The Equities of Private Equity

By James V. DeLong, special counsel and chairman of the Intellectual Property practice area in the Washington, D.C. office of Kamlet Shepherd & Reichert.  He also serves as vice president and senior analyst with the Convergence Law Institute LLC.

Congress is debating whether to increase the tax rate paid by the managers of private equity funds. The immediate contest is whether these rewards should be taxed as ordinary income rather than capital gains, a rather arcane topic to be getting so much ink, one might think, but, as usual in Washington, many forces are at work.

So here is a quick guide.

Tax fairness. The academic community bays about the unfairness of having money managers pay capital gains rates while hard working laborers and professionals, not to mention academics, pay ordinary rates.

Decent respect for the English language should bar anyone from using the words "taxes" and "fairness" in the same sentence, considering the morass of unfairness, special privilege, earmarks, and bribery that constitutes the tax code.

That aside, the importance of "fairness" as a motivating factor is limited. To start, the issue is hardly new. The structure of these PE funds is that an active manager collects financial backing from a bunch of limited partners, and in exchange for managing the assets gets a share of any increase in their value. This structure has been used for real estate and oil and gas partnerships forever.

It is also only one of many ways in which ordinary income is converted to capital gains. A carpenter (let's make him a poor but legal immigrant) who buys a building, fixes it up, and sells it at a profit is transmuting the pay he would get for his labor into a capital gain. So is an entrepreneur who takes a modest salary while she builds up a tech company and then sells the stock at a huge profit. The list is endless. Much of what tax lawyers do is seek out this alchemy.

For the most part, the academicians are concerned with equity only in the sense that they want the abstractions of the tax code to fit neatly together. The anti-market, anti-capitalist professors do not advocate leveling the playing field by enacting a flat tax; instead, they want to add even more epicycles to the system. If pinned, they probably would agree that yes, indeed, the carpenter should pay ordinary rates on much of his gain.

Delve deeper and the metaphysics become steadily more amusing. A successful investor increases his capital largely because of intense study and high skill in assessing opportunities. So perhaps capital gains treatment should be denied to that part of the gain that comes from this exercise of skill and investment of time, and the investor should be required to account for the time he spends thinking about his strategies. Start down the road of seeking perfect tax fairness and one can easily reach a conclusion that capital gains treatment should be given only for luck, which is not a strategy for fostering economic growth.

Politics. It is traditional for Congress to take up soak-the-rich legislation just before elections to encourage the rich to make campaign contributions and the non-rich to get active. The Democrats also need to be seen as seeking revenue to pay off their constituencies, and a "the rich-are-avoiding-taxes (and thus depriving you of government benefits that you deserve)" theme appeals to their base. Further, most of this base thinks the rich are Republicans even though the campaign contributions of the targets of these proposals go strongly the other way.

So how can the Dems resist, when they profit in so many ways? As Fortune's Nina Easton pointed out, almost all their presidential candidates advocate taxing the PE managers, and Senator Baucus introduced a bill to this effect, but at the same time Senators Dodd and Schumer are reassuring their Scarsdale/Greenwich constituency that it is just not going to happen.

They will have the help of the Republicans, who, trapped by their opposition to tax increases and determination to protect the economy, become enablers of the Democrats' behavior. (Though they may garner a few campaign contributions of their own.)

Financial Regulation. The government, via a steady stream of law and regulation, has made the lives of corporate officials and hands-on capitalists and entrepreneurs more risky and unpleasant, and has raised the direct and indirect costs of being a public company.

Congress and the SEC try to level the investment playing field between those who are paying attention and those who are not. The definitions of illicit insider trading expand steadily and the availability of useful information is truncated. The ability of investors to monitor the performance of public companies is being reduced rather than enhanced by the inhibitions on corporate communications and by the flow of meaningless details that tell little about the guts of a business.

Stock options, very useful in the tech world, have been undermined. Corporate governance has been bureaucratized, and managerial acceptance of risk made hazardous via criminalization and tort law, at a time when global competition makes acceptance of calculated risks crucial. Managers are under pressure to make the numbers every quarter, even at the expense of sensible long-term investment, and any manager who let her stock price decline while she reoriented a company would trigger personal disaster.

The emphasis on "independence" of directors guarantees control by the ignorant and risk averse. "[T]he ideal independent director" is characterized as "somebody you keep locked in a dark room; who cannot talk to anybody else or know anything about the affairs, issues, or plans of the company, but is available to be rolled out whenever an 'independent committee' is needed."

Ms "Equity Private," a canny participant-observer of the PE industry, quotes a colleague: "The incompetence displayed here is far too insidious, too pervasive to be the work of one person. This is clearly the work of a committee of the Board of Directors."

