The Inflation Reduction Act signed into law by President Biden last week also reignited the contentious debate regarding carried interest after the provision revising the tax break was cut from the bill.
Carried interest is the portion of profits – usually, 20% – private equity fund managers receive in return for their investment in a company. In the 1990s, an exception appeared in the IRS code that allowed carried interest to be taxed as long-term capital gains (20%) rather than ordinary income (as high as 37%).
This tax break incentive combined with the conventional strategies of incrementalism, arbitraging debt, and cost-cutting, has produced short-term returns while driving the decline in innovation essentially killing American Exceptionalism. It has also resulted in a chronic misalignment between investors, employees, and communities – damage driven by private equity fund managers working to grow their funds as large as possible to increase their management fees.
The proposed changes to the tax code would have required private equity fund managers to hold onto their portion of profits for 5 years or more – up from the current 3 years – to receive the 20% rate. If held for less than 5 years that would trigger a “short term” capital gains rate of 37%. Another proposal would have required fund managers to hold onto their profits for even longer than 5 years. None of these adjustments would have actually created any long-term economic benefit since it is merely tied to holding periods and not value creation.
Some lawmakers believe that carried interest has become a financial — and moral — burden on American society as it misaligns rewards for the wealthy, inhibits risk, reduces competitiveness, and penalizes the American workforce. Critics including Jamie Dimon, Bill Ackerman, and Warren Buffet urge the law needs to be abolished. Ackman recently tweeted that the current policy is “a stain on the tax code.”
Supporters, on the other hand — in particular, private equity firms and the institutional funds that are their investors — argue that the carried interest tax law incentivizes long term investments, and increases and more efficiently distributes the country’s wealth.
Both are wrong.
At the time the carried interest code was introduced, less than $200 billion in assets were under private equity management. Today, private equity firms now hold more than $7 trillion in companies that employ over 12 million workers and contribute 6.5% to U.S. GDP. Yet no meaningful evolution of the pertinent tax code has occurred during that time.
Carried interest should not be looked at as a tax code loophole that needs to be eliminated — but rather as an opportunity to recast it as an economic challenge for companies to rise to. The code must be rewritten so the rules for qualifying for the tax break are based on companies distributing equity amongst employees, investing in innovation, and employee upskilling. This will help restore the carried interest law’s original intent of encouraging longer-term thinking by investors and at the same time making a substantial economic impact.
We must correct the misalignment of interests for all stakeholders. We must reignite the ability of organizations to strive for more than incremental growth. We must renew innovation in the thousands of firms outside of Silicon Valley that make up the heart of the American economy. But doing so will take more than simply fiddling with the tax code.
I am seeing the results in dozens of private equity-owned companies that have shifted their focus from rampant over-optimization, which caused shortages in everything from toilet paper to baby formula, to an alignment of incentives that will produce long-term benefits like Kymera.
Kymera International is a private equity-owned company (I am a Board Member and an Operating Partner at the private equity firm). Kymera once saw itself as a commodity metals business destined to incrementally grow its profits and reinvest in its existing markets. In 2019, Kymera pivoted to focus on producing high-margin specialty materials for aerospace, electric vehicles, coatings, and 3-D printing completely changing the financial prospects of the company. Underpinning this transformation: an employee ownership program that provides equity that upon sale will convert to a financial payout that will be life-changing.
Overhead Door owned by KKR, introduced broad-based ownership similar to Kymera and saw great financial and social results. If carried interest incented private equity investors to implement such programs it would accelerate the adoption of value creation practices and have an enormous long-term impact on the economy.
The tax benefit for carried interest requires updating, not elimination. If the qualification for companies to receive the carried interest benefit was tied to equity participation amongst employees, investments in innovation, wage growth, employee upskilling, and unbiased environmental, social, and governance (ESG) metrics, then we would have the right motivations for all participants to restore American Exceptionalism and the American Dream.