Private Equity May Lose Its Bite
It’s been a bad month for hedge funds and private equity may soon share some of the pain. Faced with a swelling budget deficit and public anger over financial market excesses, Congress may reconsider the generous tax treatment private equity firms now enjoy.
“They might be next on the list,” said hedge fund specialist Andrew Wright of law firm Kirkland & Ellis in a telephone interview last week.
A move to raise taxes on private equity couldn’t come at a worse time for the firms. Many have suffered as investments soured. Cerberus Capital’s private equity arm has been hurt by its stake in Chrysler and GMAC. The major pullback in bank lending will also diminish private equity’s ability to fund future deals that could be more lucrative. Meanwhile, investors who funded these venture in the past and took big losses might not have the same appetite for these risky investments.
That trend has already hit the hedge fund industry. As capital flocked to safer investments in September, investors withdrew a record $43 billion from hedge funds, the most since the market began tracking outflows in 2000. As redemptions continue, Credit Suisse estimates 30% of the roughly 8,000 hedge funds will close in the next few years. Recent tax code reform, which closed a tax loophole that saved hedge fund managers $2 billion a year, will certainly accelerate closures as fund managers lose another incentive for keeping funds afloat.
Meanwhile, Congress has left tax perks for private equity intact. Victor Fleischer, associate professor at the University of Illinois who testified at Congressional hearings on this issue last year, said it was easy to reform the hedge fund taxation because the issue was already on the Senate Finance Committee’s agenda.
Changes in private equity taxation, he said, remain controversial.
Private equity firm managers usually receive a hefty 20 percent of the profits the firm generates. Their investors agree to this arrangement because management is supposed to be talented enough to produce outsized returns on their money.
“Ordinarily when this happens under the current tax code, the fee you get in exchange for the services you provide would be taxed as income,” said Fleischer in an interview today.
The tax code currently allows these private equity profits to be treated as capital gains because they represent profits on long-term investments. This is called “carried interest” and it is taxed at the capital gains rate of 15 percent, instead of the ordinary income tax rate that ranges from 28 to 35 percent.
Changing the treatment of these profits for private equity partnerships “will be under consideration again next year,” said Fleischer. “But changes depend on who is elected president. If it’s Obama, it is not only possible but likely” that the tax code will be changed to tax private equity managers’ income at a higher rate.
Either way, it could be a case of too little too late for the American taxpayer. With private equity set to have its worst year ever, there will be fewer profits to tax anyway.