TN Oct 22 Saving Private Equity

NEWS ANALYSIS
Saving Private Equity
By Joann M. Weiner — jweiner@tax.org
Roughly 63 years after the Allied landings at
Normandy, the private equity industry launched its
own version of Saving Private Ryan.
Faced with a double-barreled assault on its tax
position from the House and the Senate, the private
equity industry turned to its big guns — the Private
Equity Council Group and its commander in chief,
Bruce Rosenblum of the Carlyle Group — to save
private equity.
The lobbying efforts intensified in June following
the Blackstone Group’s efforts to raise more than $4
billion by going public. The Blackstone initial public
offering (IPO) attracted congressional attention
both because of its relative novelty — only one
other large private equity (leveraged buyout/
venture capital) firm, Fortress Investment Group,
had gone public in the United States — and for the
revelation of the astronomical reward that some
Blackstone Group partners stood to receive from the
IPO. Blackstone’s filing with the Securities and
Exchange Commission showed that Blackstone’s
two founders, Stephen Schwarzman and Peter G.
Peterson, together would collect $2.33 billion from
the IPO.
Armed with the SEC information, which opened
up the structure of the Blackstone Group to the
public for the first time, some members of Congress
began an intense counter-assault. It decided to no
longer merely undertake a study of the tax treat-
ment of private equity firms, hedge funds, venture
capital funds, real estate funds, funds of funds,
mezzanine debt funds, and structured debt fund
and other alternative asset management and finan-
cial advisory business activities, but to undertake a
frontal assault and consider introducing legislation
attacking the tax-favored status of those activities.
(For ease of exposition, these various funds are
referred to as alternative investment funds.)
Interest in the compensation arrangements of the
hedge fund and private equity sector had been
simmering but was focused on conducting studies
rather than introducing legislation. In March an
aide to Senate Finance Committee ranking minority
member Chuck Grassley, R-Iowa, indicated that the
examination of hedge funds included considering
whether carried interests should continue to obtain
preferential tax treatment relative to other forms of
similar compensation. Grassley announced that the
committee had no plans to introduce legislation at
that time (Doc 2007-6179 or 2007 TNT 48-1).
The issue boiled over in June when former Treas-
ury Secretary Robert Rubin said Congress should
give serious consideration to taxing some compen-
sation of these fund managers at ordinary income
rates rather than at capital gains rates. Although
Rubin was not expressing the view of his current
employer, Citigroup, many corporate investment
firms and rivals to private equity firms support the
private equity legislation on the view that it would
level the playing field. (See Sarah Lueck, Jesse
Drucker, and Brody Mullins, ‘‘Congress Hunts for
Tax Targets Among the Rich,’’ The Wall Street Jour-
nal, June 22, 2007.)
The possible tax change struck a nerve in the tax
community. Congressional committees have held
several hearings on this issue since July, dozens of
conferences have taken place, and thousands of
pages of analysis have been written on the tax
treatment of partnership carried interests and re-
lated issues.
Private equity fund managers are known for
making shrewd investment choices that lead to
spectacular returns on their investment. During the
summer, these managers may have made one of
their most spectacular investments, earning an as-
tronomical rate of return.
How did these private equity fund mangers earn
such returns? Not the old-fashioned way of Smith
Barney (‘‘we earrrrned it,’’ according to their slo-
gan). They earned it the new-fashioned way — via
lobbyists.
Taxation of Private Equity
One potential legislative measure would have
treated net income from an investment services
partnership interest as ordinary income for the
performance of services (H.R. 2834, Doc 2007-15052,
2007 TNT 122-77, cosponsored by House Ways and
Means Committee member Sander M. Levin,
D-Mich., and Committee Chair Charles B. Rangel,
D-N.Y.). Another measure would have treated all
publicly traded partnerships that directly or indi-
rectly derive income from investment adviser or
asset management services as corporations (S. 1624,
Doc 2007-14235, 2007 TNT 116-54, cosponsored by
Finance Committee Chair Max Baucus, D-Mont.,
and Grassley).
In other words, the tax rate that applied to a
significant portion of an alternative investment
fund manager’s profits might have risen from 15
percent to 35 percent or more.
The tax change was the equivalent of a declara-
tion of war.
Given the more than doubling of the tax rate,
alternative investment fund managers began in-
vesting in a campaign designed to persuade Con-
gress that the tax rate applied to their compensation
(the carry) should not more than double. Dozens of
NEWS AND ANALYSIS
TAX NOTES, October 22, 2007 309
(C)TaxAnalysts2007.Allrightsreserved.TaxAnalystsdoesnotclaimcopyrightinanypublicdomainorthirdpartycontent.

