The Carried Interest Debate Ends

Remember that big debate over how the IRS should treat carried interest, in which certain agitators (hello mirror) argued that such profits more closely resemble ordinary income than capital gains? Well, it effectively ended last night at 11pm ET, when Barack Obama corralled his 270th electoral vote.

Momentum for such a change stalled late last year, due largely to vocal opposition from President Bush and GOP Congressman Tom Reynolds. It also didn’t hurt that private equity was wiped off the front pages by credit concerns, but this was more about political power than political posturing.

Now, however, the playing field has been dramatically altered. Bush will be replaced by Obama, who signaled 18 months ago that he supports a change to carried interest tax treatment. The retiring Reynolds will be succeeded by another Republican (Chris Lee), but not by one with nearly the same seniority or influence. Plus, the Democrats will have much stronger majorities in both houses of Congress.

All of this adds up to carried interest being treated as ordinary income, perhaps by as early as 2009.

I’ve already heard some PE pros downplay the possibility, believing that this is an issue that has been forgotten behind the back burner. Moreover, they argue that the cap gains rate is going to rise regardless, so the marginal increase of shifting carried interest will do little to raise federal revenues (particularly given how little carried interest will actually be generated next year).

All good arguments, but not good enough. The public optics of this move still works for Democrats, and I’m not expecting much self-restraint from Charlie Rangel, Barney Frank, Sandy Levin, et all. Alan Patricof acknowledged as much during our keynote interview in Quebec City last Tuesday, when he said investors were fooling themselves if they didn’t expect the carried interest issue to be resurrected.

What may be particularly interesting to watch will be how the matter could further cleave the venture capital and buyout industries. Both industries structure their funds the same way, and would theoretically be affected equally by a change to ordinary income. But last year we saw the National Venture Capital Association try to argue that its members should be excluded from any rules change, because venture capital is a force for good while buyouts are a force for evil. Well, they weren’t quite so explicit, but that was the undercurrent. In fact, one NVCA member said that the group had intentionally not joined lobbying forces with the Private Equity Council, in order to maintain its pristine independence.

VCs have reason to think Obama might be sympathetic to them, as his economic plan includes a capital gains exclusion for investments in “small businesses.” This could lead to all sorts of wrangling over just what will constitute a “small business” going forward, and could even prompt some multi-stage VC firms to refocus on early-stage investments.

But that’s all speculation. All we know for sure is that carried interest and capital gains are soon to part. And pardon me for saying so, but it’s about time.