Outside the Box: Private equity, carried interest and Mitt Romney

By Jack O. Nutter
WASHINGTON (MarketWatch) — The term “private equity” is being demonized in political circles these days. The White House and some Republicans have equated private equity with some sort of evil, a disease, and a scourge. I want to believe these politicians do not really understand the concept and if they do, then I fear the country is in a whole lot more trouble than we think.
Private equity consists of investors and funds that provide private companies with direct investments or conduct buyouts of public companies. These investments can be used to fund new start-up companies, expand working capital, make acquisitions, or improve a balance sheet. Private equity is one of the foundations of the capitalist system.

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Republican presidential candidate Mitt Romney on his business experience, releasing his income tax records and illegal immigration at the Fox News Channel and Wall Street Journal GOP Debate in South Carolina. Courtesy Fox News Channel.

The majority of private equity consists of institutional and accredited investors who commit large sums of money for long periods of time. Private-equity investments often demand long holding periods to allow a turnaround of a distressed company or a liquidity event such as an initial public offering or sale to a public company. Indirectly, almost every American has a stake in the concept and results of private equity.
Mitt Romney owned and managed a private-equity firm called Bain Capital until retiring and being bought out in 1999. Listen to the political rhetoric; you would have thought he presided over the proceedings of the Spanish Inquisition.
This is not the place to debate or critique the dealings or role of private equity funds or Bain Capital.
For that, the New York Times gives a good look.
Instead, I want to discuss the tax treatment of such enterprises and to ask how such treatment may have affected Romney.
Most private-equity funds are organized as limited partnerships with the investors (pension funds, endowments, foundations and wealthy individuals) contributing capital and becoming limited partners with a general partner — such as Bain Capital — that provides the entrepreneurial management of the partnership. The general partner is paid a management fee.
The general partner may also contribute its own capital and, as an incentive, receives an additional interest in the overall eventual profits. This additional interest is known as the “promote,” “profits interest,” or “carried interest.” The carried interest is typically 20% of the profits and is generated from appreciation in the value of the partnership’s property realized when the enterprise is sold or taken public.
The tax treatment of carried interest under current law allows managers of hedge funds, private-equity funds, venture-capital funds and others to pay a lower 15% maximum income tax rate applied to investment income as capital gains, rather than higher income tax rates for ordinary income which exceed 35%. This is a huge difference.
How do they do that? It is complicated but starts with the taxation of partnerships. If you have an interest in a partnership, you are allocated a share of that partnership’s income. The income to the partner takes on the same character, such as capital gains, that it does in the partnership’s hands, and the partner is taxed on it accordingly. The partnership itself does not pay taxes.
Some investment partnerships, particularly in the private-equity industry, earn mostly capital gains by buying and selling shares in other companies. The managers of these companies thus receive their carried interest in the form of capital gains and pay capital-gains tax rather than ordinary income tax. Nifty trick!
Carried interest is a business and financial arrangement that has formed an essential structural element to almost every sector of the U.S. economy, including real-estate development, private equity, hedge funds, health care, mining, and oil and gas. Changes in the tax rules would have a profound impact on how these businesses operate and their structure.
Many policy makers believe the carried interest paid to partnership managers is really compensation for their management services, which should be taxed at the higher ordinary income rate. On the other side, supporters of the current tax treatment say the carried interest is only a potential share of partnership profits and should not be considered compensation for services.
Changes in the taxation of carried interest have passed a Democratic-controlled House of Representative three times since 2007 and the Obama administration has included a carried-interest tax increase in each of its annual federal budgets and even more recently in the American Jobs Act introduced last September, where the current law on carried interests was described as “an unfair and inefficient tax preference.”
So how does Mitt Romney fit in to all of this?
There is no question he has benefited and perhaps continues to benefit from the favorable tax treatment of the carried-interest provisions. As he retained a share of the “profits interest” after he left Bain Capital, Romney would have gotten favorable tax treatment on certain income received even though his service labor did not contribute to the profits of new investments by the firm. To what magnitude this lessens his tax burdens is not known, as Romney has not released his tax returns
Romney is a wealthy man. Of that there is no doubt. He made it the hard way — he earned it. To some, being too wealthy is somehow wrong. I do not begrudge his success. However, it is a legitimate question to ask how he stands on this particular issue. Would he support changes in the carried-interest provisions for tax policy, economic or social reasons?
It is hard to have crocodile tears for the hedge-fund and equity-fund managers and the like. They have made and continue to make enormous money, partially fueled by favorable tax treatment. “Enormous” may be even too small a word. Even the word “undeserving” comes to mind. I can say the same thing about entertainers, professional athletes, football coaches and lobbyists who do not share in the same tax breaks. However, that is part of the used-to-be-freer market system we have.
There are industries other than the financial sector where the carried-interest concept is ingrained and useful. Changes in tax policy and treatment is worth examining and a good place to start is asking Romney what he thinks.
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Q&A: Private-equity returns and the Carlyle Group

