I missed yesterday's broadcast of the UK parliamentary committee
excoriating questioning senior private equity executives from KKR, Permira, 3i and Carlyle, but I did get a few second-hand reports today. For the detail, you can still watch it on the Parliament site here, PEHub provides a summary here, and the Financial Times gave it front page treatment today. For more hysterical coverage, turn to the Daily Mail here...
I'll come to my views on the controversy in a moment, but first: what is with this process?? Neither the parliamentarians nor the private equity bigwigs were properly briefed for this debate, leading to a tetchy stalemate that made both sides look bad. The MPs have a legitimate cause to investigate the industry, but surely owe it to their constituents (and their target) to be moderately informed about it.
But it was clear from their questions that most did not understand the basic structure of private equity funds or how they earn fees and share in the success of their investments. And it is surely sad that their questions became personal and appeared to be driven more by envy of the super-rich executives in their sights than by a desire to protect the public good:
Addressing KKR's [Domnic] Murphy, Labour lawmaker Angela Eagle suggested he paid less tax on his earnings than a maid would. "Don't you agree it's embarrassing?" she asked. "You're proud you're paying less tax than your cleaner!"
Is it too much to ask that senior politicians of the world's financial centre bone up on the private equity industry before an investigation like this? Moreover, the accusatory tone of this debate seems inappropriate, as the industry is simply applying the tax rules of the Treasury as they were intended?
As an industry, private equity has bad knack for perpetuating its opaqueness and making people envious and suspicious. The coverage of Blackstone's IPO and its lucrative outcome for the top executives there doesn't help. In yesterday's public hearing, the executives were prepared for an intellectual debate with informed questioners. But they did not have the right responses to a populist harangue, and they squandered the opportunity to elucidate the industry's structure and economic impact and to gain some public understanding, if not sympathy. (OK, maybe sympathy is a step too far.) Instead they came across as defensive and somewhat arrogant.
So what about the issue then?
I think it is inevitable that both the US (see NYT coverage here) and UK governments will review once again whether to treat the profits generated by private equity partnerships ('carried interest') as capital gains or income for tax purposes. The difference between the two is significant (40% vs 10% in the UK, about 35% vs 15% in the US).
To my mind, carried interest is clearly not income. There is no guarantee it will materialise. Getting any carried interest requires taking a risk, working an investment for years and often waiting a long, long time for the investment to bear fruit. The carried interest structure drives the long-term perspective (and commitment) of investment managers, and makes possible long-term investments in a given economy. The capital gains tax regime was specifically designed to promote long-term investments and as such it should apply also to private equity.
However, it is also true that carried interest is not like investing in equities. There is only upside for investment managers and no downside risk, eg no money to lose. As such it is less risky than buying shares and probably ought not to be given the same tax treatment. But investment managers are exposed to their funds in two ways: through direct investments (the 'GP commitment', typically 1% of fund size) and the carried interest. Profits on the GP commitment should be treated as capital gains, which is precisely what they are. The carried interest should be treated as variable income which may or may not materialise. In that sense it is like a bonus, but with a much longer gestation cycle and more years of 'sweat equity' behnid it. To be fair, it should be taxed at a lower rate than regular income but at a higher rate than pure capital gains.