lobbying firms jumped into action, including the
Washington-based Private Equity Council, which
spearheaded the effort to head off any tax bill that
would increase the taxation of private equity firms.
And, unlike the soldiers on Omaha Beach, the
lobbyists did not have to cross mine-studded
beaches and scale escarpments to achieve victory.
They simply needed to spread the word that private
equity was under attack.
For the price of relatively minor lobbying ex-
penses of some $5 million to $6 million, these fund
managers stood to save taxes of some $4 billion to
$6 billion or more in 2006 alone. If they succeeded in
maintaining the status quo, they could generate
benefits of $60 billion or more over the long term. It
didn’t take a ‘‘master of the universe’’ to do the
math and figure out that the rate of return on the
investment in lobbying expenses would be impres-
sive.
Thus, the lobbyists went to work and shortly
thereafter achieved their goal. With barely a whim-
per, the Democratic and Republican leaders in
Congress simply raised the white flag.
As The Washington Post reported on October 9
(‘‘Buyout Firms to Avoid a Tax Hike’’), Senate
Majority Leader Harry Reid, D-Nev., confirmed a
statement he made last July (Doc 2007-16745 or 2007
TNT 138-2) that the Senate would not push through
legislation concerning the taxation of carried inter-
ests this year. Grassley had made a similar state-
ment in July that the private equity lobby had
effectively killed any legislation dealing with the
issue. Given the election year in 2008, this means
the issue is off the table for at least two years.
The lobbyists could do the math once again and
calculate that their efforts had preserved a $10
billion tax benefit over the next two years. With a
greater than 800 percent return on investment, the
Private Investment Fund Structure
The figure below presents a chart from the Joint Committee on Taxation that illustrates a typical private investment
fund structure.
In the typical structure, the fund manager is a separate partnership whose partners are the individuals with
investment management expertise. The fund manger partnership is itself a partner in the investment fund
partnership. The investors are limited partners in the investment fund partnership.
In this typical structure, the carried interest held by the fund manager is a profits interest in the investment fund
partnership. The IRS takes the position that the receipt of a partnership profits interest for services generally is not
a taxable event. Because the character of a partnership’s income passes through to partners, the fund manager’s share
of income has the same character as the income has when it is realized by the underlying investment fund.
Accordingly, income from carried interests may be reported as long-term capital gain to the extent that the income is
attributable to gains realized by the investment fund from capital assets held for more than one year.
asset managers (individual partners)
fund manager
(general partner)
investors
(limited partner)
investment fund partnership
assets under management
Source:
Doc 2007-20255, 2007 TNT 172-12
Joint Committee on Taxation, JCX-62-07, “Present Law and Analysis Relating to Tax Treatment of Partnership
Carried Interests and Related Issues, Part I,” p. 2, .
capital and
services
carried interest,
management fees,
return on capital capital
NEWS AND ANALYSIS
310 TAX NOTES, October 22, 2007

