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

Tue May 6 08:41:22 PDT 2008

Jeff:

Interesting stuff, and your little tutorials have, at least for me,
clarified quite a bit about what the media seem to be getting wrong.  :-)

But would you mind elaborating on your third assumption? I'm not wholly
following how "you can't raise taxes on either PE/VC without raising it on
entrepreneurs."  Effect, I get.  Taxes though?

C

On Tue, May 6, 2008 at 11:17 AM, Jeff Bone <jbone at place.org> wrote:

>
> 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
>
>
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