Clouds on horizon for private investment funds
The May 28 passage of H.R. 4213, the “American Jobs and Closing Tax Loopholes Act of 2010” by the U.S. House — with Senate approval of a substantially similar bill anticipated — completes a perfect storm for private investment fund managers. Among the most controversial provisions of the act is the long-debated taxation of the “carried interest” earned by fund managers as part of their compensation (one of the “tax loopholes” suggested by the act’s title). The carried interest represents the portion of cash distributions paid to the fund manager, for his or her efforts on behalf of the fund, which is disproportionate to, or in excess of, the manager’s capital contribution.In the traditional hedge fund model, the carried interest takes the form of a 20 percent reallocation of fund income to the manager. Venture, private equity, real estate, and other private funds are often more creative with the carry, structuring distribution “waterfalls” with the carried-interest payments beginning and increasing based on certain triggers, such as internal rate of return or another measure of return for passive investors.
Under the existing tax regime, the carried interest portion of a fund manager’s compensations is generally taxed at the long-term capital gain rate of 15 percent. The act, however, would distinguish a carried interest that is deemed to be a return on invested capital (the fund manager has made a cash contribution to the fund) and all other carried interest compensation.
The former will continue to be taxed at capital gains rates. With respect to the latter, the act would require fund managers to treat 75 percent of the carried interest as ordinary income (50 percent for tax years beginning before Jan. 1, 2013). Fund managers will be subjected to a 35 percent ordinary income tax (presumably increasing to 39.6 percent in 2011) on the vast majority of their compensation — more than doubling the current tax burden.
Fund managers and lobbyists for the private investment fund industry have adamantly argued that the carried interest provisions of the act close no loopholes, but instead single out fund managers for a targeted repeal of well-settled partnership taxation rules.
Although questions have been and will continue to be raised about the roles of certain styles of hedge funds, the combination of needed capital and industry expertise that venture, private equity and real estate funds bring to their respective investments is rarely in dispute. Economic disincentives for talented fund managers could hardly come at a worse time.
One of the trickle-down effects of the financial crisis has been the shifting of the balance of power between fund managers and investors. The Institutional Limited Partners Association has released a “best practices” publication capturing many of the investor-friendly terms that are being negotiated into private investment funds.
Downward pressure is being exerted on management fees (into the 1.5 percent range for managers accustomed to operating funds based on the “2 and 20” model), while ILPA’s best practices call for management fees to be fully disclosed and based on actual budgeted operational expenses.
Even more disconcerting for fund managers, however, are the potential implications this shift of negotiating power represents for the carried interest. Fund managers are encountering investors with the desire and leverage to negotiate both the gross percentage of distributions payable and the required pro rata return to investors before a carried interest is triggered under the fund’s waterfall, including the requirement that investors receive a complete return of their capital contributions prior to the payment of any carried interest.
For funds in which returns are measured on a per-investment basis (a “deal-by-deal” fund), investors are seeking highly nuanced clawback provisions requiring the fund manager to repay carried interest distributions if losses arise from subsequent investments.
The ILPA best practices suggest, among other things, a 30 percent carried-interest escrow and joint and several liability for the fund’s management team for this purpose.
Private investment fund managers are slowly awakening to a new reality — management fees are lower and the carried interest is both more difficult to earn and hold on to. Few observers argue that enhanced investor bargaining power is not a positive development for the private investment fund industry. However, doubling the federal income tax on the carried interest in the current environment appears to carry with it an implicit assumption that either a significant number of fund managers will not seek other means of earning a living or that the economy at large will not be significantly impacted if they do so. Both are dangerous assumptions for the long-term prospects for the U.S. economic recovery.
Joel T. Shaw is a shareholder in Bernstein Shur’s Securities and Financial Services Industry Group. Steven R. Gerlach is an associate in the firm’s Tax, Trusts and Estates Practice Group.