tn oct 22 saving private equity

NEWS ANALYSIS

Saving Private Equity

By Joann M. Weiner — [email protected]

Roughly 63 years after the Allied landings atNormandy, the private equity industry launched itsown version of Saving Private Ryan.

Faced with a double-barreled assault on its taxposition from the House and the Senate, the privateequity industry turned to its big guns — the PrivateEquity Council Group and its commander in chief,Bruce Rosenblum of the Carlyle Group — to saveprivate equity.

The lobbying efforts intensified in June followingthe Blackstone Group’s efforts to raise more than $4billion by going public. The Blackstone initial publicoffering (IPO) attracted congressional attentionboth because of its relative novelty — only oneother large private equity (leveraged buyout/venture capital) firm, Fortress Investment Group,had gone public in the United States — and for therevelation of the astronomical reward that someBlackstone Group partners stood to receive from theIPO. Blackstone’s filing with the Securities andExchange Commission showed that Blackstone’stwo founders, Stephen Schwarzman and Peter G.Peterson, together would collect $2.33 billion fromthe IPO.

Armed with the SEC information, which openedup the structure of the Blackstone Group to thepublic for the first time, some members of Congressbegan an intense counter-assault. It decided to nolonger merely undertake a study of the tax treat-ment of private equity firms, hedge funds, venturecapital funds, real estate funds, funds of funds,mezzanine debt funds, and structured debt fundand other alternative asset management and finan-cial advisory business activities, but to undertake afrontal assault and consider introducing legislationattacking the tax-favored status of those activities.(For ease of exposition, these various funds arereferred to as alternative investment funds.)

Interest in the compensation arrangements of thehedge fund and private equity sector had beensimmering but was focused on conducting studiesrather than introducing legislation. In March anaide to Senate Finance Committee ranking minoritymember Chuck Grassley, R-Iowa, indicated that theexamination of hedge funds included consideringwhether carried interests should continue to obtainpreferential tax treatment relative to other forms ofsimilar compensation. Grassley announced that thecommittee had no plans to introduce legislation atthat time (Doc 2007-6179 or 2007 TNT 48-1).

The issue boiled over in June when former Treas-ury Secretary Robert Rubin said Congress shouldgive serious consideration to taxing some compen-sation of these fund managers at ordinary incomerates rather than at capital gains rates. AlthoughRubin was not expressing the view of his currentemployer, Citigroup, many corporate investmentfirms and rivals to private equity firms support theprivate equity legislation on the view that it wouldlevel the playing field. (See Sarah Lueck, JesseDrucker, and Brody Mullins, ‘‘Congress Hunts forTax Targets Among the Rich,’’ The Wall Street Jour-nal, June 22, 2007.)

The possible tax change struck a nerve in the taxcommunity. Congressional committees have heldseveral hearings on this issue since July, dozens ofconferences have taken place, and thousands ofpages of analysis have been written on the taxtreatment of partnership carried interests and re-lated issues.

Private equity fund managers are known formaking shrewd investment choices that lead tospectacular returns on their investment. During thesummer, these managers may have made one oftheir most spectacular investments, earning an as-tronomical rate of return.

How did these private equity fund mangers earnsuch returns? Not the old-fashioned way of SmithBarney (‘‘we earrrrned it,’’ according to their slo-gan). They earned it the new-fashioned way — vialobbyists.

Taxation of Private EquityOne potential legislative measure would have

treated net income from an investment servicespartnership interest as ordinary income for theperformance of services (H.R. 2834, Doc 2007-15052,2007 TNT 122-77, cosponsored by House Ways andMeans Committee member Sander M. Levin,D-Mich., and Committee Chair Charles B. Rangel,D-N.Y.). Another measure would have treated allpublicly traded partnerships that directly or indi-rectly derive income from investment adviser orasset management services as corporations (S. 1624,Doc 2007-14235, 2007 TNT 116-54, cosponsored byFinance Committee Chair Max Baucus, D-Mont.,and Grassley).

In other words, the tax rate that applied to asignificant portion of an alternative investmentfund manager’s profits might have risen from 15percent to 35 percent or more.

The tax change was the equivalent of a declara-tion of war.

