NEW YORK (Reuters Breakingviews) - Private equity’s recipe for creating riches has two main ingredients: debt and tax perks. Joe Biden wants to turn the second one into a fond memory. If the Democrat becomes U.S. president after the election on Nov. 3, his tax plans could undermine buyout barons’ business model and pit shareholders, clients and employees against one another.
THE CARRY TRADE
At the heart of Biden’s assault on companies like Blackstone and KKR is capital gains tax. The levy on profit from selling assets is currently lower than that applied to rich Americans’ income, and has been since 1990. Right now, the gap is up to 17 percentage points. Private equity managers love this arrangement, because they collect hefty rewards in the form of “carried interest,” a share of the returns made by their funds that tax authorities see as a capital gain.
For at least a decade, politicians have shied away from taxing this form of compensation, which looks like pay for performance, as income. Under Biden’s plan they wouldn’t have to make that call: for people who earn over $1 million a year, both capital gains and income would be taxed at the same rate of nearly 40%. Buyout firms’ star managers would lose out big time.
But it gets worse for them. A higher capital gains tax would also penalize big shareholders of companies they hope to buy and the executives they employ to run them, who are often paid in stock. Many entrepreneurs might be less willing to sell in the first place; those that do may demand higher prices.
The result could be less rain for the private equity rainmakers. Persuading their clients – pension firms, sovereign funds and so on – to pay more for the privilege of investing would be a tough sell. Right now, a typical buyout firm creams 20% off the profit from an investment. Assume that’s taxed at the 20% capital gains rate. If Biden gets his way, that rate would double, and the firm would need to raise its bounty to 26% of the investment profit to get the same after-tax amount. Maybe some blockbuster firms can wangle that; most can’t.
MOVE IT OR LOSE IT
Some of those involved are already taking action, according to industry sources and advisers, looking into offloading investments before any tax change can kick in. The clock may already be ticking, since legislation passed even late in 2021 could conceivably be applied retroactively to the beginning of the year. A similar rush for the exit happened in December 1986, after President Ronald Reagan equalized the two tax rates, albeit at the relatively low level of 28%. Alternatively, some firms are considering moving from high-tax states like New York to low-tax states such as Florida, a shift which would help minimize their overall tax burden. Paul Singer’s Elliott Management is one of those, according to Bloomberg.
There’s an extra barb for Blackstone, KKR and Carlyle. As well as hiking capital gains tax, Biden also plans to increase the corporate income tax rate from 21% to 28%. Most private equity firms are partnerships, meaning they pass untaxed profit onto their owners, who are taxed on the income. But these three companies took advantage of President Donald Trump’s tax cuts that took effect in 2018 to turn into so-called C corporations – a change that meant they started paying income tax on their earnings. With the corporate tax rate at just 21%, there seemed little to lose. At a 28% rate it no longer seems so smart, although they surely anticipated that tax rates can rise as well as fall.
That further reduces buyout firms’ scope to reward their executives. A higher corporate tax rate means their earnings will be lower, putting downward pressure on their stock-market valuations. The pain for holders of their stock could be magnified because former Vice President Biden also wants to increase the tax on dividends to nearly 40%. It’s hardly compatible with fatter pay packages for staff.
In sum, shareholders, company founders, employees and investor clients could all find that private equity’s magic recipe loses its flavor if Biden prevails. It’s quite the reversal. Buyout moguls like Stephen Schwarzman have amplified their billions by taking advantage of the U.S. tax system. Just during Trump’s four-year term, Blackstone’s shares have generated double the returns of the S&P 500 Index, with rivals Carlyle and KKR close behind. Some loopholes, like the taxation of carried interest, have been open for too long. Biden could be the boogeyman who finally slams them shut.
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