Carried Interest Loophole

Jason Kelly, in a recent book about the private equity industry, tells a story about a visit he made to

Zuccotti Park in lower Manhattan in November 2011. As you may remember, the “Occupy Wall Street” folks had taken over the park two months before and were seeking to focus public anger about “Wall Street,” both as a literal and as a metaphorical term. 

When people think of “Wall Street” they think first of the big investment banks, the folks who received their much-discussed bail-outs in the fall of 2008. They don’t necessarily think of private equity: of Bain Capital, or Carlyle, or even Blackstone. But at least some portions of the Occupy movement wanted to change this.

As Kelly was walking around the park he saw as sign that said, “No Bulls, No Bears, just Pigs.”  That was catchy: it played upon well-known animal metaphors for Wall Street optimists and pessimists respectively.  But he also saw a sign that was a good deal less catchy. It was made up of orange cardboard, and it had the words “Carried Interest Loophole” and “a circle-and-dash symbol in fluorescent marker around it.”

He thought, that’s why private equity has been avoiding negative press.  The policy arguments don’t really translate into snappy phrases or compelling graphics.

In case you are one of the many who won't understand his point here, allow me to begin with that bit of finance lingo. "Carried interest," often shortened to "carry," refers to the profits of investment partnerships (including, but not exclusively, private equity funds) that go to the managers of the fund as part of their compensation for their managerial labors.

In a typical investment partnership, the investors are limited partners, and another entity, often itself a partnership or an LLC, is the general partner. The fund proper might be called “Investment Fund L.P.” and the GP might be “Investment Fund Advisors LLC.”

In such a case the G.P. itself will be sparsely staffed, so its proceeds don’t have to be shared amongst too many hands. Also, the G.P is generally a “pass-through” entity for tax purposes. It does not itself pay taxes. Since I propose to discuss a tax issue, understand that hereafter when I use the phrase “fund managers” I will be referring not to the G.P. as an entity but to the individuals, the human beings, behind it.

Sources of Reward

Historically there are three sources of reward for the fund managers in the PE context or elsewhere.  First, any one of them can as the saying goes “eat his own cooking.” He can make an investment in the fund he helps to run from his own savings, and receive either profit or loss on the same terms as the other investors, the LPs.  Any money that he makes this way is a capital gain, just as it is for their investors.

Second, though, managers as a group typically receive an annual management fee based on the total assets within the fund. For example, a $1 million fund might have a contracted-for 1% fee which will imply a $10,000 management-fee payout.  The $10,000 will go to the GP, thence to its principals and staff.    

The third source of remuneration is the carry. This is the share of the profits of a fund that goes to its GP. Suppose our million-dollar fund begun life a year ago after raising a half-million-dollars as seed money. The profit, then, is $500,000. If the carry, by contract, is 15% then the management can claim $75,000, in addition to the $10,000 fee.  

As Kelly writes in this book on the PE industry, the management fee “pays the bills” and keeps the doors open, but it is the carried interest that “buys the second and third houses and the jets and means you have the coin to get your name on a building at your alma mater or a symphony hall somewhere.”  

If the first year has been a down year, if the assets are less than they were, then the management won’t typically be entitled to a carry. This is another feature of the situation thought to align manager and investor interests. Note, though, that the managers will still charge the 1% management fee: that is charged on the basis of assets on a closing date, not on the basis of profits, and regardless of performance.

In the customary lingo, our hypothetical Investment Fund L.P. has a fee structure of 1 + 15. That is, these days, as a consequence of the increasing competitive pressure of recent years, fairly common:  many fund managers look back nostalgically upon the days when 2 + 20 was the norm.

There are important qualifications that one might make to that simple description of the fee structures. The most important of them for purposes of a discussion of Kelly’s book, because it relates specifically to this structure in the PE context, is this: the carry only becomes taxable when it is actually distributed, and that can happen sporadically: for example, when one of a PE funds’ portfolio companies is sold.    

So What's the Loophole

The sign said no to the "carried interest loophole." What's the loophole?  Consider the three sources of income again. The fee charged as a percentage of assets is taxed as ordinary income as a matter of course. Money made by managers who, in their separate capacity as investors, eat their own cooking, is counted as capital gains, also as a matter of course.

But by what tax-law authority Victor Fleischer calls a “quirk in the tax law” the carry defined against profit is considered capital gain. That is a significant benefit for some very wealthy people: they are taxed at 15% when they might have been expected to be taxed at 33%.

Why is this? It doesn’t make a lot of sense on its face. It sure looks like labor income. After all, many salaried employees receive performance based rewards, perhaps as an end-of-year bonus. If I work for Manufacturing Company Inc., the size of my year-end bonus is (like the size of Mitt Romney’s carry) unknown beforehand. Each is tied to performance. Yet a run-of-the-mill bonus is ordinary income, whereas a partnership-profit carry distribution is capital gains. Something smells.

Yes: as I may have just unwittingly illustrated, the stench can be difficult to explain. Movements to reform the carried-interest tax rate tend to be limited to the circles of policy wonks.  
Will It Last?

I'll be damned if I know whether it will last. Thus far, despite considerable pressure in recent years, it has. This doesn’t mean that the PE industry and its allies have paid no price for maintaining it, though. As Kelly also says, PE lobbyists would like to press legislation on a range of matters of concern to them, but they have found that every visit they make to Capitol Hill has been “derailed by discussions around carried interest.”

Congressmen and their staffers have figured it out, even if they haven’t brought the general public along: the issue is a handy way of putting one particular group of lobbyists on the defensive in any conversation.