Given the more than doubling of the tax rate,alternative investment fund managers began in-vesting in a campaign designed to persuade Con-gress that the tax rate applied to their compensation(the carry) should not more than double. Dozens of

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lobbying firms jumped into action, including theWashington-based Private Equity Council, whichspearheaded the effort to head off any tax bill thatwould increase the taxation of private equity firms.

And, unlike the soldiers on Omaha Beach, thelobbyists did not have to cross mine-studdedbeaches and scale escarpments to achieve victory.They simply needed to spread the word that privateequity was under attack.

For the price of relatively minor lobbying ex-penses of some $5 million to $6 million, these fundmanagers stood to save taxes of some $4 billion to$6 billion or more in 2006 alone. If they succeeded inmaintaining the status quo, they could generatebenefits of $60 billion or more over the long term. Itdidn’t take a ‘‘master of the universe’’ to do themath and figure out that the rate of return on theinvestment in lobbying expenses would be impres-sive.

Thus, the lobbyists went to work and shortlythereafter achieved their goal. With barely a whim-per, the Democratic and Republican leaders inCongress simply raised the white flag.

As The Washington Post reported on October 9(‘‘Buyout Firms to Avoid a Tax Hike’’), SenateMajority Leader Harry Reid, D-Nev., confirmed astatement he made last July (Doc 2007-16745 or 2007TNT 138-2) that the Senate would not push throughlegislation concerning the taxation of carried inter-ests this year. Grassley had made a similar state-ment in July that the private equity lobby hadeffectively killed any legislation dealing with theissue. Given the election year in 2008, this meansthe issue is off the table for at least two years.

The lobbyists could do the math once again andcalculate that their efforts had preserved a $10billion tax benefit over the next two years. With agreater than 800 percent return on investment, the

Private Investment Fund StructureThe figure below presents a chart from the Joint Committee on Taxation that illustrates a typical private investment

fund structure.In the typical structure, the fund manager is a separate partnership whose partners are the individuals with

investment management expertise. The fund manger partnership is itself a partner in the investment fundpartnership. The investors are limited partners in the investment fund partnership.

In this typical structure, the carried interest held by the fund manager is a profits interest in the investment fundpartnership. The IRS takes the position that the receipt of a partnership profits interest for services generally is nota taxable event. Because the character of a partnership’s income passes through to partners, the fund manager’s shareof income has the same character as the income has when it is realized by the underlying investment fund.Accordingly, income from carried interests may be reported as long-term capital gain to the extent that the income isattributable to gains realized by the investment fund from capital assets held for more than one year.

asset managers (individual partners)

fund manager(general partner)

investors(limited partner)

investment fund partnership

assets under management

Source:

Doc 2007-20255, 2007 TNT 172-12

Joint Committee on Taxation, JCX-62-07, “Present Law and Analysis Relating to Tax Treatment of PartnershipCarried Interests and Related Issues, Part I,” p. 2, .

capital andservices

carried interest,management fees,return on capital capital

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investment in lobbying expenses turned out to havebeen well worth the effort.

Mission accomplished.

It’s Only TaxesFederal tax law treats hedge and private equity

funds as partnerships, and investors in these fundsbecome general or limited partners. In general, arelatively small number of individuals, who are thegeneral partners, manage these funds and provideinvestment advice concerning the use of the funds’assets.

In exchange for their services, the fund managersgenerally receive a management fee plus a share ofthe partnership profits as compensation, which isdivided between an asset-based management fee asa share of the fund’s capital plus an interest in thefund’s future profits. The typical compensationstructure is known as ‘‘2 and 20.’’ The 2 refers to themanagement fee percentage, and the 20 refers to thepercentage of fund profits received without a re-quirement to contribute capital to the fund. Thisright to receive a share of future profits is known asthe ‘‘carry’’ or ‘‘carried interests.’’

Not all fund managers are compensated underthe 2 and 20 formula. James Simons, the head ofRenaissance Technologies, earned $1.7 billion in2006 under his 5 and 44 compensation formula.

Other relatively successful venture capital fundshave increased their profit shares to 25 percent or 30percent.