investment in lobbying expenses turned out to have
been well worth the effort.
Mission accomplished.
It’s Only Taxes
Federal tax law treats hedge and private equity
funds as partnerships, and investors in these funds
become general or limited partners. In general, a
relatively small number of individuals, who are the
general partners, manage these funds and provide
investment advice concerning the use of the funds’
assets.
In exchange for their services, the fund managers
generally receive a management fee plus a share of
the partnership profits as compensation, which is
divided between an asset-based management fee as
a share of the fund’s capital plus an interest in the
fund’s future profits. The typical compensation
structure is known as ‘‘2 and 20.’’ The 2 refers to the
management fee percentage, and the 20 refers to the
percentage of fund profits received without a re-
quirement to contribute capital to the fund. This
right to receive a share of future profits is known as
the ‘‘carry’’ or ‘‘carried interests.’’
Not all fund managers are compensated under
the 2 and 20 formula. James Simons, the head of
Renaissance Technologies, earned $1.7 billion in
2006 under his 5 and 44 compensation formula.
Other relatively successful venture capital funds
have increased their profit shares to 25 percent or 30
percent.
According to The New York Times, Simons’s fund
earned an 84 percent gross return and a 44 percent
return after fees. That return, while sizable, does not
approach the returns that investors may earn in
other sectors. The CBN 600, for example, returned
272 percent while the Turkey Titans index returned
more than 100 percent in the past year. Investors
could also have made better returns than Simons by
investing in index funds in India or China, which
increased by more than 45 percent and 75 percent,
respectively, in 2006.
If investors were uncomfortable with the emerg-
ing market risk, they could have invested in T.
Rowe Price’s European mutual stock fund, which
returned a respectable 35 percent in 2006 and had a
trivial 1.03 percent expense ratio. As René Stulz said
in the context of hedge funds, ‘‘an investor in such
a fund is paying hedge fund fees for mutual fund
risk and returns.’’
A Sweet Deal on Sweat Equity
Managing an alternative investment fund is a
lucrative business. The top 25 hedge fund managers
made more in one year — $14 billion, or an average
of $560 million each — than the CEOs of the S&P
Figure 1. Ordinary Income and Capital Gains Tax Rates, Individuals
1998-2010 (projected)
Percent
Source: Doc 2007-9680,
2007 TNT 74-16
Gregg A. Esenwein, “Capital Gains Tax Rates and Revenues,” Congressional Research Service Report RS20250 (Apr. 4, 2007),
.
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Income tax rate
Capital gains rate
NEWS AND ANALYSIS

500 companies combined. Individuals must have a
net worth of $1.3 billion to make the Forbes 400 list
of the richest Americans, and roughly 20 of this
year’s new members manage private equity or
hedge funds.
By contrast, the Census Bureau reports that the
median income for American households was about
$48,000 in 2006, and the real median earnings of
men and women working full time, year-round fell
last year for the third year in a row. (There are no
publicly available lists for private equity managers.)
Even though each dollar of earnings has the same
purchasing power whether it is in the hands of a
private equity fund manager or an autoworker, the
tax code treats the income of the manager and the
autoworker very differently. Private equity man-
agers generally pay taxes at a 15 percent capital
gains rate on their earnings. Everyone else pays at
rates up to 35 percent or more on their income. The
rate on wage earners can also go higher because
wages are subject to employment taxes but capital
gains are not.
Victor Fleischer, a University of Illinois law pro-
fessor who has advised Congress on this tax issue,
seems to understand the inequity of the situation.
He refers to the tax treatment of partnership profits
carried interests as ‘‘the single most tax-efficient
form of compensation available without limitation
to highly paid executives.’’
Local tax experts also understand that the tax
code treats some forms of
income as more equal than
others.
Shifting ordinary income
into capital gains income is
what Eugene Steuerle, a
former Treasury deputy as-
sistant secretary for tax
analysis and now at the Ur-
ban Institute, calls ‘‘tax arbi-
trage’’ that allows the
recipient of the income to
take advantage of the differ-
ent tax treatment that ap-
plies to different types of
income. As long as the capi-
tal gains rate is lower than
the ordinary income rate,
there is an incentive to en-
gage in this type of arbi-
trage. (Capital gains receive
a secondary benefit because,
unlike ordinary income,
gains are taxed only when
realized and thus gain the
benefit of deferral so that the effective capital gains
rate is significantly lower than the statutory tax
rate.)
In testimony before Congress, Steuerle said tax
arbitrage opportunities reduce national income,
drive talented individuals into less productive jobs,
and add substantially to the debt in the economy.
He also noted that regardless of one’s political view,
reducing tax differentials across types of income
helps promote a ‘‘more vibrant and healthy
economy.’’
Despite this bipartisan agreement on the adverse
effects created by rate differentials, the differentials
are essentially a permanent feature of the tax code.
Figure 1 shows the difference between the ordinary
income and the long-term capital gains rate for the
past two decades. The two rates have diverged
since 1990 when both forms of income were taxed at
28 percent. Since 1991, when the maximum tax rate
on ordinary income rose to 31 percent, capital gains
have had a favorable treatment, and this favorable
treatment has generally increased steadily as in-
come tax rates have increased while capital gains
rates have fallen. The current 15 percent rate for
long-term capital gains is the lowest rate since
Franklin D. Roosevelt was president.
Thus, outside the period 1988-1990 when both
ordinary income and capital gains were taxed at 28
percent, capital gains have received a preferential
treatment relative to ordinary income since 1921.
Figure 2. Capital Raised by U.S. Private Equity Funds
(billions of dollars)
Chart taken from “The Taxation of Carried Interest,” statement of Congressional Budget Office Director Peter Orszag,
before the Ways and Means Committee, Sept. 6, 2007, p. 4, .Doc 2007-20480, 2007 TNT 174-5
Source: Congressional Budget Office, based on data from Thomson Financial, Morgan Stanley
Research.
1990 1992 1994 1996 1998 2000 2002 2004 2006
0
50
100
150
200
250
Buyout Funds
Venture Funds
Other Private Equity
NEWS AND ANALYSIS

