Insider Leo Hindery on Appropriate Tax Rate for “Carried Interest”

No one can say Economy Watch readers aren’t interested, because as soon as we posted a previous item about Venture Capitalists / Private Equity / “Carried Interest”,

we got a number of emails suggesting emendations, but mostly additions that, in their view,

No one can say Economy Watch readers aren’t interested, because as soon as we posted a previous item about Venture Capitalists / Private Equity / “Carried Interest”,

we got a number of emails suggesting emendations, but mostly additions that, in their view,

would make the case for taxing “carried interest” at the regular 35% – as opposed to the current – 15 / 20% “capital gains” rate – even STRONGER …

One substantive point we should definitely add is that the measure concerned affects not JUST Venture Capitalists,

but ALL those who deal in the management of PRIVATE EQUITY.

To get a good sense of what a scam the current set-up is, below is the testimony before the House Ways and Means Committee in September 2007 – a full year BEFORE Black September 2008 – by Leo Hindery Jr.,

at that time, Managing Director of Intermedia partners, and whose other credentials in this area he outlines in his extremely cogent statement,

which comes about 70% down the page, as he is the first witness in the final of 4 groups testifying.

It was sent to us by our avid, intelligent and extremely well-informed reader Deepak Moorjani,

who was a student at Duke after I taught there, and is currently a member of Phoenix Holdings, LLP (f/k/a Upstart Management, LLC).

Previously, he worked at Deutsche Bank AG, Morgan Stanley and The Lodestar Group.

So without any further ado, here is Leo Hindery Jr. on why “carried interest” should be taxed at the regular – & in our view, still too low 😉 – rate of 35%, rather than the current 15 – 20% capital gains rate.

STATEMENT OF LEO HINDERY, JR.,

MANAGING DIRECTOR, INTERMEDIA PARTNERS

— *Mr. Hindery.  Thank you, Mr. Chairman, and members for convening this important hearing, as late in the day that it is, its importance justifies our being here.

— As many of my colleagues have commented today, at the onset, I speak only for myself and certainly not my firm. 

As you will hear from my comments, many would think I do not speak for my industry as well.

— I am the Managing Partner of InterMedia Partners, which is a private equity firm I formed in 1988, and I ran continuously until 1997 when I became the Chief Executive Officer of Telecommunications, Inc. or TCI, and later, its successor, AT&T Broadband.

— I returned full time to private equity in 2001, and my business career includes nearly 20 years of direct and indirect involvement with investment partnerships. 

As a consequence, I am intimately familiar with their history, their realities and their economics.

— As we have heard often today, hundreds of thousands of Americans throughout the U.S. economy work hard every day managing things for other people, ranging from grocery stores to gas stations to money.

— All of these managers earn a base level of compensation and in addition, most of them earn some form of performance fee. 

Except for one group of individuals, all of them pay ordinary income taxes on their personally earned management income.

— I am here today to talk about the management income being earned by that one particular group, namely those women and men, of whom I am one, who use special purpose investment partnerships to manage money belonging to others.

— The management income which we earn, which we call “carried interest,” is taxed as capital gains, when I and others believe it should instead be taxed as ordinary income.

— Of course, because the 15 percent capital gains tax rate is less than half, the 35 percent maximum ordinary income tax rate paid by virtually every other manager and by regular Americans,

how this issue is resolved will have an enormous impact on the nation’s tax receipts on the order, as we have heard, of $12 billion a year.

— The reason this tax loss figure is so high is simply because of the magnitude of the earnings which are now escaping ordinary income taxation.

— To fully appreciate this, all this Committee has to do is reflect on the fact that in 2006, the top 20 hedge fund and private equity managers in America earned an average of $658 million a piece. 

That is 22,255 times the pay of the average U.S. worker, and of course, most of these earnings were taxed at just the 15 percent rate.

— I should note that my concern today is not about the taxation of the operating income earned by any of these special purpose partnerships,

although there is very substantial inconsistency and thus abuse in how income from operations is currently being taxed from one type of partnership to another.

— I should further note that while much of the public’s attention to this issue has been directed at hedge funds and private equity managers,

the management income earned by managers of all investment partnerships needs to be scrutinized alike, hedge funds, private equity, oil and gas, real estate and timber.

— It really is not all that hard to decide how to properly tax carried interest. 

Is carried interest income which a money earns on his or her personal investments or instead is it the performance fee earned for managing other people’s investments?

— If carried interest is personal investment income, then it is properly entitled to capital gains treatment. 

However, if it is a performance fee, and my 20 years of firsthand experience clearly tells me it is, then it should be taxed as ordinary income.

— Simply put, members, a very bright line needs to be drawn between investor type partners

who invest their own money and are thus entitled to capital gains treatment on the investment income they earn

and manager type partners who contribute only their services.

— A prominent private equity manager recently contended to this Congress that investment manager earnings are “Capital gains in every technical and spiritual sense.”

— All I can say in answer is no church or synagogue I know would consider it very spiritual to each year selfishly characterize as capital gains literally billions of dollars of management income that has absolutely no down side risk to the managers,

especially when doing so comes at such a great expense to the rest of our nation’s taxpayers.

— On the issue of risk, about which much has been said today, I would note that there is a very, very big difference between the risk of losing one’s money, which is real risk,

and the risk of not making as much as you hoped, which is not risk in any meaningful way.

— Some of my fellow investment partnership managers also say that this hearing is nothing more than a vindictive singling out of their firms because of their extraordinary success,

and they say that increasing the tax rate on their earnings to the ordinary income level

will create an investment tax of sorts with dire, dire unintended consequence for the entities whose money is being managed and for the American economy.

— These conclusions are self serving and they are poppycock. 

Congress is not considering changing the tax rates on the investments made by investors. 

Congress is only considering restoring fairness in how the women and men who manage these investments are individually taxed compared to other managers and to regular workers.

— It is beyond disingenuous to predict dire unintended consequences when no consequences at all will occur.

— A tax loop hole the size of a Mac truck is right now generating unwarranted and unfair windfalls

to a privileged group of money managers and to no one’s surprise, these individuals are driving right through this $12 billion a year hole.

— Congress, starting with this Committee, needs to tax money management income, what we call “carried interest,” as what it is, which is simply plain old ordinary income.

— I hope, Mr. Chairman and members, that my comments have been helpful.  I look forward to your comments and your questions.  Thank you, Mr. Chairman.

—————————–

From the fact this is STILL a major issue almost three years later – and in the wake of the near global crash of Black September 2008,

you can pretty much assume that, his eloquence aside, a Congress bought and paid for by the financial sector, basically ignored what he said –

and, even worse, is more than likely to do so again.