Tuesday, February 28th, 2012
After Mitt Romney reluctantly exposed himself and his 13.9% tax rate by releasing his returns for the past two years he reignited the debate over what is called the carried interest exemption. For a couple of days it was even front page news, until it was very nicely bumped off page one by the surprising and more compelling story about Jeremy Lin, the Harvard educated, undrafted Asian-American point guard now leading the re-surging Knicks to victory in five straight games. Although it cannot compete with one of great sports stories of the decade, the carried interest exemption also deserves our attention for several reasons, one of them being who supports it and who wants to see it end.
First, some background. The rationale behind the carried interest exemption is that people who put capital at risk should be encouraged to do so within the context of a progressive tax code. So Mitt Romney’s firm Bain Capital, other private equity firms, along with venture capitalists and other investors take early stage risky stakes in the future Google’s and Facebook’s. Or in the case of private equity firms, they often reconstitute the management and capital structures of older companies that are not realizing their value and need to go through a process of creative destruction in order to do so. The vehicle of such investments are typically investment limited partnerships, limited liability companies (LLC) or convertible preferred stock, so the term carried interest refers to the structure of the investment, and not to interest in the usual sense of a bond coupon or savings rate. The exemption has been a fairly hot potato in the US Congress since it does initially benefit wealthy and well placed investors, or those who were decried as “the malefactors of great wealth” by President Teddy Roosevelt at the beginning of the prior century and “the fat cats on Wall Street,” by the current occupant of the White House. The argument advanced by these initial beneficiaries is that the successful investments of Bain Capital, such as Staples have created thousands of jobs, foster long term benefits for the US economy through business formations and without the favorable tax advantage investors would be less inclined to put their capital at risk.
Yet there are some surprising voices raised in favor of eliminating the benefit. A very loud one is that of Rupert Murdoch, the controversial CEO of News Corp which owns Fox News and the Wall Street Journal. While both Fox News and the editorial page of the Journal strongly support continuing the exemption, Rupert himself rails, or more specifically “tweets” against it, calling the exemption “a racket that makes fund managers rich.” And in an even more populist vein, the publisher of the Wall Street Journal might be mistaken for Dennis Kucinich, Senator Bernie Sanders or perhaps candidate Ron Paul when he said (tweeted) that “both parties need to stop selling out to Wall Street.” Other fat cats who share Rupert’s view on ending the carried interest exemption are New York Mayor Michael Bloomberg and less surprisingly Warren Buffett, whose secretary, who we all now know pays taxes at a higher rate than the Oracle of Omaha, sat in the Presidential box during the most recent State of the Union speech as the Commander in Chief made his pitch for the 30% millionaire tax.
Rupert Murdoch’s acerbic comment that the carried interest exemption is “a racket that makes fund managers’ rich” also helps to explain why it is still on the books, and it might be more accurate for Rupert and others to tell Congress to stop selling out to Greenwich, CT and Route 128. Since 2007 a bill to eliminate the exemption has passed the House four times but does not make it through the Senate. The Republican Senators who are against it get some needed help from the Democratic Senators who represent the states with the highest concentration of hedge fund and private equity managers—New York, Massachusetts and Connecticut—namely Chuck Schumer, John Kerry and before his retirement, Christopher Dodd. As if often said in the investment business: Follow the Money. Another Democrat against the bill has been Warren Buffett’s home state Senator and friend, Ben Nelson, who seems to want Warren’s tax rate to stay lower even if Mr. Buffett does not. Now that some heat has been generated by the Romney returns, it will be interesting to see how the future votes on the exemption play out. Senator Schumer has said that he will “reconsider” his position and there might be some other egg-on-my face reconsiderations. Representative Jim Himes, a Democrat, and former Goldman Sachs Investment Banker, whose district includes Greenwich and Fairfield, CT, noted that it is “difficult to see how a mutual fund manager pays ordinary tax rates but the manager of a private equity firm doesn’t.” The private equity manager and venture capitalist might argue, however, that they are putting their capital at risk to further business formation—and there is something to be said for that argument. A Hedge Fund manager who trades stocks and bonds of public companies and receives a performance based management fee is a different matter, and as Representative Hines said about his constituents, it is difficult to see why they should be treated differently than mutual fund managers or investment advisors who manage separate accounts and do the same thing. Hopefully there might be a way to make a distinction between at risk capital and collecting management fees in future versions of the bill. Meanwhile, Bernie Madoff who sits in a prison cell for the next 150 years if necessary for orchestrating a Ponzi Scheme with separate accounts can at least claim that he never benefitted from the carried interest exemption.