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What the Proposed Carried Interest Tax Means for Private Equity Portfolio Companies

In all the hubbub about healthcare reform and the economy recently you might not have heard about Congress’ plan to raise taxes on private equity firms by 133% starting in 2011.  The House Ways & Means committee introduced some legislation in December 2009 to start taxing private equity firms carried interest income as ordinary income (35%) versus the current approach of taxing those earnings as capital gains (15%).  In the New Year momentum is building to make this tax change a reality.  As noted in a recent Wall Street Journal article:

“Fund managers aren’t likely to get any help from the White House. President Obama has expressed support for raising the carried interest tax, and his budget would start taxing carried interest as ordinary income in 2011.

“Private equity will endure, but the draconian tax hike, if enacted, will unquestionably slow the flow of capital to companies struggling to get back on their feet during this very fragile economic recovery,” said Doug Lowenstein, president of the Private Equity Council, a trade group.

University of Colorado tax law professor Victor Fleischer, whose views caught the attention of Congress two years ago, agrees with this approach. He notes that profits earned by managers from their own money invested in their funds—typically a small percentage of the total fund size—are appropriately taxed at capital-gains rates. But he said the portion of pay managers get for investing other people’s money should be taxed at ordinary income rates, just like other forms of salary.

“It’s amazing to me that at the same time the U.K. is imposing a 50% excise tax on bankers’ bonuses, the private-equity guys aren’t even willing to pay the usual ordinary income rate,” Mr. Fleischer said. “You would think they would recognize a fair deal when it’s offered.”

Private equity firms generally earn money two ways:  management fees and carried interest.  PE firms typically charge their investors a 2% annual fee for funds under management, and then claim 20% of the profits (aka carried interest) when the investment is sold (the infamous 2 and 20 rule).  Historically, carried interest has been taxed as a capital gain in the United States since the profits are only realized upon the successful sale of an investment, not unlike what happens when you sell shares of stock you have held for more than a year.  The legislation bouncing around Congress now would change this historical approach and raise taxes on carried interest from 15% to 35%, the rate for ordinary income.  It is important to note that this change typically will not impact the returns received by operating executives of the PE firm’s portfolio companies.  Most executives are incented through stock options that vest on an exit event.  The proceeds from stock options are taxed as either short or long term capital gains – not ordinary income as in the case of PE firm carried interest.

Basically, this change will reduce the returns earned by a private equity firm by about 24%, as shown in the following spreadsheet.  If a private equity firm invested $100 million in your company 4 years ago, and sells your firm to a strategic buyer in 2011 for $600 million, the proposed change in the tax laws will reduce their return by $100 million or about 24% in comparison to what they could if they sold your firm before the tax change goes into effect.

So what does this mean for executives of PE firm portfolio companies?  Quite a few things.  If the tax hike goes through as planned, starting in 2011 a private equity form will need accept either a materially lower return for their investment, or seek higher sales prices to generate the same amount of returns they would have had under the old tax regime.  Seeking higher sales prices could result in much longer exit horizons.  Alternatively, PE sponsors may seek an interim return on their investment via dividends.  At the height of the recent private equity bubble the leveraged recap and dividend.  Under this approach, a portfolio company would take on new debt and pay a significant portion of the raised money to their private equity sponsors as a special dividend.  With the collapse of the credit markets in 2008 leveraged recaps have temporarily gone the way of the Dodo.  Sponsors could still fund dividends by having the portfolio company significantly ratchet up their profitability and then distributing the newly generated cash as a dividend on a quarterly or annual basis.  Using cash to fund dividends versus investing in growing the business is a hard trade off that boards of directors and management teams will need to make.

Perhaps the greatest issue for portfolio company executive teams is that in 2011 there will be a significant mismatch between financial incentives for private equity firms and their management teams.  If the plan is for your company to achieve some type of exit in the next two years, private equity owners are highly incented to achieve such an exit in 2010 versus 2011.  As shown in the following spreadsheet, owners can yield the same return in 2010 at significantly lower sales prices than they could in 2011. 

That means that PE firms could accept up to 25% less for their properties in 2010.  While the PE firms returns are not impacted, portfolio company executives and other option holders would see a 25% reduction in their payoff for a successful exit.  The pressure to exit will certainly rise in the second half of 2010 as the inevitability of the pending tax law change becomes reality.

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