According to The New York Times, Simons’s fundearned an 84 percent gross return and a 44 percentreturn after fees. That return, while sizable, does notapproach the returns that investors may earn inother sectors. The CBN 600, for example, returned272 percent while the Turkey Titans index returnedmore than 100 percent in the past year. Investorscould also have made better returns than Simons byinvesting in index funds in India or China, whichincreased by more than 45 percent and 75 percent,respectively, in 2006.

If investors were uncomfortable with the emerg-ing market risk, they could have invested in T.Rowe Price’s European mutual stock fund, whichreturned a respectable 35 percent in 2006 and had atrivial 1.03 percent expense ratio. As René Stulz saidin the context of hedge funds, ‘‘an investor in sucha fund is paying hedge fund fees for mutual fundrisk and returns.’’

A Sweet Deal on Sweat EquityManaging an alternative investment fund is a

lucrative business. The top 25 hedge fund managersmade more in one year — $14 billion, or an averageof $560 million each — than the CEOs of the S&P

Figure 1. Ordinary Income and Capital Gains Tax Rates, Individuals1998-2010 (projected)

Per

cen

t

Source: Doc 2007-9680,2007 TNT 74-16

Gregg A. Esenwein, “Capital Gains Tax Rates and Revenues,” Congressional Research Service Report RS20250 (Apr. 4, 2007),.

0%

5%

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15%

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25%

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45%

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Income tax rate

Capital gains rate

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500 companies combined. Individuals must have anet worth of $1.3 billion to make the Forbes 400 listof the richest Americans, and roughly 20 of thisyear’s new members manage private equity orhedge funds.

By contrast, the Census Bureau reports that themedian income for American households was about$48,000 in 2006, and the real median earnings ofmen and women working full time, year-round felllast year for the third year in a row. (There are nopublicly available lists for private equity managers.)

Even though each dollar of earnings has the samepurchasing power whether it is in the hands of aprivate equity fund manager or an autoworker, thetax code treats the income of the manager and theautoworker very differently. Private equity man-agers generally pay taxes at a 15 percent capitalgains rate on their earnings. Everyone else pays atrates up to 35 percent or more on their income. Therate on wage earners can also go higher becausewages are subject to employment taxes but capitalgains are not.

Victor Fleischer, a University of Illinois law pro-fessor who has advised Congress on this tax issue,seems to understand the inequity of the situation.He refers to the tax treatment of partnership profitscarried interests as ‘‘the single most tax-efficientform of compensation available without limitationto highly paid executives.’’

Local tax experts also understand that the taxcode treats some forms ofincome as more equal thanothers.

Shifting ordinary incomeinto capital gains income iswhat Eugene Steuerle, aformer Treasury deputy as-sistant secretary for taxanalysis and now at the Ur-ban Institute, calls ‘‘tax arbi-trage’’ that allows therecipient of the income totake advantage of the differ-ent tax treatment that ap-plies to different types ofincome. As long as the capi-tal gains rate is lower thanthe ordinary income rate,there is an incentive to en-gage in this type of arbi-trage. (Capital gains receivea secondary benefit because,unlike ordinary income,gains are taxed only whenrealized and thus gain the

benefit of deferral so that the effective capital gainsrate is significantly lower than the statutory taxrate.)

In testimony before Congress, Steuerle said taxarbitrage opportunities reduce national income,drive talented individuals into less productive jobs,and add substantially to the debt in the economy.He also noted that regardless of one’s political view,reducing tax differentials across types of incomehelps promote a ‘‘more vibrant and healthyeconomy.’’

Despite this bipartisan agreement on the adverseeffects created by rate differentials, the differentialsare essentially a permanent feature of the tax code.Figure 1 shows the difference between the ordinaryincome and the long-term capital gains rate for thepast two decades. The two rates have divergedsince 1990 when both forms of income were taxed at28 percent. Since 1991, when the maximum tax rateon ordinary income rose to 31 percent, capital gainshave had a favorable treatment, and this favorabletreatment has generally increased steadily as in-come tax rates have increased while capital gainsrates have fallen. The current 15 percent rate forlong-term capital gains is the lowest rate sinceFranklin D. Roosevelt was president.

