Carried interest and the big lie

June 1, 2010

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 BIG LIE
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.)

12 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

While entertaining, this article puts forth A BIG LIE. Taxing the investment brokers at 100% does not fix the Pension Ponzi.

Prepare for a sunset career, greeting at Wal-Mart or groping passengers at the Airport. The Retirement Myth is now exposed.

Posted by JoeElector | Report as abusive

The private equity industry’s goal is early retirement in luxury … for themselves.

Posted by HBC | Report as abusive

This is just one of any bankers spiffs that are in place because of the politician addiction to campaign funds. Remember, any actual investment that they make is treated as capital gains, the joke was that fund managers got the same treatment for their gains on OUR money.

It was wrong, just like the fees banks got for lending our money to our college student, just like politicians being able to inside trade on information gleaned on the hill, just like mortgage deductions which is a tax that benefits only the rich and banks.

I could go on but it gets tiring to list all of the things that the politicians have given to the rich, including the wink and nod treatment of overseas tax shelters.

We don’t need reform packages, we just need people to obey the law and put greed down the list of acceptable social problems.

Posted by jstaf | Report as abusive

This just raises the fundamental tax policy issue of whether to tax investment income at lower rates than ordinary income. Reagan equalized the rates in the Tax Reform Act of 1986, and the financial sky did not fall.

Posted by Gaius_Baltar | Report as abusive

Ah, generalizations – they are so easy for the lazy. I can generalize as well – increase the tax, and the manager increases its carry % (passes the tax to the investor) – the law of unintended consequences in its simplest form. Over time, as net returns fall, PE gets less attractive to enter (as you say, the best and brightest end up in civil engineering) and less PE funds are born. unfortunately, many PE funds (not the big bad monsters from wall street mind you) actually invest in job creating industries. They put their money in small local business, which create base employment, which fuels economic expansion. But, easier to bark about the income levels of those monsters that work 20 hour days than to focus on the complexity of job creation and aligned interest.

Posted by PortlandMP | Report as abusive

Nice article .

Posted by Wicki | Report as abusive

the author is apparently selective in posting comments as well – both lazy, and scared.

Posted by PortlandMP | Report as abusive

Excellent article, and about time. Private Equity (say, venture capital) has a glorious 11-year history of negative returns to its limited partners. Plus, given the fact that of these oh so rarely talented “innovators” charge a 2-3% “management” fee, you will find that MANY of these titans of wealth creation pull down multimillion dollar *risk free* “returns” simply out of fees. Plus, given the 20 (and up) % of carried interest on money “managed” by them, plus a lower tax bracket for when they do return the occasional if rare return, this is–literally–a gravy train whose rapaciousness needs to be ended, and the sooner the better.

Posted by blago | Report as abusive

Everyone is for laissez faire and fair taxes until success makes them less bold and thus in need of advantage over competitors, or in the marketplace in general. Every business seems to need that subsidy, tax relief, or loophole to make them special in their eyes. Farmers, bankers, students, oil men, financiers, doctors, lawyers, and every other specialist absolutely must have that favored status. Specialism is the philosophy of politicians, so everyone cries to his specialist. If this is the beginning of a new age of No Special Treatment, then let’s go across the board. P.S. Some pro-government commentators might get caught up too.

Posted by JanJan | Report as abusive

You say: “Carried interest is compensation for labor, earned income in other words, rather than gains on capital that might be lost.” Huh? Get educated if you are going to write about a subject or risk sounding like an idiot. Every VC and PE guys MUST invest their own capital in alongside their LPs, ergo it is subject to loss. And if they do not generate a PROFIT (carry is a % or profit), thy earn nothing. So how is this ‘income’, based on what? An hourly rate? You sound like a liberal apologist.

Posted by CarmA | Report as abusive

I am wonder why the left hates the word profit, people and companies that profit pay taxes unlike most of the people in this country. The sad part is that I pay 35% of my income, and I am okay with that, what i hate is what I get for what I am paying. Schools that don’t perform, roads that are falling apart, a complete lack of confidence in the federal government to use common sense. It’s not the amount I pay what I get for it. So stop complaining that I don’t pay enough spend it more wisely.

Posted by JAFOINMN | Report as abusive

CarmA, the money they make off investing their own capital should be taxed at investment rates. The money they make off investing their LP/client’s capital should be taxed at income rates. Easy distinction, no?

Posted by TFF | Report as abusive