A Bad Idea for America

In their inevitable search for more tax revenue, some in Congress have latched onto an idea that would irreparably damage the most effective growth engine of the American economy: Private equity funds.

Convinced that they can have their cake and eat it too, they want to change tax treatment of long-term “carried interest” rights held by fund general partners from capital gains to ordinary income. They believe government can take more capital profits and still benefit from the same number of funds producing similar gains in the future. Nothing could be further from the truth.

It’s not a new idea, just the latest iteration of one floated periodically by those hoping to find “easy” money for government spending. Jimmy Carter proposed ordinary income treatment of capital gains in 1978. Congress concluded Carter was wrong—deciding that more preferential treatment was called for, not less. The 1969 capital gains tax increase had hurt high-tech companies and experts argued that Carter’s proposal would so inhibit risk investment that government revenue from capital gains taxes would fall, not rise. Congress cut the capital gains tax rate in 1978 by 43% and then reduced it again in 1981. That lower rate was a foundation block of 1980s economic growth.

Fast forward 30 years to the latest iteration of the bad idea, apparently driven by the fact that a few in private equity have made very large gains from a few—not all—of their partnerships. Why the success of a few should lead to a change for all is unclear. No one suggests changing tax treatment for stock sales because some have amassed fortunes far beyond reasonable comprehension. Nor are we about to tax gain from personal residences as ordinary income—or gain from the sale of family businesses. These are not at issue; it can only be that the proposers do not appreciate the long-term risk involved in managing private equity funds or that increasing capital gains taxes will discourage formation and mobility of capital—reducing the standard of living of all Americans.

The American private equity sector did not exist in its present form prior to the 1950s. Then, in response to a Federal Reserve Board finding that the biggest impediment to growth in America was the lack of “patient” capital, Congress created the Small Business Investment Company program in 1958. SBICs became the first institutionally supported private equity funds in America and have invested $50 billion in more than 100,000 small U.S. companies—with $2.9 billion invested in 2,121 small companies in FY 2006 alone. Many well-known U.S. companies received early financing from SBICs: including Intel; Apple Computer; Callaway Golf; Whole Foods Market; Palm Computing; Staples; Quiznos; Federal Express; Outback Steakhouse; Costco; Mothers Work; and Build-A-Bear Workshop; to name but a few.

As successful as the SBIC program has been—and continues to be—its biggest success was as the seedbed for today’s large, non-SBIC venture oriented private equity firms such as Kleiner Perkins Caufield & Byers, Battery Ventures, New Enterprise Associates, Novak Biddle Venture Partners, and the like. These firms provide billions in high-risk growth capital for America’s entrepreneurs. Total venture investments equaled $26 billion in 2006. Without such annual investments the U.S. economy would never have achieved what it has in the past fifty years. According to the National Venture Capital Association, U.S. companies that received venture capital from 1970 to 2005 accounted for 10 million jobs and $2.1 trillion in revenue in 2005 alone. Between 2003 and 2005 they had collective a compound annual growth rate of 4.1% in job creation—outperforming non-venture-backed companies by 215%. With today’s intense global competition, America cannot afford to lose its private equity edge.

Two things are required to drive the U.S. private equity industry: (a) individual and institutional risk capital; and (b) investment professionals who can identify diamonds in the rough and nurture those companies through perilous growth and reorganization stages. It’s not a business for the faint of heart. Not all investments make money and not all private equity funds are successful. A study by Thompson Venture Economics of venture capital returns for the period 1983-2002 found that 25% of funds lost money, 25% of funds broke even, and 25% had returns equal only to about what would have been available through investing in the S&P 500 index. Only 25% had returns substantially above the public market indexes.

With those odds, why choose a private equity fund management career? The monetary incentive is clear: if one reaches the top quartile—after years of making and tending investments—the returns are substantial and taxed as capital gains. Talented professionals, most with MBAs or other highly valued credentials, work 10 years or more for ordinary income fees often less than market value for those with their credentials—all with the hope that the long-term investments they make will put them among the 25% of private equity professionals who enjoy substantial gains. Their profit, their carried interest, is not guaranteed—it is only a long-term, high-risk, 25% potential.

The proposal to tax carried interest as ordinary income would change the risk / reward equation and accruing unintended consequences would irreparably damage America’s small business growth engine. Changing the tax treatment would make the uncertain potential value of carried interest less attractive by a minimum of 24%—the difference in after tax gain between amounts taxed at 15% (capital gains) versus 35% (ordinary income). But the real percentage disincentive would be greater. If only 25% of managers have potential for substantial gain, taxing any gain as ordinary income would remove all incentive for entering the business. Far better from a risk / reward standpoint to work 10 years for a salary commensurate with one’s market worth than for 10 years at a reduced salary coupled with only a small potential for a far less valuable gain.

The damage to small business finance in America would flow from the following. First, fund managers would likely attempt to offset the tax increase by charging businesses they finance more for investment capital—leaving less capital for innovation and job creation. Second, the fund managers would attempt to offset the tax increase by seeking greater fees or carried interest from investors in their funds. With only a 25% chance of investing in a fund that will yield substantial returns, investors likely would reject the attempt or find less risky investment vehicles. Third, if unsuccessful in the first two attempts to offset the tax increase, many fund managers would simply leave the private equity field.

These natural reactions would result in less growth capital at greater cost being available to American entrepreneurs—inhibiting the creation of new technologies, the creation of new jobs, and the growth of young companies that drive innovation, competition and efficiency in our capitalistic system.

The American small business / private equity combination that is our competitive edge in global competition would be broken. If successful, proponents of taxing carried interest as ordinary income may garner a few dollars for government in the short run, but will irreparably damage the engine of our economic success for future generations. That is a bad idea for America.

Lee Mercer is president of the National Association of Small Business Investment Companies (NASBIC)