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Framing the debate on carried interest.

|Includes: BX, KKR & Co. Inc. (KKR)
Can Private Equity Firms and Hedge Funds Stir Popular Opposition to Taxes?

I've talked a lot in recent months about how private equity compensation will be affected by proposals from Congress to change the taxation of carried interest.  This is a big concern, as the carry is a huge part of the private equity compensation structure. 

As many of you are probably aware by now, there is a growing movement to close the "tax loophole" that private equity firms are many hedge funds benefit from.  This is the carried interest (the profits made to the private equity fund by buying and selling the portfolio company).  In a typical buyout fund, the compensation structure is 2-and-20.  The 2 is the management fee which is usually 2% of the fund's net asset value.  This fee covers the fund's cost of operation while bonuses come from the carry. 

The 20 in the 2-and-20 model is the 20% of profits most funds charge which is commonly known as a performance fee.  Private equity firms pay their staff largely from this performance fee (or carried interest).  The problem is that carried interest is taxed at a lower rate than ordinary income.  This is because in our tax code carried interest is viewed as capital gains which is taxed at just 15% whereas ordinary income gets taxed as high as 35%.  With a massive federal deficit worrying many Americans and politicians, closing the carried interest "loophole" and thus taxing buyout firms significantly more is becoming an increasingly popular method for increasing federal revenue.  It also carries the added bonus of giving a cut to what many view as outrageously large bonuses paid to hedge fund and private equity executives. 

This may be a valid point, but the Private Equity Council--a trade group representing buyout firms such as Blackstone Group (NYSE:BX), TPG Capital and Kohlberg Kravis Roberts & Co. (NYSE:KF)--has been fighting this tax saying that it will hurt private equity firms and the businesses they support and manage.  The Private Equity Council--after exhausting its traditional lobbying method--is now trying to drum up popular opposition to the carried interest tax proposal through a grass roots campaign.  The message: private equity firms do good and taxing them will hurt the economy and small businesses. 

It's hard to say yet if this message will resonate with politicians or people outside the PE industry.  My instinct is yes.  The electorate generally supports small businesses and the number one issue for Americans is still the economy (i.e. jobs).  The unemployment rate is still lingering just below 10% and the PEC seems to be using this issue to argue that taxing private equity firms will have a negative impact on small businesses and that means a continued recession will fewer new jobs.  One private equity official seemed to agree when talking to the NYP, "Everyone knows what this [tax hike] means for the big PE firms, but it's small business that would really be hurt by these moves."

If the PEC taps into the mass opposition to tax increases it will gain support from the middle class in addition to its current support base among people in the financial industry and those who benefit from the current tax treatment. 

On the other hand, the budget deficit has many of these same people who are opposing tax increases concerned and there is widespread anger toward financial firms.  If the message shifts to one of "say no to cutting our bonuses" I doubt there will be any popular support.  But if the PEC succeeds in framing the tax proposal as raising taxes on Americans in a bad economy, Washington will have a tough time pushing this through.

Comments: What are your thoughts on the taxation of carried interest?  Will the tax hike affect you? 

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