With a projected revenue effect of $252 billion from
2008 to 2012, the capital gains tax preference is the
fifth costliest tax expenditure in the code.
What’s at Stake
Hedge fund assets and capital under private
equity management are both significant and grow-
ing. According to Thomson Financial, assets in 8,500
hedge funds increased by 20 percent last year and
totaled more than $1.2 trillion. The 566 domestic
private equity companies manage slightly under
half that amount.
In testimony before the Ways and Means Com-
mittee in September, Congressional Budget Office
Director Peter Orszag showed that private equity
firms raised more than $240 billion in capital last
year and now manage about $1 trillion. Investment
is significantly skewed toward a few successful
firms. Over the last five years, five firms have raised
an average of $30 billion in capital.
Capital gains represent a large share of the in-
come that flows through private equity and other
partnerships and S corporations. Orszag shows that
in 2005, capital gains from these flow-through enti-
ties made up 22 percent of current long-term gains
on individual income tax returns. Attempts by the
Blackstone Group to maintain partnership tax sta-
tus after going public (that is, to maintain exemp-
tion from the corporate income tax) demonstrate
how important the favorable taxation of the part-
nership form is to the private equity industry.
Examining Flow-Through Treatment
The Senate may be smart to delay a tax bill that
would raise taxes on carried interests during an
election year.
Yet it may be time for the Senate to take a closer
look at the treatment of flow-through income in
general. Chapter 3 of the Treasury report on busi-
ness taxation and global competitiveness shows
that the flow-through sector generates one-third of
business receipts and one-third of salaries and
wages and produces half of business net income.
Moreover, the importance of flow-through entities
is steadily rising, with the share of total business net
income accounted for by partnerships rising from
2.6 percent in 1980 to 21.4 percent in 2006.
Unlike corporations, partnerships don’t pay an
entity-level tax and the partnership income flows
through to the partners for taxation at their indi-
vidual income rates. This tax feature, combined
with the ease of choosing the tax treatment since
implementation of the check-the-box regulations a
decade ago, may explain a great deal of the growth
in this form of business organization. After taking
into account the 2.9 percent employment tax that
Figure 3. Flow-Through Shares of All Business Returns, Receipts, and Net Income,
1980-2004
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1980 1985 1990 1995 2000
Number of businesses Total receipts Net income (less deficit)
Source: Internal Revenue Service, Statistics of Income, http://www.irs.gov/taxstats.
Figure taken from Chart 3.1 (page 14) of Treasury Conference on Business Taxation and Global Competitiveness, Background Paper, July 26, 2007,
.
Doc 2007-17146, 2007 TNT
142-14
NEWS AND ANALYSIS

