Obama PE/hedge fund plan more sizzle than steak

By Svea Herbst-Bayliss and Megan Davies - Analysis

BOSTON/NEW YORK (Reuters) - Angry investors may feel vindicated as President Barack Obama seeks to raise taxes on hedge fund and private equity fund profits, but critics caution the proposal will not raise significant money for years and may be watered down or fail to pass Congress.

Taxing "carried interest" has long been a hot-button issue in the $1.4 trillion hedge fund and $2.5 trillion private equity industries and it exploded on Thursday as Obama's new budget proposes raising about $24 billion over ten years by eliminating what has been called the "carried interest" tax loophole.

Carried interest, or carry, is the cut of profits -- typically 20 percent -- that private equity and hedge fund firms' partners keep as compensation.

For years, they have had to pay only the 15 percent long-term capital-gains tax rate on carry instead of the roughly 35 percent tax for ordinary income.

"There is a very strong argument to be made that the 20 percent (managers charge in performance fees) is real income but it is a moot point today because it will take the funds years to get back to their high water marks," said Cornelius Hurley, director of Boston University School of Law's Morin Center for Banking and Financial Law.

Managers and industry experts note, with some irony, that the plan is being announced at a time these once high-flying fund firms are not earning much money and years before the proposal is set to take effect in 2011.

Facing tumbling financial markets, private equity funds have been making large writedowns on their portfolios, while many hedge funds suffer heavy losses. This means their managers are nowhere close to earning their lavish 20 percent performance fees.

"Proposing the plan now, creates more noise now than is probably necessary," Hurley said.

NOT A DONE DEAL

Looking ahead to the day such a proposal might have real teeth, experts say that raising the carry would be a hit for private equity and hedge fund firms but would not kill the industry.

Steven Kaplan, a professor of finance specializing in private equity at the University of Chicago, said some private equity firms may in response try and raise the carry from the typical 20 percent to perhaps 25 percent.

"The second thing is smart lawyers will try to maneuver around this," Kaplan said. "There is a case that this is capital gains not ordinary income."

The Private Equity Council, an industry group, said it believed that profits generated by increasing the value of capital assets should continue to be treated as capital gains.

"We recognize that our country is facing enormous economic challenges," Douglas Lowenstein, PEC president, said in an emailed statement. "With more than $500 billion in new capital to invest, private equity partnerships can and will be part of the solution."

But even if still classed as capital gains tax, managers might have to pay more on carry anyway. The capital gains tax could revert back to 20 percent on January 1, 2011, unless lawmakers extend cuts that brought the rate down.