Thus, outside the period 1988-1990 when bothordinary income and capital gains were taxed at 28percent, capital gains have received a preferentialtreatment relative to ordinary income since 1921.

Figure 2. Capital Raised by U.S. Private Equity Funds(billions of dollars)

Chart taken from “The Taxation of Carried Interest,” statement of Congressional Budget Office Director Peter Orszag,before the Ways and Means Committee, Sept. 6, 2007, p. 4, .Doc 2007-20480, 2007 TNT 174-5

Source: Congressional Budget Office, based on data from Thomson Financial, Morgan Stanley

Research.

1990 1992 1994 1996 1998 2000 2002 2004 2006

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Buyout Funds

Venture Funds

Other Private Equity

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With a projected revenue effect of $252 billion from2008 to 2012, the capital gains tax preference is thefifth costliest tax expenditure in the code.

What’s at StakeHedge fund assets and capital under private

equity management are both significant and grow-ing. According to Thomson Financial, assets in 8,500hedge funds increased by 20 percent last year andtotaled more than $1.2 trillion. The 566 domesticprivate equity companies manage slightly underhalf that amount.

In testimony before the Ways and Means Com-mittee in September, Congressional Budget OfficeDirector Peter Orszag showed that private equityfirms raised more than $240 billion in capital lastyear and now manage about $1 trillion. Investmentis significantly skewed toward a few successfulfirms. Over the last five years, five firms have raisedan average of $30 billion in capital.

Capital gains represent a large share of the in-come that flows through private equity and otherpartnerships and S corporations. Orszag shows thatin 2005, capital gains from these flow-through enti-ties made up 22 percent of current long-term gainson individual income tax returns. Attempts by theBlackstone Group to maintain partnership tax sta-tus after going public (that is, to maintain exemp-

tion from the corporate income tax) demonstratehow important the favorable taxation of the part-nership form is to the private equity industry.

Examining Flow-Through TreatmentThe Senate may be smart to delay a tax bill that

would raise taxes on carried interests during anelection year.

Yet it may be time for the Senate to take a closerlook at the treatment of flow-through income ingeneral. Chapter 3 of the Treasury report on busi-ness taxation and global competitiveness showsthat the flow-through sector generates one-third ofbusiness receipts and one-third of salaries andwages and produces half of business net income.Moreover, the importance of flow-through entitiesis steadily rising, with the share of total business netincome accounted for by partnerships rising from2.6 percent in 1980 to 21.4 percent in 2006.

Unlike corporations, partnerships don’t pay anentity-level tax and the partnership income flowsthrough to the partners for taxation at their indi-vidual income rates. This tax feature, combinedwith the ease of choosing the tax treatment sinceimplementation of the check-the-box regulations adecade ago, may explain a great deal of the growthin this form of business organization. After takinginto account the 2.9 percent employment tax that

Figure 3. Flow-Through Shares of All Business Returns, Receipts, and Net Income,1980-2004

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1980 1985 1990 1995 2000

Number of businesses Total receipts Net income (less deficit)

Source: Internal Revenue Service, Statistics of Income, http://www.irs.gov/taxstats.

Figure taken from Chart 3.1 (page 14) of Treasury Conference on Business Taxation and Global Competitiveness, Background Paper, July 26, 2007,.

Doc 2007-17146, 2007 TNT

142-14

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applies to ordinary income, the top marginal in-come tax rate rises to 37.9 percent. As the JointCommittee on Taxation notes in Part I of its part-nership interest report, this nearly 23 percentagepoint rate differential ‘‘is thought to be a motivatingfactor in taxpayers’ choice to structure income as acarried interest that can give rise to capital gainrather than as fees or other ordinary compensationincome.’’

Thus, the classification of carried interest ascompensation for services or as a right to income orgain from capital has significant tax consequences.

The Treasury study also showed that the toptaxpayers in the flow-through sector had an aver-age tax rate of just under 20 percent. The richestpartners in the flow-through sector paid $113 billionin taxes on $573 billion in income in 2006.

Other CountriesThe United States is not the only country with a

thriving private equity/hedge fund industry and,thus, is not the only country that is struggling withhow to tax the earnings of this industry.