applies to ordinary income, the top marginal in-
come tax rate rises to 37.9 percent. As the Joint
Committee on Taxation notes in Part I of its part-
nership interest report, this nearly 23 percentage
point rate differential ‘‘is thought to be a motivating
factor in taxpayers’ choice to structure income as a
carried interest that can give rise to capital gain
rather than as fees or other ordinary compensation
income.’’
Thus, the classification of carried interest as
compensation for services or as a right to income or
gain from capital has significant tax consequences.
The Treasury study also showed that the top
taxpayers in the flow-through sector had an aver-
age tax rate of just under 20 percent. The richest
partners in the flow-through sector paid $113 billion
in taxes on $573 billion in income in 2006.
Other Countries
The United States is not the only country with a
thriving private equity/hedge fund industry and,
thus, is not the only country that is struggling with
how to tax the earnings of this industry.
A recent Congressional Research Service report
shows that 13 European countries treat the income
as capital gain, 8 treat it as ordinary income, and 3
treat it as dividends or other forms of income.
The OECD has also weighed in, reporting that
both the United Kingdom and the United States
provide favorable tax treatment for carried inter-
ests. These tax rules may provide one reason why
more than 1 in 5 European hedge funds, including
the 14 largest European hedge funds, are located in
the United Kingdom.
The tax benefits in the United Kingdom are even
more generous than those available in the United
States. United Kingdom law allows carried interests
to receive a 30 percentage point tax rate break
(capital gains are taxed at 10 percent and income is
taxed at 40 percent), compared with the paltry 20
percentage point tax rate break available in the
United States.
The Redcoats Are Coming!
The British are also attempting to close a tax
provision that allows private equity to benefit from
such a large unintended tax break. On October 9
U.K. Chancellor of the Exchequer Alistair Darling
announced in the prebudget report that all inves-
tors would pay a flat 18 percent capital gains rate.
This rate is a sharp increase from the current 10
percent capital gains rate that applies under the
taper relief system.
Unlike in the United States, private equity firms
in the United Kingdom are providing powerful
ammunition to the government to change the tax
rules. As The Economist reported, Nicholas Fergu-
son, the chair of SVG Capital, argued that it is
wrong that private equity executives are ‘‘paying
less tax than a cleaning lady.’’ In the United States,
this call to equity is left to a single man, Warren
Buffett.
In one sense, the British move is bolder than the
moves under consideration in the United States.
Under the U.K. taper relief regime that allows
partners to pay a lower rate if they hold the
investment for more than two years, the marginal
rate on carried interest can be reduced from 40
percent to just 10 percent.
With a 30 percentage point difference, the United
Kingdom has a strong incentive to narrow this gap.
In so doing, it may reap an unintended benefit from
increasing the capital gains rate to 18 percent.
Coupled with a reduction in the ordinary income
tax rate to 28 percent (or to 20 percent, as the
opposition Conservative Party recommends), this
increase will significantly narrow the gap in the
rates of tax that apply to these two types of income.
Flow-Through Income and Individual Income Taxes, 2006
Number
(millions)
Flow-Through
Income/Loss
($ billions)
Tax on
Flow-Through
Income/Loss
($ billions)
Averate Tax
Rate
(percent)
Tax per
Taxpayer
($)
All flow-through income
All taxpayers 27.5 $938 $159 17.0% $5,782
Top 2 tax brackets 2.1 671 131 19.5 62,381
Top tax bracket 1 573 113 19.7 113,000
Active, positive flow-through income
All taxpayers 18.3 762 145 19.0 7,923
Top 2 tax brackets 1.4 433 109 25.2 77,857
Top tax bracket 0.7 349 92 26.4 131,429
Note: ‘‘Flow-through income/loss’’ includes net ordinary income from sole proprietorships, S corporations, and partnerships
plus net long-term and short-term gains from partnerships, S corporations, estates and trusts.
Source: Table 3.3 (page 13) of Treasury Conference on Business Taxation and Global Competitiveness, Background Paper, July
26, 2007, Doc 2007-17146, 2007 TNT 142-14. Treasury Department and author’s calculations.
NEWS AND ANALYSIS

