In its latest issue, The Economist tackles private equity from all angles. A special dossier covers PE’s surge, as well as the upcoming challenges. It is worth the read not only because some of the underlying subjects (carried interest taxation) have become national topics due to the Clinton-Trump debate but also because it frames PE’s value proposition, including venture capital, in a new light.
The briefing gloats about the four largest PE firms (Blackstone, KKR, Carlyle and Apollo) whose leaders are officially becoming senior citizens reaching well over their seventies. In forty years these firms have assembled more assets and indirectly, through their majority ownership, employ 725,000 people (Carlyle), 720,000 people (KKR), way more than some sovereign firms in their own country. In fact they have turned into the largest private employers in the U.S.
And their cash hoard does not cease to grow. PE firms globally handle $4.5 trillions under management, doubling since 2008. Even more astounding that PE firms keep over $1.3 trillion (no, there is no typo) under the mattress for future deals or as cushion while they still earn management fees, a healthy 2% or $90 billion on the funds confided to them.
A Harvard Business School study emphasizes that this trend has percolated throughout the economy. The number of PE firms has exploded going from 24 in 1980 to over 6,300 in 2016. With over $400 billion of deals in 2015 in Asia, Europe and America, they have penetrated the mid-market, mid-sized companies and supplanted the IPO as an exit source for entrepreneurs.
Why indeed bother after Sarbanes-Oxley rocked the boat under George W. Bush’s presidency? Why manage under the scrutiny and public markets regulations? The consensus among CEOs is that the nightmarish and unnatural act of running a company with a 90-day deadline distorts strategies and provokes ill-fated decisions.
The crux of the issue relates of course to how to keep an economic democracy where middle America’s destiny is tied to the business world with millions of shareholders’ savings vested with public companies. And of course about the merits of the PE or venture capital compensation. Both sectors generally get paid to manage their investors’ money (2% as a benchmark) and 20% for profits above a certain hurdle rate. The latter is called carried interest.
The debate is heating up. Both Mr. Trump and Senator Clinton have attacked the PE industry. It remains to be seen if electoral tactics will translate into legislation. Trump does not mince his words, and pesters against the excessively generous carried interest tax treatment.
The PE sector and venture capitalists argue that the profits randomness does not bode well with a higher tax rate, and should not be treated as if it were income. In the VC industry, some partners have publicly declared they would just quit if a tax reform bill would alter their carried interest.
In fact, both sides have solid arguments. On the one hand, public officials should look into the PE industry compensation system. Management fees which used to help sustain operations for $100 million funds have turned into a lifestyle boon once the funds grow to the tens of billions.
Worse off, even when the PE and VC backers lose money, the partners in the PE and VC firms get paid for up to ten years. By the way, more LPs have started to reduce management fees in the PE sector to 1.5 % or even 1.2% as noted by The Economist.
On the other, VCs and PE firms justifiably highlight that carried interest beyond a hurdle rate aligns them with their LPs. The whole concept of venture capital and PE originates from that point, and toying with the fundamentals is risky at best.
Private ownership stirs speed, reactivity and innovation; it encourages board members to take action, replace incompetent management. Beyond the glitz and the fanfare, results prove that only a few firms succeed during serial cycles. Taxing carried interest would jeopardize not only the profession but slow down competitiveness as a whole.
Limited partners will be facing a dire choice: go back to the roots of the business and encourage general partners to keep focused on IRR, profits; spend their constituents’ money (endowment, pension, sovereign) in management fees without any guarantee of returns.
Tom Perkins, the legendary founder of the eponymous firm, Kleiner Perkins, once stressed that VC or PE) is just “about creating incredible companies, not about management fees.” He was right.