A recent Congressional Research Service reportshows that 13 European countries treat the incomeas capital gain, 8 treat it as ordinary income, and 3treat it as dividends or other forms of income.

The OECD has also weighed in, reporting thatboth the United Kingdom and the United Statesprovide favorable tax treatment for carried inter-ests. These tax rules may provide one reason whymore than 1 in 5 European hedge funds, includingthe 14 largest European hedge funds, are located inthe United Kingdom.

The tax benefits in the United Kingdom are evenmore generous than those available in the UnitedStates. United Kingdom law allows carried intereststo receive a 30 percentage point tax rate break(capital gains are taxed at 10 percent and income is

taxed at 40 percent), compared with the paltry 20percentage point tax rate break available in theUnited States.

The Redcoats Are Coming!The British are also attempting to close a tax

provision that allows private equity to benefit fromsuch a large unintended tax break. On October 9U.K. Chancellor of the Exchequer Alistair Darlingannounced in the prebudget report that all inves-tors would pay a flat 18 percent capital gains rate.This rate is a sharp increase from the current 10percent capital gains rate that applies under thetaper relief system.

Unlike in the United States, private equity firmsin the United Kingdom are providing powerfulammunition to the government to change the taxrules. As The Economist reported, Nicholas Fergu-son, the chair of SVG Capital, argued that it iswrong that private equity executives are ‘‘payingless tax than a cleaning lady.’’ In the United States,this call to equity is left to a single man, WarrenBuffett.

In one sense, the British move is bolder than themoves under consideration in the United States.Under the U.K. taper relief regime that allowspartners to pay a lower rate if they hold theinvestment for more than two years, the marginalrate on carried interest can be reduced from 40percent to just 10 percent.

With a 30 percentage point difference, the UnitedKingdom has a strong incentive to narrow this gap.In so doing, it may reap an unintended benefit fromincreasing the capital gains rate to 18 percent.Coupled with a reduction in the ordinary incometax rate to 28 percent (or to 20 percent, as theopposition Conservative Party recommends), thisincrease will significantly narrow the gap in therates of tax that apply to these two types of income.

Flow-Through Income and Individual Income Taxes, 2006

Number(millions)

Flow-ThroughIncome/Loss($ billions)

Tax onFlow-ThroughIncome/Loss($ billions)

Averate TaxRate

(percent)

Tax perTaxpayer

($)All flow-through income

All taxpayers 27.5 $938 $159 17.0% $5,782Top 2 tax brackets 2.1 671 131 19.5 62,381Top tax bracket 1 573 113 19.7 113,000

Active, positive flow-through incomeAll taxpayers 18.3 762 145 19.0 7,923

Top 2 tax brackets 1.4 433 109 25.2 77,857Top tax bracket 0.7 349 92 26.4 131,429

Note: ‘‘Flow-through income/loss’’ includes net ordinary income from sole proprietorships, S corporations, and partnershipsplus net long-term and short-term gains from partnerships, S corporations, estates and trusts.Source: Table 3.3 (page 13) of Treasury Conference on Business Taxation and Global Competitiveness, Background Paper, July26, 2007, Doc 2007-17146, 2007 TNT 142-14. Treasury Department and author’s calculations.

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And as the gap between the two tax rates dimin-ishes, the incentive to shift income from one form toanother diminishes. This action benefits both tax-payers and tax authorities, as it leads to reducedcompliance costs and to reduced administrativecosts.

But in another sense, U.K. policymakers haveshown no more courage than theirAmerican counter-parts. According to the Financial Times, privateequity firms are ‘‘happy’’ with the chancellor’sdecision to increase the capital gains rate. Increas-ing the rate by a modest few percentage pointsseems likely to stave off calls for even greater taxincreases or changes in the treatment of carriedinterests.

Not all U.K. businesses share this view. TheFinancial Times also reported that businesses areangry at the changes to the capital gains tax rate.These firms, which were not benefiting from the taxrate differential between capital gains and ordinaryincome, will now pay higher rates on their gains.

