New Carried Interest Study Struggles To Explain Itself

The Senate today takes up the carried interest taxation issue, which means it’s time for another industry study about how increasing taxes on PE partnerships will cost the nation fortune and jobs (last part emphasized, since the relevant legislative language is part of a jobs bill).

This one comes from the Private Equity Council, which argues that each “one percentage point increase in the effective tax rate on private equity investment is associated with a $1.8 billion decline in annual private equity investment.”

The study (download here) claims to have “detrended” macro-economic changes, in order to make tax rate changes the most significant variable. It also emphasizes that those $1.8 billion decreases are relative to expected private equity ebbs and flows (i.e., it does not necessarily mean that a 1% change today results in a $1.8b decrease from current levels — but rather a $1.8b decrease from what the level otherwise would be).

Before continuing, let me remind you that I am neither an economist nor a statistician (the study’s author is a pending PhD). But it seems to me that what PEC has proven is a correlational relationship rather than a causal one. Such things often intermingle, but not always (seems one regression analysis confirms his hypothesis, while another does not).

The author makes the following claim to support the existence of a causal relationship:

Higher taxes reduce the after- tax return associated with private equity investment; this makes marginal investments (i.e. often those posing the highest risk) less attractive because the private equity firm retains far less of the “upside”  after taxes, but still must absorb all of the downside in terms of capital contributed and the considerable costs associated with the investment process and subsequent monitoring and oversight.

Let me reply with an eloquent: “Huh?????????”

Private equity firms “must absorb all the downside in terms of capital committed?” Really? Tell that to the limited partners who, you know, actually commit the capital.

The second part is that PE firms will source fewer deals because they gave less take-home profit potential. I guess this is the Schwarzman Shrugged principle.

Oh, and it doesn’t make much sense. If you want to argue that PE firms will decide that the business is no longer lucrative enough to maintain, then we can have that debate. But the author notes that aggregate PE investment could continue to rise in spite of tax increases (just not as much as it would have at IRS status quo) — but that firms will simply source fewer deals.

If it because fund sizes would be smaller? Unlikely, since larger funds would mean larger fees (which become even more important with less take-home carry). Is it because firms will become more risk-averse? Unlikely, since a good way to mitigate risk is to increase due diligence/sourcing activities.

As regular readers know, I’m biased in this debate. I believe carried interest should be taxed as ordinary income (all of it, not just a percentage as is being proposed), but I acknowledge that there are valid arguments on the other side. Until and unless I’m persuaded otherwise, this isn’t one of them.