Demanding a federal budget that is fair, responsible, and meets our nation's priorities

Friday, October 12, 2007

Wall Street Quick & Dirty on Carried Interest

Wall Street folk don't have much time for nonsense. Motley Fool ran an interview this week with private equity veteran Dan Primack of Thomson Financial entitled The Golden Age of Private Equity? Primack doesn't mince words:

Motley: What is the current political spat about carried interest all about?

Primack: Do you have a few hours? OK, here's the CliffsNotes version: Democrats want to raise taxes on private equity professionals. Republicans don't. The Democrats are right.

Here's how a typical private equity firm operates: It raises a fund (i.e., blind investment pool) from limited partners like university endowments and state pension plans. These are just commitments, with the fund able to call down capital as needed. The limited partners pay an annual management fee on the committed capital -- typically 2% -- which is used to pay salaries, lease office space, etc. -- and it generally ratchets down over time. All of that management fee income is taxed at ordinary income rates.

But there is a second way private equity pros make money, and it's called carried interest. For every dollar in profit that a fund makes off of its investment, only about 80% (sometimes less) actually gets distributed to the limited partners. The rest gets kept by the general partner, as a sort of incentive bonus. This gets taxed as capital gains, which currently stands at 15%. So if a buyout pro made $4 million last year with $3.5 million of it coming from carried interest, he only paid around $700,000 in taxes.

This is a great deal for private equity pros, but is fundamentally unfair to everyone else. It really does border on corporate welfare, and the only decent counter-argument is that a change in tax treatment would be the first step toward an overall abolition of capital gains benefits (which limited partners do, and would continue to, receive). But wrong is wrong.

Per the New York Times, "a spokesman for the Senate majority leader, Harry Reid, told The [Washington] Post that time appeared to have run out to act this year and that, in any event, the issue needs more study."

Reid thinks the issue needs more study. One thing is clear: he's no Fool. That's a shame.