The new tax plans eliminate the taper relief thatPrime Minister Gordon Brown introduced 10 yearsago when he was chancellor of the exchequer. Taperrelief reduces the capital gains tax payable accord-ing to how long the investor has held the asset andwas designed to offset the impact of inflation on thevalue of assets as well as to provide a favorable taxto investments held for the long term. With theelimination of the favorable long-term rate, unlessinvestors sell off their positions before April 6, 2008,they will be subject to a rate of tax levied on thegains that is 8 percentage points higher than it wasthe day before.

The British plan is far from certain to become law.Shortly after Darling released his proposal, theFinancial Times reported that the leaders of fourmajor business groups — the British Chambers ofCommerce, CBI, Federation of Small Businesses,and Institute of Directors — condemned the pro-posal as putting the U.K.’s plans to create a pro-entrepreneurship economy ‘‘into reverse gear.’’

No ‘Special Relationship’The United States could follow the British move

and change the way carried interests are treated.But neither the Treasury nor Congress seems likelyto initiate a change.

Treasury Assistant Secretary for Tax Policy EricSolomon admitted in his July testimony before theFinance Committee that tax considerations prob-ably motivated private equity and hedge funds toorganize as partnerships. Yet Treasury finds noreason to change this treatment, at least for now. AsSolomon emphasized, the current rules providecertainty to taxpayers and are administrable to thetax authorities.

Congress also seems willing to wait. Since Levinintroduced H.R. 2834 on June 22, and continuingthrough Finance Committee hearings on September6, Congress has heard seemingly endless hours oftestimony and received reams of reports on how totreat carried interests. No clear consensus hasemerged because there is no clear consensus.

How should the tax authorities react in the faceof this uncertainty? A responsible step might be forprivate interests and the politicians to work to-gether to draft a bill that would narrow or eliminatethe gap between the taxation of capital gains andthat of ordinary income. Whether this step involvesincreasing one rate, decreasing another rate, orsplitting the difference remains to be determined.Other attempts to modify the tax treatment ofprivate equity may be just as likely to introducemore complexity and controversy into the systemthan exists now.

This step would require modifying tax rules thathave existed for decades.

However, just because a law has existed longenough to become a seemingly immutable law doesnot mean it cannot be changed. As an example, onNovember 5 the Supreme Court will hear a chal-lenge to the nearly century-old practice in the statesof exempting income that residents earn from theirin-state municipal bonds while taxing residents onthe income they earn from out-of-state municipalbonds. (See the state’s brief in Kentucky v. Davis atDoc 2007-23085 or 2007 TNT 201-15.) This practiceclearly discourages residents from buying bondsfrom states other than their own. Yet, since the turnof the 20th century, the states have followed thisapparently discriminatory practice, justified by‘‘market participant’’ reasons. Only one state treatsbonds identically.

Although legal arguments may allow the statusquo to continue, economic principles indicate thatthe discriminatory state practice should be abol-ished. A Supreme Court ruling in favor of theeconomic principle might lead to an initial disrup-tion of the municipal bond market as states figureout what to do, but over time, the elimination of thetax discrimination should lead to a more efficientmuni market.

A similar argument occurs in the treatment ofincome earned in the alternative investment indus-try. There is little reason why two firms — say theBlackstone Group and Goldman Sachs — that per-form the same investment functions should betreated differently on the income they earn on thosefunctions.

Yet, the tax law allows exactly such a difference.As The New York Times reported, Goldman Sachspaid $1.1 billion in corporate income taxes on its

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$3.4 billion second-quarter profits, while the Black-stone Group paid just $14 million on its $1.1 billionin first-quarter earnings. One investment firm paysabout a 32 percent tax rate, and the other pays a 1.3percent tax rate for doing essentially the samebusiness.

Changing the tax treatment of carried interestsmight create a bit of market volatility initially. Butthe result would be a more efficient allocation ofresources brought about by the elimination of thetax distortion.

Too Good to Be TrueAlthough any legislative outcome is too uncer-

tain to predict, one thing that is certain about theeffect of any legislation is that modifying the taxlaw that allows carried interests to be taxed at afavorable rate will not mean the tax law is free ofloopholes. The code is stuffed full of tax preferencesthat allow a clever tax manager to find a perfectlylegal way to reduce taxation almost to any leveldesired.

The private equity industry has self-reportedsome spectacular returns. Over a 25-year period thereturn on the best private equity investments wasmore than three times the return on the S&P 500companies during the same period, perhaps evenmore than three times.

