tax, instead of the 40.8% top rate. This is provided that the fund has held onto an asset for more than three years (until the Tax Cuts and Jobs Act of 2017, that threshold was one year).

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This rarely poses a challenge for the private equity asset class, where typically the holding extends well beyond three years. But some Democratic lawmakers want to extend that to five years. What’s more, that holding period may need to be even longer than five years for the manager to qualify for the preferential tax treatment. Cécile Beurrier, a tax lawyer with Debevoise & Plimpton, explains that under the proposals in the US, the clock won’t start ticking until the fund is fully deployed.

“This is a very important nuance in the context of a fund that lasts eight to 10 years, because usually in the first couple of years the fund is in ramp-up mode, so it usually is not substantially invested until the end of the investment period of maybe three to five years.”

This is a problem for fund managers, especially when it comes to investments made during this ramp-up period. According to PitchBook data, US buyout firms’ holding periods have been getting shorter. The median time has fallen from 6.2 years in 2014 to 4.9 years so far in 2021.

For venture capital in the US, meanwhile, median holding periods—dated from the first VC round—have risen from 4.8 years to 5.5 years in the same period. But even if holding periods were to trend downward in the coming years, many investments could still likely fall outside preferential tax treatment. What’s more, it could influence when managers decide to exit.

Jenny Wheater, who is also a lawyer with Debevoise’s tax department, says there have been similar concerns in the UK, where the current tax regime surrounding carried interest has been under review for over a year. “If, for example, there is an investment where it’s suddenly a really good time to sell but you’ve got a manager who’s thinking, ‘I’m going to be better off if we hold off for a few months,’ that slightly takes them out of alignment with [the investor].”

Currently in the UK, any carried interest from an asset held less than 36 months is taxed as regular income; anything beyond 40 months is capital gains. Between those two thresholds there is a sliding scale.

However, politicians from the UK’s opposition Labour Party suggested this week that the taxman should get an even bigger slice of the carried interest pie by abolishing the capital gains designation altogether and taxing all carried interest as ordinary income.

For now, at least, Labour is unlikely to be enacting its policies anytime soon. The party has been out of power since 2010, and the country’s next general election isn’t scheduled until 2024. But given that even Prime Minister Boris Johnson’s traditionally business-friendly Conservative party has been reviewing the regulations, it might be naive to expect the rule to remain completely unchanged.

The hard reality is that governments need to raise tax revenues to rebuild economies ravaged by the pandemic. As such, new taxes that may have seemed unthinkable two years ago could now be a matter of necessity.

Featured image by Joey Schaffer/PitchBook News

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