And as the gap between the two tax rates dimin-
ishes, the incentive to shift income from one form to
another diminishes. This action benefits both tax-
payers and tax authorities, as it leads to reduced
compliance costs and to reduced administrative
costs.
But in another sense, U.K. policymakers have
shownnomorecouragethantheirAmericancounter-
parts. According to the Financial Times, private
equity firms are ‘‘happy’’ with the chancellor’s
decision to increase the capital gains rate. Increas-
ing the rate by a modest few percentage points
seems likely to stave off calls for even greater tax
increases or changes in the treatment of carried
interests.
Not all U.K. businesses share this view. The
Financial Times also reported that businesses are
angry at the changes to the capital gains tax rate.
These firms, which were not benefiting from the tax
rate differential between capital gains and ordinary
income, will now pay higher rates on their gains.
The new tax plans eliminate the taper relief that
Prime Minister Gordon Brown introduced 10 years
ago when he was chancellor of the exchequer. Taper
relief reduces the capital gains tax payable accord-
ing to how long the investor has held the asset and
was designed to offset the impact of inflation on the
value of assets as well as to provide a favorable tax
to investments held for the long term. With the
elimination of the favorable long-term rate, unless
investors sell off their positions before April 6, 2008,
they will be subject to a rate of tax levied on the
gains that is 8 percentage points higher than it was
the day before.
The British plan is far from certain to become law.
Shortly after Darling released his proposal, the
Financial Times reported that the leaders of four
major business groups — the British Chambers of
Commerce, CBI, Federation of Small Businesses,
and Institute of Directors — condemned the pro-
posal as putting the U.K.’s plans to create a pro-
entrepreneurship economy ‘‘into reverse gear.’’
No ‘Special Relationship’
The United States could follow the British move
and change the way carried interests are treated.
But neither the Treasury nor Congress seems likely
to initiate a change.
Treasury Assistant Secretary for Tax Policy Eric
Solomon admitted in his July testimony before the
Finance Committee that tax considerations prob-
ably motivated private equity and hedge funds to
organize as partnerships. Yet Treasury finds no
reason to change this treatment, at least for now. As
Solomon emphasized, the current rules provide
certainty to taxpayers and are administrable to the
tax authorities.
Congress also seems willing to wait. Since Levin
introduced H.R. 2834 on June 22, and continuing
through Finance Committee hearings on September
6, Congress has heard seemingly endless hours of
testimony and received reams of reports on how to
treat carried interests. No clear consensus has
emerged because there is no clear consensus.
How should the tax authorities react in the face
of this uncertainty? A responsible step might be for
private interests and the politicians to work to-
gether to draft a bill that would narrow or eliminate
the gap between the taxation of capital gains and
that of ordinary income. Whether this step involves
increasing one rate, decreasing another rate, or
splitting the difference remains to be determined.
Other attempts to modify the tax treatment of
private equity may be just as likely to introduce
more complexity and controversy into the system
than exists now.
This step would require modifying tax rules that
have existed for decades.
However, just because a law has existed long
enough to become a seemingly immutable law does
not mean it cannot be changed. As an example, on
November 5 the Supreme Court will hear a chal-
lenge to the nearly century-old practice in the states
of exempting income that residents earn from their
in-state municipal bonds while taxing residents on
the income they earn from out-of-state municipal
bonds. (See the state’s brief in Kentucky v. Davis at
Doc 2007-23085 or 2007 TNT 201-15.) This practice
clearly discourages residents from buying bonds
from states other than their own. Yet, since the turn
of the 20th century, the states have followed this
apparently discriminatory practice, justified by
‘‘market participant’’ reasons. Only one state treats
bonds identically.
Although legal arguments may allow the status
quo to continue, economic principles indicate that
the discriminatory state practice should be abol-
ished. A Supreme Court ruling in favor of the
economic principle might lead to an initial disrup-
tion of the municipal bond market as states figure
out what to do, but over time, the elimination of the
tax discrimination should lead to a more efficient
muni market.
A similar argument occurs in the treatment of
income earned in the alternative investment indus-
try. There is little reason why two firms — say the
Blackstone Group and Goldman Sachs — that per-
form the same investment functions should be
treated differently on the income they earn on those
functions.
Yet, the tax law allows exactly such a difference.
As The New York Times reported, Goldman Sachs
paid $1.1 billion in corporate income taxes on its
NEWS AND ANALYSIS