These data are difficult to interpret, however. Ameaningful comparison of returns would comparethe best private equity returns with the comparableshare of the top S&P 500 firms to the S&P 500average over that period. During the past 25 years,the S&P 500 has frequently reported annual returnsabove 20 percent, indicating that the best firms inthat group earned somewhat more than 20 percent.Regardless of the overall average during that pe-riod, it is certain that the return earned by the topquartile of the S&P 500 firms exceeded the S&P 500average.

Some researchers have examined the entire poolof private equity partnerships and found that theyperform no better than the S&P 500. Using datavoluntarily reported by the private equity industry,Kaplan and Schoar, for example, find that theaverage private equity fund return net of fees from1980 to 2001 roughly matched the S&P 500 average.The substantial variation in the returns amongfirms, however, suggests that some spectacularlosses exist among the spectacular gains.

Given the relatively small amount of capitalmanaged by private equity firms until the past fewyears, it is also possible that these funds earnedexceptional returns in the early years because oftheir ability to invest in the most lucrative ventures.In 1980 private equity funds managed less than $5billion in capital.

The story is very different now, with total capitalunder private equity management above $1 trillion.As the pool of capital under private equity manage-ment expands, the law of diminishing returns kicksin so that the average return on $1 trillion will bemuch lower than the average return on $100 billionin capital.

Of course, a higher return comes only by takingon a higher amount of risk. Private equity fundmanagers attempt to achieve what is known as‘‘portable alpha’’ by choosing investments that willdo better than the market; thus, a manager strivesfor a positive alpha to show that the manager’sinvestment skills are better than those available fora given systematic risk. An alpha of 3, for example,would indicate that the manager earned a returnthat exceeded the market benchmark by 3 percent.Investors look to beta to determine the systematicrisk of a stock or overall portfolio; investors with ahigh tolerance for risk would choose a high beta, allelse equal, while risk-averse investors would seek alow beta. Utility funds tend to have a beta value lessthan 1, for example. A fund with a beta of 1 wouldexpect to earn the market return.

Introductory finance courses show that fundsearn a greater expected return only by taking ongreater risk. (Ex post, the return on any particularinvestment could be higher than another for a givenamount of risk, but ex ante, this is not possible.)

A study from 2004 by Susan Woodward showedthat the returns earned by venture capital andbuyout funds are not above average for a givenamount of risk. Reports of ‘‘super’’ returns aretainted by the fact that there are little pricing dataavailable on private equity funds. In such circum-stances, Woodward shows, the fund’s beta will beunderestimated, thus leading to an overestimate ofthe fund’s alpha, that is, its managerial contribu-tion. In other words, the underlying risk will beincorrectly seen as too low, while the contribution ofthe fund manager as represented by alpha will beincorrectly viewed as too high. Correcting for thesebiases shows, for example, that in the case ofventure capital, the estimated beta rises from 0.6 to2, while the estimated alpha falls from 1.8 to essen-tially zero.

What You See May Not Be What You GetA fundamental difficulty in examining the per-

formance of the private equity industry is that thefirms are not required to make their results public.Thus, to the extent that firms report performanceresults, it is conceivable that the reported resultswill be tilted toward the better results.

The lack of transparency in the alternative invest-ment community does not bode well for financial

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markets. An increasing share of financial transac-tions occurs away from public scrutiny as the pricesof more and more securities are established outsidethe marketplace.

In a front-page story on October 12, The WallStreee Journal recalled that the Long-Term CapitalManagement hedge fund collapsed after ‘‘bad betson opaque bond markets.’’ Some $25.2 trillion ofbonds now do not trade on markets with readilyavailable prices. As one former trader noted, manyprices are obtained by asking traders what theywould like to receive for the position, a process shesaid was ‘‘akin to a homeowner valuing a housebased on how much he wants for it, not how mucha buyer is willing to pay.’’

It is The Wall Street Journal, that has once againraised the issue of Enron. In discussing the risks tothe markets created by the off-balance-sheet struc-tured investment vehicles, the Journal noted thatbecause ‘‘off-balance-sheet liabilities played a majorrole in the 2001 collapse of Enron Corp., the makersof accounting rules have generally sought to getaffiliated entities back on the balance sheets of thecompanies creating them.’’

