Hike in carried interest tax not causing GPs to worry

(updated with correction)

Alternative investment industry groups might be fighting a tax increase on carried interest, but secretly most general partners acknowledge that changing its treatment to match that of ordinary income won't have a huge impact on their businesses.

Some managers believe they or their tax attorneys will figure a way around it, others might be in denial and still others believe they will be able to shift the added expense of higher taxes to their limited partners, insiders say.

The president's fiscal 2012 budget estimated a change in the tax treatment of carried interest would raise $13 billion in revenue over 10 years. A House bill aiming to do just that, the Carried Interest Fairness Act of 2012, was introduced in February by Rep. Sander Levin, D-Mich. and Rep Charles B. Rangel, D-N.Y. It was referred to the House Committee on Ways and Means and did not advance further, but work is ongoing behind the scenes.

Unless income tax rates are changed, treating carried interest as ordinary income would mean executives at alternative investment managers would be charged at the ordinary income rate of 35% rather than 15% rate on capital gains. While profits took a hit as a result of the 2008 economic meltdown, millions of dollars goes into the carry pool that alternative investment firm executives share. At KKR & Co. LP for example, $473.7 million was allocated to the carry pool in the nine months ended Sept. 30, up from $67.9 million allocated in the nine months ended Sept. 30, 2011, according to KKR's third-quarter earnings report.

“Everything seems to be on the table with tax legislation and the prevailing sentiment is ... that there is a higher likelihood of it passing now than a year ago,” said Gary Robertson, senior vice president at San Francisco-based consulting firm Callan Associates Inc. “It will not impinge on the activity in the marketplace.”

“It doesn't feel as if it (the tax increase) will impact the industry in a major way one way or another,” said Brad Morrow, senior private markets consultant in the New York office of consulting firm Towers Watson & Co.

“I believe the general partners will probably find a way to come up with a clause in the contract to solve for it (the tax increase). Most managers don't seem to be disturbed.”

After years of stops and starts, the time appears to be ripe for alternative investment firm managers to pay the ordinary income tax rate on carried interest — which is their share of the profits — rather than the lower capital gains tax rate, industry insiders and their lawyers say. The newest version of what has become very complex legislation appears to be a bundle of good news and bad news for alternative investment managers.

What is the good news? Managers would be allowed capital gains treatment if they sold their general partnership interest in a fund.

But, unlike earlier versions, the newest language in Congress would include all alternative investment managers. In addition to the treatment of manager profits as income, the pending proposal would prevent managers from taking a tax loss for a portfolio company gone bad.

Executives at New York-based alternatives firm Blackstone Group are taking a wait-and-see approach. “We think that should changes in the treatment of carried interest occur, they will most likely be in the context of major tax reform,” said Peter Rose, Blackstone spokesman, in an e-mail. “We would need to weigh those changes against our evaluation of the package as a whole.”

Still, most managers interviewed believe a carried interest tax hike is coming.

“I felt carried interest was in the cross hairs no matter who would win the election, not just the presidency but Congress too,” said Juan Alva, partner in Los Angeles at specialty finance and business development company Fifth Street Finance Corp., which provides financing for private equity. “It's easy to throw private equity under the bus. Private equity's tax rates are probably going up.”

So for the past year or so, tax attorneys have been trying to figure out ways to get around the tax increase, said Nancy Lashine, managing partner at Park Madison Partners LLC, New York.

The debate over how to tax alternative investment managers appears to have turned into a game of keep-away. Micah Bloomfield, partner in the New York office of Stroock & Stroock & Lavan LLP, said every time legislators hear about a fix some tax attorneys are considering, they seek to forbid it in the current bill, Mr. Bloomfield said.

For example, not long ago an idea was floated that general partners could avoid the higher tax by creating a loan structure in which a certain percentage of the carried interest would be in the form of a loan from limited partners to general partners. “That is dead. Congress killed it in the legislation,” he said.

That doesn't keep lawyers from continuing to try. Another idea was to set up foreign entities to be the manager and, if the alternative investment firm sold the entity, the income might float through as capital gains, Mr. Bloomfield said. Although the legislators added a ban of that practice when they heard about it, Mr. Bloomfield still thinks there might be a way to get around it.

Whether tax lawyers are able to find a fix, some managers just don't think a tax change will affect the way they make investments, said Marc McMorris, co-founder and managing director of San Francisco-based private equity firm Carrick Capital Partners.

“It would have a tax impact for people in the carried pool at Carrick,” said Mr. McMorris. Carrick closed its first fund with $180 million, which it began raising in January.

“It is not motivating strategy or dismotivating the team we hired. It's not guiding our decisions,” he said.