COLUMN-Carried interest and the big lie: James Saft

June 1, 2010

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

Greensboro, Alabama, May 31 (Reuters) – As an investment strategy, making private equity and hedge fund managers rich is a probable loser. As a tax policy, it is a guaranteed one.

The U.S. House of Representatives passed a bill last week that would raise the taxes that private equity and other investment managers pay on “carried interest,” their share of the takings when a holding such as a startup or turnaround is sold at a profit.

Carried interest is currently taxed at the lower capital gains rate, meaning that many private equity barons can pay less in tax than the people who clean their swimming pools or mind their children. This is patently unjust. Carried interest is compensation for labor, earned income in other words, rather than gains on capital that might be lost.

As you might expect, the private equity industry is not happy:

“Remember we manage money for union employees, for corporate employees, for teachers, firemen and the like and our job is to help these unions and pension funds protect their employees when they retire. This is why private equity needs to have the treatment we have to attract the best and brightest to this sector.” Robert L. Johnson, of private equity firm RLJ Companies told CNBC television.

“Many state pensions and corporate pensions are terribly underfunded. You take away the some of the incentive on this industry and its going to backfire on the people who need pensions when they retire.”

The words “self-serving” and “twaddle” come to mind.

Hoping to rescue the pensions mess by paying private equity mangers big bucks is a bit like trying to save the Titanic by tipping the barman well. It will pass the time, he’ll appreciate it, but the ship still has a whacking great hole in the side.

Private equity funds may, just possibly, be able to, in some circumstances, achieve superior returns, but there are some very serious flaws in Mr. Johnson’s reasoning.

There is very little chance that private equity will ever be large enough to make a meaningful hole in what is a very large and very structural pension fund deficit. Pension funds don’t have enough money, not because they’ve been failing to compensate their mangers well enough, but rather because their promises were built upon assumptions that now prove false.


The first error is actually good news: people are living far longer and medical advances may well extend the average pensioners’ life still more in the years to come.

Typical portfolio returns are also falling short of the highly optimistic eight to ten percent benchmark that many pension funds assume they will be able to achieve over the long term. Those assumptions were set mostly in the 1980s and 90s when falling inflation artificially boosted returns. In a low growth, lower leverage economy those figures now look highly unlikely, if ever they were realistic.

The idea that private equity and hedge funds need special tax treatment to attract talent is laughable too. Remember Ken Feinberg, the compensation czar who slapped a $500,000 limit on pay at some government supported firms? Well, he found that very few jumped ship.

Even if they did, there is a strong argument that the U.S. would be better off economically encouraging its ablest minds to go into a different kind of engineering from financial engineering.

The larger story here is really the lies we tell ourselves as returns drop and we resist taking the hard choices of working longer, saving more and consuming less.

As interest rates and structural returns have dropped over the past twenty years, finance has, time and again, come up with wave upon wave of products to turn investment straw into gold.

Collateralized Debt Obligations and other forms of structured finance was one wave, sold to German banks and Kansas pension funds alike, and alike a disaster.

Hedge funds and private equity are two other examples. Both employ leverage and supposed manager selection and execution advantages and both, tellingly, charge a huge premium for the dubious privilege.

The investor or would-be pensioner has been like a gambler at the race track who, seeking a profit as the final race draws near, gets talked by his bookie into borrowing money to make bigger bets and paying a higher fee to do it.

Selling this hope shouldn’t be subsidized by the tax code, so cracking down on carried interest is good policy.

It would be good policy too if politicians and pension fund trustees were honest with the people they represent. We will all have to work longer and save more and we’d be better off if we got on with it rather than buying expensive magic beans from financial products salesmen.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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