The Carried Interest Debate
(This was originally sent to my email newsletter list. I'm posting this publicly because people have asked for examples of what I publish. You can sign up at letter.ly/dave)
Hot topic the last few days are VCs railing against the proposed new tax legislation on carried interest. The proposal is to tax the money VCs make on their investments as regular income instead of as capital gains (which is the tax you pay if you were to make money buying stocks on the stock market). The argument for the tax is that it is income, and special capital gains treatment should be reserved for cases when you are investing your own money (a big risk), not somebody elses (and getting paid to do so).
Here's more detail, for those of you who aren't familiar. University endowments, giant pension funds, and the like invest their money in a bunch of different ways to both maximize their returns and diversify their risk. One of these "asset classes" is venture capital. They pay VC firms a fee of 2% of the total money invested to take their money and invest it into promising startups. To encourage VCs to pick the most promising startups, they also give VCs 20% of the profits from the startups that are successful. This is called the "carry".
From the NY Times article:
"Under current rules, carried interest is taxed federally at a rate of 15 percent because it is treated as a capital gain. That contrasts with the tax rate on ordinary income, which can be as high as 35 percent. The plan approved by the House, which overcame strong lobbying pressure from Wall Street, amounted to a compromise that would tax 75 percent of carried interest as ordinary income and 25 percent as capital gains. It is expected to raise more than $17 billion in tax revenue over the next decade."
The argument against the tax increase is that VCs will immediately pass along the higher tax cost to the LPs in an effort to maintain their profit margins. In the face of reduced revenues, LPs will divert money going to VCs into other asset classes that have higher returns. This (they claim) will result in fewer dollars available to invest into startups, which will result in the creation of fewer jobs. Therefore, the new tax hurts the economy.
I don't buy it, and here's why. First of all, the best startups will always be able to find VC money because VC money isn't disappearing, just shrinking (maybe). And it's the best startups that result in creating the majority of jobs. It's also the best startups that create the 100x returns that VC funds are structured to require. The top funds result in the majority of VC returns, with the rest (over the last decade) barely breaking even or worse. So LPs will be even more competitive to try and get their money into the top funds, and it's the poor performing funds that will suffer. So yes, fewer jobs will be created, in that sucky VC firms will die and the bad investments they would have made will never exist. In my opinion, the projected $17 Billion in tax revenue seems more than enough to make up for it.
My argument breaks down if LPs shift so much money away from VC that it affects the top VC firms. I don't think that will happen, as LPs need to diversify their portfolios and high risk / high reward asset classes like VC are important pieces of that portfolio. The poor returns of VC funds over the last decade will be a good test of this theory – who cares what the tax rate is if your ROI was 0%!
This is definitely a complex issue, and I want to hear your thoughts on the matter, so please reply!