Indeed, "studies suggest that supermajorities of independent directors may have a negative effect on corporate performance."

The consequence of the outpouring of regulatory ignorance is that entrepreneurs and managers have strong incentives to take public companies private, or to avoid going public in the first place, or at least to avoid the U.S., and financiers see opportunities to arbitrage the inefficiencies that have been imposed on the public markets.

Naturally, the government opposes such presumption. An axiom of the regulatory world is that failure must be expanded rather than acknowledged, and that any industry damaged by regulation must be protected against more efficient competition rather than freed from its destructive burdens.

So railroad regulation was extended to trucking and television regulation to cable, and the response to the news that much regulation of public markets is counterproductive is to attack its rising competitor, private equity. In this context, the tax issue is just a handy stick with which to beat the dog.

Intraclass Strife. The capitalist class is by no means of one mind. The savings of individuals are channeled into the hands of institutional money managers. These take a few percent for management fees and a few more for transaction costs, and then deliver returns to their principals that, about 75% of the time, are less than the returns these would get from buying and holding an index fund.

The business of most of these intermediaries is not really that of managing money to achieve superior returns. Their business is getting money in the door and then avoiding any quarter so bad that it would trigger a serious outflow. Everyone purports to have superior stock-picking skill, but there is a lot of closet indexing.

Why should firms in this manage-the-money-and-let-some-of-it-stick business like the private equity partnerships, which boast that they can indeed achieve superior returns, and have a payoff structure whereby they get paid only if they make good on it?

Just as the private equity firms are creating benchmarks for the performance of public companies, they are creating benchmarks for the performance of the money management industry. Their ability to win a popularity contest seems in doubt. If the PE firms knew who is really stoking the fires of "tax reform" here, they might find quite a few fellow Wall Streeters.

Financial Capital & Human Capital. This is the murkiest, but most interesting, dimension.

A tectonic shift in the nature of capital is occurring. The world is awash in financial capital. Harder to find and identify are the human abilities necessary to deploy this financial capital effectively, ranging from the technical savvy that creates the computer and the internet to the entrepreneurial skill that puts great enterprises together to the managerial talent that keeps them humming.

Whereas a generation ago most of the value of an enterprise was accounted for by its hard assets, such as factories or inventory, now about 75% of it lies in intangibles - patents, copyrights, staff creativity, trade secrets, know-how, reputation, brand names, customer relationships, and the ability to manage them all.

It is a truism of the world that the scarcest resource commands an outsize share of the returns, because those who control it can force the holders of the more common resources to bid against each other.

If finance capital is scarce, the financiers rule. But in a world in which finance capital is plentiful and creative capital less so, the financiers get to bid for the privilege of going into business with the creatives, and sharing the returns from their intangible capital.

This shift in power is resisted because it does not accord with the 19th century model of the corporation, in which the financiers are the principals and all others are their subordinates and agents, and because the finance capitalists are not too keen on the shift. In fact, much of the work of the government that is undermining the efficiency of the public markets can be viewed as an effort to retard this change, to maintain the dominance of the finance capital over creative capital.

The private equity firms' fat pay-offs and occasional ostentation on a Veblenian scale make them good targets, but their real sin is to be leaders and symbols of the shift. They earn their returns by identifying the opportunities for superior deployment of capital and by revamping the internal structure of the companies they take over so as to empower and reward the creativity of the managers and employees, collecting a handling fee along the way for their own intellectual contributions.

Granted, this picture can be over-idealized. As is true of all such market shifts, not every private equity firm is the real deal. There is considerable froth and hype, as the headlines of the past few weeks attest. Not many private equity firms really understand their role in the great scheme of things, and most will probably fail to outperform the public markets. That's show biz.

But it is hard to refute a strong suspicion that a good part of the opposition to giving capital gains treatment to the earnings of the private equity types is psychological. These people are supposed to be employees, not principals, and only on the latter should the tax gods smile. These people are uppity. The proposals are the tax code equivalent of medieval sumptuary laws, which prohibited dressing above one's station.

* * *

So the debate spins, with "fairness" and "tax the rich" countered by "investment incentives." Where the wheel will stop is uncertain. The PE firms will probably win this round, after they have been sufficiently milked for campaign contributions. Their supporters are making clear that pain-spreading is part of their strategy -- "[Senator Schumer] told the Senate Finance Committee this month that he would agree to the proposals only if taxes were also raised on oil-and-gas, venture-capital and real-estate partnerships" - and it would be difficult to nail the PE firms without upsetting laws and practices concerning existing economic relationships of all kinds. Even the most retarded politician has sense enough to avoid this thicket.

But the underlying issues are fundamental, and the troublesome question of private equity will be a hardy perennial.

Originally published in the TCS Daily, August 8, 2007