What did you think of the compensation and share of the profits paid to the three founders of the Carlyle Group, and did they deserve it?
Obviously, $400 million — the amount the founders earned — is a large amount of money.
But they earned it because compensation is heavily tied to performance in private equity.
Carlyle returned at least $15 billion to its investors this year. The $15 billion represents the [very successful] performance of Carlyle’s investments in companies over the last five to 10 years.
And $400 million is less than 3 percent of the $15 billion. In years that Carlyle does not return money to its investors, like 2009, the founders earn far, far less.
My guess is that the investors in the Carlyle funds are extremely happy with the returns they have received this year even after paying the fees.
Discuss the private business model by which people can earn that kind of money.
The big investors in private equity are pension funds and endowments. In Carlyle’s case, those investors include the Maryland State Retirement and Pension System, the New York State Teachers’ Retirement System and Calpers [the California Public Employees’ Retirement System]. When private-equity fund returns are strong, a lot of pensioners and workers benefit.
Private-equity funds take this capital and use it to buy companies. When the private-equity funds buy the companies, they often use leverage, hence the common name of leveraged buyouts. These days, the leverage is usually on the order of 60 or 70 percent of the purchase price — less than the leverage in most home purchases.
The private-equity funds then work very hard to increase the value of the company. Usually, this involves looking for ways to increase the growth of the business as well as cutting costs. If the values of the companies increase, the private-equity fund and its investors will make money (when the companies are sold). If the values decrease, the private-equity fund and its investors lose money.
Private-equity funds receive an annual management fee on the money invested. For large funds, this is usually 1.5 percent per year. In addition, private-equity funds typically receive 20 percent of the profit of their investments. The founders earned so much this year because they had an unusually profitable year. (It is worth adding that funds get this share of the profits only if their investors earn at least an 8 percent annual return.)
Overall, the performance of private-equity funds has been very strong over the past 20 years. On average, each dollar invested in one has returned 27 percent more than that same dollar would have earned in the S&P 500 or other public-equity fund.
Please explain carried interest and why it is taxed at a lower rate than income tax.
The carried interest is the 20 percent share of investment profits I mentioned above. It is taxed at capital gains rates rather than ordinary income tax rates. That has been the case for a very long time.
There is a lot of debate about whether this is appropriate. Some argue that carried interest is compensation and should be taxed as ordinary income.
The counterargument is that the carried interest represents an investment return and should be taxed like other equity investments. If the carried interest were taxed as ordinary income, I think it also is likely that private-equity firms would be able to avoid much of the tax increase by restructuring the carried interest into equity investments.
Who invests in private equity and how does it work?
As mentioned above, the big investors in private equity are pension funds and endowments.
Do private-equity firms create jobs, destroy jobs or neither?
The best empirical evidence says the answer is that private equity both creates and eliminates jobs. After a buyout, employment in existing operations tends to decline relative to other companies in the same industry by about 3 percent. (This may mean employment actually grows, but just by less than at other companies). At the same time, employment in new operations tends to increase by more than other companies in the same industry by more than 2 percent. Net job losses were relatively greater in retail buyouts. This is not surprising, given that Wal-mart and Amazon have put a great deal of pressure on retailers over the past 20 years. If retail buyouts are not included, it is likely that net employment growth was positive. In other words, there does not seem to be a large net employment effect. That is not to say, however, that some people do not lose jobs. The overall pattern suggests that private-equity firms make firms more productive. They make cuts or grow more slowly when that makes sense, and they invest and grow more quickly when that makes sense.