Caveat Lector - Calling BS On an unsuspecting columnist

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I got one of those emails I love getting from my Father, today. He'd read an article, and wanted my opinion. For those who don't know, I work as a Private Equity accountant. I spend hours every week working with this type of thing.

Sorry, Mr. President, Raising Taxes on Carried Interest Won't Work

The Obama administration is once again proposing to raise the tax on the carried interest managers of hedge funds, private equity fund, and venture capital funds receive. Even if it were to pass Congress, however, the tax would likely raise far less than the Obama administration expects.

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Byron - Thought you might find this interesting reading. Let me know your take on this. Would be curious to hear your thoughts! Saw this on the CNBC site & made me think of you!

To which I replied:

Carney, the author, gets the overall idea of Carry correct, but he doesn't delve into the mechanics of how carry is paid out, and he uses an absurd example (100% rate of return) under the guise of simplicity to gloss over the differences in the two structures.

Carry income is incentive income. It is structured in such a way as to align the interests of the GP (Private Equity Managers) and LPs (Investors).

He throws the slightly-critical reader a bone with his caveat about interest rates at the end, but as in all things finance, the incentives are in the details and in the range of likely outcomes.

The most important detail that isn't covered by his loan structure is that GPs get 20% of the entire gain after they surpass the hurdle rate. So on a $100 mm fund with an 8% hurdle rate, the first $8 mm of gain is split pro-rata, but then the next $2 mm goes entirely to the GP. This is called GP carry catchup, and so at $110 mm the GP has 20% of the entire gain. Under a loan structure, and with current tax rates and assuming carry is taxed at ordinary rates, the GP needs to earn about 39% annual return before they are worse off on an after-tax basis using carry rather than a loan. Nobody earns 39%. (See attached spreadsheet.)

Finally, his column fails the logic test: If it's so simple and everyone would agree to it, why aren't funds structured his way now? Well, the easy answer is the GP under almost any reasonable scenario would still prefer the carry model as they are better off under virtually every realistic return scenario using carry, plus the LPs (investors) would perceive the loan situation as riskier than the current model. Some other considerations that would be big issues in a real market:
- LPs would also have to carry part of these equity investments as debt, and this would throw off their portfolio allocation calculations.
- GPs would have massive tax liability issues if the Funds were to lose money. When non-recourse debt is not repaid, it all flows through as ordinary income to the defaulter. GP's don't want to take the risk of paying approximately 8% (40% ordinary rates on 20% of the fund as a "loan") of their invested capital to the IRS should their fund fail.
And here's the spreadsheet I attached. Carry Model vs Loan Model.xlsx