Roughly a year ago, in September, in the first presidential debate of the 2016 election cycle, then-Republican presidential candidate Trump suggested he would raise taxes on private equity and hedge fund managers. Throughout his campaign, Trump insisted that "hedge fund guys are getting away with murder."
Flash forward to November 2017. We're almost 12 months into the first year of President Trump's administration, with no action yet on buyout shop and hedge fund taxes. The White House still seems keen on eliminating tax breaks for wealthy hedge fund owners, but perhaps not so much for billionaire private equity managers like Blackstone Group LP (BX) co-founder Stephen Schwarzman.
At issue in the battle over fund taxes is the way carried interest—the profits received by many hedge funds and private equity managers—are treated as capital gains with a top basic rate of 23.8% as opposed to the top ordinary income rate of 39.6%. A move to treat carried interest as ordinary income could significantly increase the amount of taxes fund managers pay.
As tax reform legislation continues to swirl around on Capitol Hill, White House Economic Adviser Gary Cohn last month told CNBC that the president remains committed to eliminating the so-called carried interest provision in the tax code, which if approved across-the-board would raise taxes on private equity and hedge fund managers.
However, it looks like private equity managers could become a big winner in any changes to carried interest tax treatment that takes place in a legislative overhaul. That's because Treasury Secretary Steven Mnuchin, an ex-hedge fund manager himself, recently said that the White House might seek to keep the tax break for firms that create jobs.
Mark Proctor, a partner at Vinson & Elkins LLP, argues that from a 50,000-foot level it is easier to argue that private equity firms help their portfolio companies create jobs. Alternatively, he suggested that hedge funds that focus exclusively on high-frequency trading, short-selling or short-term investments would presumably not qualify for reduced tax rates under such an approach. Consequently, PE firms and their portfolio companies could benefit if Congress and the White House decide to keep the lower tax treatment for owners of entities that create jobs. That would be good news for the private equity industry, which invested roughly $187 billion in the third quarter of 2017, according to the buyout shop lobby group American Investment Council.
"It may be that if you are in the private equity business, you get the benefit but if you are involved in hedge funds, you don't," Proctor said. "People may then try to adjust their strategy to make them look more like private equity and by doing so shoehorn themselves into a lower tax treatment."
Nevertheless, a move to try to keep the existing tax treatment for job-creators will likely raise the ire of any category of fund manager that is on the losing end of tax reform. In short, expect such a political strategy to open up a hornet's nest of criticism, as well as a fury of lobbying from fund managers on Capitol Hill.
For example, asking all hedge fund managers to pay higher taxes based on the assumption that they aren't job-creators would likely lead to serious opposition. Proctor, who advises private equity funds and hedge funds, argued that a credit-focused hedge fund that lends money to a company so that it can hire more employees helps create jobs and therefore should be eligible for lower tax treatment under the job-creating scenario. Other hedge funds employ quasi-private equity strategies by acquiring companies or making direct investments in public or private companies, just like private equity firms. This business also could be considered jobs creators as well.
Also, large asset managers employ multiple strategies, including stock trading, which presumably doesn't create jobs, and longer-term private equity investments. Their multifaceted structure raises the question of whether part of those firms would be treated differently than other units under a regime that kept the specialized low tax treatment for companies that create jobs. Proctor suggested that the Internal Revenue System would have to differentiate between investment strategies at large asset managers, complicating their regulatory oversight.
"You would have to drill down to the level of the investment strategy," said Proctor. "This goes against the notion that the tax code should be simple. Regulators may have to figure out what percentage of the investment was a private equity strategy and what percentage of the investment was a trading one."
Also, consider the world of activist hedge fund managers and the companies they target. Typically, insurgent funds hold large minority stakes in companies for more than a year, which means managers' incentive allocation is often taxed at the lower capital gains rate. However, their role in the economy raises similar questions. A simplistic definition of funds that create jobs would likely exclude activist managers from a reduced tax treatment, since they, for the most part, do not invest directly in portfolio companies, but rather acquire shares in the stock market.
However, Procter argued that activist fund managers would disagree with the notion that their investment strategy does not create jobs, arguing that they push companies to cut costs, refocus operations and spin-off divisions so businesses can prosper and hire more employees down the road. "Activists would argue they are creating jobs, though they often push companies through painful reorganizations," Proctor said. "However, their critics would say they are just pushing companies to sell assets, which isn't creating jobs."
As the debate expands, also expect critics of private equity to argue that buyout shop restructuring destroys jobs.
- Watch: What we know about Trump's tax plan:
With confusion around this provision, it isn't surprising that Congress is in a holding pattern. A blockbuster tax reform package issued Thursday by the House of Representative's top tax reform legislator, House Ways and Means Chairman Kevin Brady, does not modify the current law on carried interest. Brady told reporters last month that the committee has yet to decide on the provision in the tax code.
What's next? With job creation in the spotlight, expect Brady to be surrounded by private equity firms, hedge funds and activist managers spending a lot of time on Capitol Hill making the case that, yes, they too are engines of job creation.
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