$3.4 billion second-quarter profits, while the Black-
stone Group paid just $14 million on its $1.1 billion
in first-quarter earnings. One investment firm pays
about a 32 percent tax rate, and the other pays a 1.3
percent tax rate for doing essentially the same
business.
Changing the tax treatment of carried interests
might create a bit of market volatility initially. But
the result would be a more efficient allocation of
resources brought about by the elimination of the
tax distortion.
Too Good to Be True
Although any legislative outcome is too uncer-
tain to predict, one thing that is certain about the
effect of any legislation is that modifying the tax
law that allows carried interests to be taxed at a
favorable rate will not mean the tax law is free of
loopholes. The code is stuffed full of tax preferences
that allow a clever tax manager to find a perfectly
legal way to reduce taxation almost to any level
desired.
The private equity industry has self-reported
some spectacular returns. Over a 25-year period the
return on the best private equity investments was
more than three times the return on the S&P 500
companies during the same period, perhaps even
more than three times.
These data are difficult to interpret, however. A
meaningful comparison of returns would compare
the best private equity returns with the comparable
share of the top S&P 500 firms to the S&P 500
average over that period. During the past 25 years,
the S&P 500 has frequently reported annual returns
above 20 percent, indicating that the best firms in
that group earned somewhat more than 20 percent.
Regardless of the overall average during that pe-
riod, it is certain that the return earned by the top
quartile of the S&P 500 firms exceeded the S&P 500
average.
Some researchers have examined the entire pool
of private equity partnerships and found that they
perform no better than the S&P 500. Using data
voluntarily reported by the private equity industry,
Kaplan and Schoar, for example, find that the
average private equity fund return net of fees from
1980 to 2001 roughly matched the S&P 500 average.
The substantial variation in the returns among
firms, however, suggests that some spectacular
losses exist among the spectacular gains.
Given the relatively small amount of capital
managed by private equity firms until the past few
years, it is also possible that these funds earned
exceptional returns in the early years because of
their ability to invest in the most lucrative ventures.
In 1980 private equity funds managed less than $5
billion in capital.
The story is very different now, with total capital
under private equity management above $1 trillion.
As the pool of capital under private equity manage-
ment expands, the law of diminishing returns kicks
in so that the average return on $1 trillion will be
much lower than the average return on $100 billion
in capital.
Of course, a higher return comes only by taking
on a higher amount of risk. Private equity fund
managers attempt to achieve what is known as
‘‘portable alpha’’ by choosing investments that will
do better than the market; thus, a manager strives
for a positive alpha to show that the manager’s
investment skills are better than those available for
a given systematic risk. An alpha of 3, for example,
would indicate that the manager earned a return
that exceeded the market benchmark by 3 percent.
Investors look to beta to determine the systematic
risk of a stock or overall portfolio; investors with a
high tolerance for risk would choose a high beta, all
else equal, while risk-averse investors would seek a
low beta. Utility funds tend to have a beta value less
than 1, for example. A fund with a beta of 1 would
expect to earn the market return.
Introductory finance courses show that funds
earn a greater expected return only by taking on
greater risk. (Ex post, the return on any particular
investment could be higher than another for a given
amount of risk, but ex ante, this is not possible.)
A study from 2004 by Susan Woodward showed
that the returns earned by venture capital and
buyout funds are not above average for a given
amount of risk. Reports of ‘‘super’’ returns are
tainted by the fact that there are little pricing data
available on private equity funds. In such circum-
stances, Woodward shows, the fund’s beta will be
underestimated, thus leading to an overestimate of
the fund’s alpha, that is, its managerial contribu-
tion. In other words, the underlying risk will be
incorrectly seen as too low, while the contribution of
the fund manager as represented by alpha will be
incorrectly viewed as too high. Correcting for these
biases shows, for example, that in the case of
venture capital, the estimated beta rises from 0.6 to
2, while the estimated alpha falls from 1.8 to essen-
tially zero.
What You See May Not Be What You Get
A fundamental difficulty in examining the per-
formance of the private equity industry is that the
firms are not required to make their results public.
Thus, to the extent that firms report performance
results, it is conceivable that the reported results
will be tilted toward the better results.
The lack of transparency in the alternative invest-
ment community does not bode well for financial
NEWS AND ANALYSIS

