Yesterday Victor Fleischer, professor at the UCLA School of Law presented, "'Two and Twenty' Partnership Profits in Hedge Funds, Venture Capital Funds, and Private Equity." Fascinated by this subject, and immediately alarmed at Professor Fleischer's proposal to impose reform to more aggressively tax these gains, I sought out a copy. Professor Fleischer replied to other requests on the always thought provoking Conglomerate thus:
"It's not quite ready for prime time, but I will post it to SSRN in a couple of weeks."
I guess he shouldn't have left a Google searchable copy of the draft in the open then.
Ok, ok. I know. Sorry. I didn't want to wait. Bad Equityprivate. No bone.
It is most certainly worth the read, and contains some very good analysis. I think, however, the professor has missed some things.
First, the central issue with respect to character of compensation centers around the premise that:
...while the carried interest can give rise to capital gains (depending on the character of the underlying partnership income), management fees give rise to ordinary income. Some GPs, recognizing the tax play, opt to reduce the management fee in exchange for an enhanced allocation of fund profits.
The argument goes that since these reduced management fees are exchanged for higher carries, there is a structural wrong being perpetrated.
The professor eventually concludes that:
The granting of a profits interest in a partnership should not be treated as a taxable event. When those allocations of profits eventually arrive, however, they should be treated as compensation, not investment income, and taxed as ordinary income and not capital gain.
I believe this fails to account for several issues.
1. Capital calls often are allocated proportionally to a partner's carry in the fund. Accordingly, if management fees are exchanged for carry, these fees are "at risk" in a more substantial way than I think the professor accounts for. Since when is ordinary income treated compensation for service subject to the foibles of interest rates (other than in hyper inflationary situations)? If a GP puts these at capital gains risk levels he should be compensated via capital gains rates. The professor ducks this by hinting that "risks are not as large as they seem" but I don't think he has studied hedge funds carefully enough. The reality is that management fees in most funds barely even pay the bills. Only the supermassive funds can hope to promise more. 2% of $200,000,000, for example, makes for a very lean fund in Manhattan. The source of those fees, and most compensation, eventually comes from capital gains. We might as well make the argument that none of the gains obtained purely due to structuring (i.e. leverage and deleveraging) should be afforded capital gains treatment either.
2. Enforcing the distinction between "carry for service" and "carry for non-service" necessarily requires a document somewhere demonstrating that that tradeoff has actually been made. It also seems to suggest that some "standard" in the industry would serve as a benchmark to determine if "gamesmanship" is being played. General partners typically have their own funds at risk. (1% of a typical buyout fund comes from GPs). How we can distinguish the carry we give GPs between service or non-service carry is somewhat beyond me.
3. These thoughts are not new. Similar hintings have caused quite the uproar in the UK. Funds would likely flee to jurisdictions without burdensome tax schema designed particularly to impact investment funds if the current status quo were tinkered with. And there are plenty of places to go. Luxembourg, for instance. Many funds already take clear advantage of these jurisdictions. Soros is famous for it. (His Quantum fund is domiciled in Curacao though it is managed in Manhattan). See how a sudden exodus would impact tax revenues. (The professor does acknowledge this at least).
Nothing is more sacred than the 2 and 20 we PE types lust after for
our sweat and tears. I don't recommend toying with them if you want
funds to stick around. I think we do want funds to stick around also.
Drawing any more attention to the benefits they would gain from
offshore domiciles is not a good bit of policy.
I suppose I'm not surprised that he's from California. What does surprise me is that he's not a Stanford grad.
(Do examine the professor's other work, of note: "The Missing Preferred Return.")