The Carried Interest Dilemma

A couple colleagues and I were discussing the "carried interest" issue today. In a nutshell, a private equity firm, and other investment vehicles as well, such as venture capital firms, are organized as a partnership, with limited partners (LPs) providing the cash to invest and the general partner (GP) providing the management (and maybe a little bit of cash). The GP is often compensated in two parts, as memorialized in the phrase "2 plus 20": the GP gets 2% of the assets as a management fee, but they also get 20% of any gains when the investment is closed out.

The controversy is over Federal taxation. Now, the 2% is taxed as ordinary income (high rates!) and the 20% is taxed at capital gains rates (lower). Many folks feel that is unfair, letting these rapacious private equity fellows pay such low taxes on huge capital gains.

Before going too far into this, the right question of course is: what will be the different economic outcomes of different tax policies, and what do we think of those outcomes? Fairness is not foremost in my mind -- incentives, behavior, and outcomes loom larger.

It is not hard to think of analogies where similar compensation is paid. The taxation of those situations is instructive. For analogies, how about employees' grants of stock or stock options? Suppose I give stock to an employee, to create incentives for her to increase value. At the time of the stock grant, my understanding is that the value of the shares at that time is income, taxed at ordinary rates. Any capital gain in the stock would be taxed at capital gains rates, assuming the holding period was long enough. If I give the employee options, there is generally no tax due with the option grant, but when exercised, the difference between strike price and market value is ordinary income, unless the stock obtained through exercise is held for a certain period of time.

Another interesting case to consider would be if I lent money to an employee with the requirement that they use it to buy stock. My guess is that what would be taxable at ordinary rates here would be any difference in the interest rate charged the employee versus market rates. If there was a capital gain on the stock, then those would be taxed at capital gains rates.

This latter situation is close to what is happening with private equity. The GPs are being given an interest free loan to buy 20% of the portfolio. They should certainly pay taxes on that interest free loan.

A paper that comes to this conclusion is: Cunningham and Engler, The Carried Interest Controversy: Let's Not Get Carried Away, 61 Tax L. Rev. 121 (2007-2008).

But there is more than just the interest free loan, as the GPS essentially get to buy the shares at a zero price as well.

The more appropriate analogy seems to be the options one. The GPs are being given a call option on 20% of the portfolio, with a strike price of zero. Following the employee stock option tax policy, the grant of the option is not a taxable event. But when the option is exercised, it would be taxed at ordinary income rates, unless the GP somehow maintained their investment position for a period of time after that.

The idea of not taxing the granting of the option but taxing the gain at ordinary rates seems a nice balancing of our desire to stimulate incentives for creating long term value against the creation of excess incentives to enter one specific industry or profession. The tax advantage is essentially one of deferment of taxes -- no tax liability upon grant of the option, but upon exercise.

I think this solution balances nicely the incentives we want to preserve for investments that create value against giving excess incentives for supplying talent to certain industries.