The Smartest Guy in the RoomChanging the tax treatment of private equity

won’t kill the industry. Simple math shows thateven if the income of top fund managers was taxedat twice the current rate, their returns would still bepositive.

Likewise, requiring firms to provide informationabout their investment structure and their rates ofreturn would not hurt the industry.

One expects that the private equity industrythrives because of its expertise in making superiorinvestments, not because it receives favorable taxtreatment or because it reports the good news andhides the bad news. A fundamental principle thatall business managers learn is that if a project makessense only because of its tax treatment, then it is nota worthwhile project. If the private equity industryneeds this tax break and nontransparency to sur-vive, perhaps it is time to question whether the taxcode should be extending a lifeline to the industry.

Otherwise, it may turn out that the sequel toSaving Private Equity is not The Smartest Guy in theRoom, Part 2.

Where to Find More InformationThousands of pages have been written on this

issue. A selection appears below.For a flavor of the debate, see Donald J. Marples,

CRS Report RS22717, ‘‘Taxation of Private Equityand Hedge Fund Partnerships: Characterization ofCarried Interest,’’ Doc 2007-20687, 2007 TNT 176-32.

For details on the tax treatment of partnershipcarried interests and related issues, see the docu-

ments prepared by the JCT, ‘‘Present Law andAnalysis Relating to Tax Treatment of PartnershipCarried Interests and Related Issues, Part I,’’ (JCX-62-07), Doc 2007-20255, 2007 TNT 172-12, and Part II(JCX-63-07), Doc 2007-20256, 2007 TNT 172-13.

For additional discussion of the tax issues, seeMark Jickling and Donald J. Marples, CRS ReportRS22689, ‘‘Taxation of Hedge Fund and PrivateEquity Managers,’’ Doc 2007-15994, 2007 TNT 131-40.

For further explanation, see the testimony ofTreasury Assistant Secretary for Tax Policy EricSolomon before the Finance Committee on thetaxation of carried interests (July 11, 2007), Doc2007-16265, 2007 TNT 134-42.

For a discussion of tax arbitrage, see ‘‘Tax Re-form, Tax Arbitrage, and the Taxation of CarriedInterest’’ testimony of C. Eugene Steuerle, seniorfellow at the Urban Institute, before the Ways andMeans Committee (Sept. 6, 2007), Doc 2007-20478,2007 TNT 174-54.

For an analysis of the compensation structure,see Victor Fleischer, ‘‘Two and Twenty: Taxing Part-nership Profits in Private Equity Funds,’’ LegalStudies Research Paper Series, Working Paper 06-27, revised Aug. 2, 2007.

For a view from the private equity industry, seethe statement of Bruce Rosenblum, managing direc-tor of the Carlyle Group, and chair of the PrivateEquity Council, before the Ways and Means Com-mittee (Sept. 6, 2007), Doc 2007-20473, 2007 TNT174-49.

For a discussion of beta and alpha, see René M.Stulz, ‘‘Hedge Funds: Past, Present, and Future,’’Journal of Economic Perspectives, Vol. 21, No. 2,Spring 2007, pp. 175-194.

For an analysis of how to evaluate private equity,see Susan E. Woodward, ‘‘Measuring Risk andPerformance for Private Equity,’’ Sand Hill Econo-metrics, Aug. 11, 2004.

For an evaluation of private equity performance,see Steve Kaplan and Antoinette Schoar, ‘‘PrivateEquity Performance: Returns, Persistence and Capi-tal Flows,’’ Journal of Finance 55, Aug. 2005.

For a criticism of the tax issues that arise underH.R. 2834, see Lee A. Sheppard, ‘‘The UnbearableLightness of the Carried Interest Bill,’’ Tax Notes,July 2, 2007, p. 15.

Data on income and earnings come from U.S.Census Bureau, Income, Poverty and Health InsuranceCoverage in the United States: 2006 (Aug. 2007),available at http://www.census.gov/prod/2007pubs/p60-233.pdf.

NEWS AND ANALYSIS


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