[FoRK] Private equity, venture capital, entrepreneurs, and tax policy

[Jeff Bone]

So I hope that by this point I've convinced you guys that the  
investment activities of e.g. private equity (henceforth PE) guys are  
different from the active trading characteristic of most hedge funds  
in fact and in tax treatment.  I've stipulated that there's a  
legitimate discussion to be had regarding current tax treatment of  
gains stemming from e.g. PE investment.  I now intend to engage that  
discussion and, hopefully, convince you that attempting to put the tax  
policy screws to PE guys will have negative consequences for society  
as a whole and for a particular economic activity that many on this  
list engage in and hang their financial hopes on.

Oh, and I'm going to explain to you how Warren Buffett is an old man  
who clearly has no idea how the low-end of the market works anymore,  
and therefore is talking right out of his ass when he yammers about  
raising the long-term cap gains rate.

--  

PE and VC are very similar in structure and behavior.  Both work on  
generally the same model.  A group of individuals forms a partnership  
("the firm") and go out to raise capital to invest ("the fund" --- a  
separate partnership, typically, with its investors as limited  
partners and the firm as its general partner).  They then invest the  
fund into companies (ongoing concerns private or public in the case of  
PE, startups in the case of VC) in return for equity in the company.   
The equity is held in the fund's partnership structure on behalf of  
the GP;  the funds pay a yearly management fee to the firm, which is  
distributed to the firm's partners via flow-through and taxed  
primarily at the highest rate.  In addition, the firm gets a certain  
percentage ownership of each of the portfolio companies --- and this  
is how PE and VC guys make their fortunes, the management fees  
generally aren't all that impressive (though they can be.)

The PE or VC takes a seat or seats on the portfolio company's board,  
and attempts to steer the company's management to success.  If all  
goes well, at some point in the future the portfolio company undergoes  
a "liquidity event" during or after which the PE or VC will liquidate  
their own holdings in the company and distribute the proceeds to their  
partners, including their own vig.  This will typically be taxed at  
the long-term cap gains rate, as the holding period for said equity  
has at that point usually been years.

The objection you're hearing raised is on how these windfalls are  
taxed.  The objection is that since these windfalls represent so much  
of the PE or VC partner's total income on a year in which they happen,  
that taxing them at the long term cap gains rate brings the effective  
blended tax rate down to near its minimum of 15%.  This is entirely  
true, it does.  It represents tax on a long-term risky investment.   
That's what the long-term cap gains rate is *for* --- to encourage  
long-term investment and reward the greater degree of risk associated  
with it.  This low tax rate is a good thing, entirely appropriate (or  
rather, no less appropriate than any other part of our tax system) ---  
and it would be dangerous to mess with it.

You might argue that the PE isn't risking his or her own money.   
True.  Neither is a VC.  And for that matter, neither is the bare- 
knuckles entrepreneur in the startup game.  But, you say, that  
entrepreneur is putting in sweat equity, the PEs and VCs are not.   
Well, somewhat true;  it's a matter of degree.  PE and VC guys aren't  
layabouts;  they generally work hard for their portfolio companies,  
it's just that they divide that labor up across several of them.  They  
have a "hit rate" of about 1 in 7 (VC industry average over the long  
haul, PE is somewhat better) so they're risking 6/7 of their time,  
generally speaking.  And while the entrepreneur is often drawing at  
least a subsistence salary, the external board is rarely directly  
compensated for their time by the portfolio company.

And it's a riskier proposition on some level for them relative to the  
entrepreneur;  typically the entrepreneur has or is thought to have a  
more direct individual role in the outcome of their venture than folks  
who "just" come to board meetings.  At any rate, I see no reasonable  
way to modify the policy to tax PEs or VCs higher than LPs or  
entrepreneurs, and doing so to any of these folks will adversely  
impact our economy in the large and the pocketbooks of the  
entrepreneurially-minded on this list.  Illustration of previous to  
follow...

Note too that the LP investing in the PE's or VC's fund is also taxed  
the same way, so if you increase the tax rate on their gains through  
this mechanism, you dry up available capital for investment and  
concentrate what's left.  This has all sorts of bad consequences.   
Such a venture capital concentration has occurred in Texas through  
various non-tax means, and the net result is that the VC / startup  
picture in this state is quite grim relative to what it was a decade  
ago.  You can expect to see the same kind of thing nation-wide as a  
consequence of the contemplated tax policy changes.

--

Now I'll make a number of assertions that are hopefully obvious or  
that at least follow from each other:

   - you can't raise taxes on PEs w/o also raising it on VCs, as they  
are basically equivalent
     - raising taxes on VCs will result in less early-stage investments
     - less early-stage capital investments will retard technological  
progress
     - less early-stage capital investments will discourage  
entrepreneurs
   - you can't raise taxes on PE/VC without also raising it on LPs
     - this will dry up the ultimate capital sources
     - will reduce the number of PE/VC firms and swell the size of the  
remaining
     - will force a shift to larger, safer investments
     - will hinder entrepreneurship and technological progress /  
innovation
   - you can't raise taxes on either PE/VC without raising it on  
entrepreneurs
     - this will also discourage entrepreneurship by lowering the reward
     - and believe me, when everybody has their slice of pie it's  
already low enough!
   - bad idea.  QED.

--

Apropos Warren Buffett, he's only doing the biggest deals at the top- 
end of the market these days.  He doesn't have the time or the staff  
to make onesy-twosie investments in early-stage / younger / smaller  
companies.  He hasn't thought through how all this impacts the little  
guys, the companies w/o large capital investment needs, and the  
capital ecosystem that feeds and nurtures them.  When you're worried  
about things like the Microsoft-Yahoo! merger and feeling guilty about  
the big pile of lucre you've accumulated over your career, you clearly  
aren't worrying about (even if you're capable of it) how such tax  
policy might effect the guy thinking about starting NewCo, or the guys  
thinking about how to fund and benefit from investment in the success  
of NewCo.

--

So - be careful what you wish for.  If in your attempts to "screw the  
rich" you advocate raising taxes on the gains made by the usual  
activities of PE guys (and hence VCs) you may well screw up some  
economic activities or prospects that are near and dear to your own  
hearts...

$0.02,

jb