markets. An increasing share of financial transac-
tions occurs away from public scrutiny as the prices
of more and more securities are established outside
the marketplace.
In a front-page story on October 12, The Wall
Streee Journal recalled that the Long-Term Capital
Management hedge fund collapsed after ‘‘bad bets
on opaque bond markets.’’ Some $25.2 trillion of
bonds now do not trade on markets with readily
available prices. As one former trader noted, many
prices are obtained by asking traders what they
would like to receive for the position, a process she
said was ‘‘akin to a homeowner valuing a house
based on how much he wants for it, not how much
a buyer is willing to pay.’’
It is The Wall Street Journal, that has once again
raised the issue of Enron. In discussing the risks to
the markets created by the off-balance-sheet struc-
tured investment vehicles, the Journal noted that
because ‘‘off-balance-sheet liabilities played a major
role in the 2001 collapse of Enron Corp., the makers
of accounting rules have generally sought to get
affiliated entities back on the balance sheets of the
companies creating them.’’
The Smartest Guy in the Room
Changing the tax treatment of private equity
won’t kill the industry. Simple math shows that
even if the income of top fund managers was taxed
at twice the current rate, their returns would still be
positive.
Likewise, requiring firms to provide information
about their investment structure and their rates of
return would not hurt the industry.
One expects that the private equity industry
thrives because of its expertise in making superior
investments, not because it receives favorable tax
treatment or because it reports the good news and
hides the bad news. A fundamental principle that
all business managers learn is that if a project makes
sense only because of its tax treatment, then it is not
a worthwhile project. If the private equity industry
needs this tax break and nontransparency to sur-
vive, perhaps it is time to question whether the tax
code should be extending a lifeline to the industry.
Otherwise, it may turn out that the sequel to
Saving Private Equity is not The Smartest Guy in the
Room, Part 2.
Where to Find More Information
Thousands of pages have been written on this
issue. A selection appears below.
For a flavor of the debate, see Donald J. Marples,
CRS Report RS22717, ‘‘Taxation of Private Equity
and Hedge Fund Partnerships: Characterization of
Carried Interest,’’ Doc 2007-20687, 2007 TNT 176-32.
For details on the tax treatment of partnership
carried interests and related issues, see the docu-
ments prepared by the JCT, ‘‘Present Law and
Analysis Relating to Tax Treatment of Partnership
Carried Interests and Related Issues, Part I,’’ (JCX-
62-07), Doc 2007-20255, 2007 TNT 172-12, and Part II
(JCX-63-07), Doc 2007-20256, 2007 TNT 172-13.
For additional discussion of the tax issues, see
Mark Jickling and Donald J. Marples, CRS Report
RS22689, ‘‘Taxation of Hedge Fund and Private
Equity Managers,’’ Doc 2007-15994, 2007 TNT 131-
40.
For further explanation, see the testimony of
Treasury Assistant Secretary for Tax Policy Eric
Solomon before the Finance Committee on the
taxation of carried interests (July 11, 2007), Doc
2007-16265, 2007 TNT 134-42.
For a discussion of tax arbitrage, see ‘‘Tax Re-
form, Tax Arbitrage, and the Taxation of Carried
Interest’’ testimony of C. Eugene Steuerle, senior
fellow at the Urban Institute, before the Ways and
Means Committee (Sept. 6, 2007), Doc 2007-20478,
2007 TNT 174-54.
For an analysis of the compensation structure,
see Victor Fleischer, ‘‘Two and Twenty: Taxing Part-
nership Profits in Private Equity Funds,’’ Legal
Studies Research Paper Series, Working Paper 06-
27, revised Aug. 2, 2007.
For a view from the private equity industry, see
the statement of Bruce Rosenblum, managing direc-
tor of the Carlyle Group, and chair of the Private
Equity Council, before the Ways and Means Com-
mittee (Sept. 6, 2007), Doc 2007-20473, 2007 TNT
174-49.
For a discussion of beta and alpha, see René M.
Stulz, ‘‘Hedge Funds: Past, Present, and Future,’’
Journal of Economic Perspectives, Vol. 21, No. 2,
Spring 2007, pp. 175-194.
For an analysis of how to evaluate private equity,
see Susan E. Woodward, ‘‘Measuring Risk and
Performance for Private Equity,’’ Sand Hill Econo-
metrics, Aug. 11, 2004.
For an evaluation of private equity performance,
see Steve Kaplan and Antoinette Schoar, ‘‘Private
Equity Performance: Returns, Persistence and Capi-
tal Flows,’’ Journal of Finance 55, Aug. 2005.
For a criticism of the tax issues that arise under
H.R. 2834, see Lee A. Sheppard, ‘‘The Unbearable
Lightness of the Carried Interest Bill,’’ Tax Notes,
July 2, 2007, p. 15.
Data on income and earnings come from U.S.
Census Bureau, Income, Poverty and Health Insurance
Coverage in the United States: 2006 (Aug. 2007),
available at http://www.census.gov/prod/2007pub
s/p60-233.pdf.
NEWS AND ANALYSIS

TN Oct 22 Saving Private Equity

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Viewers also liked

Viewers also liked (12)

Similar to TN Oct 22 Saving Private Equity

Similar to TN Oct 22 Saving Private Equity (16)

TN Oct 22 Saving Private Equity