Rewarding High-Risk Innovation: The Case for Carried Interest
As Washington grapples with the deficit, nothing generates more emotion than tax “loopholes.” A priority “loophole” target in the budget that President Obama sent to Congress last week is the treatment of managers’ carried interest in private equity funds as capital gains, which he characterizes as “unfair” and the key reason for the low tax rate paid by Mitt Romney.
When John Steele Gordon declared “Carried Interest is not a Capital Gain” in a recent commentary for the Wall Street Journal, he drew a slew of comments, most of which supported his view. Some were downright virulent, as in, “These vultures are leaches who will eventually ruin our economy. No way they should get a huge tax break for doing it.”
Before changing the rules in this area, I suggest that we consider the argument for capital gains treatment, particularly in the case of venture capital funds. I have a vested interest in the issue. I am a life sciences venture capitalist.
In the article Gordon explains that “Managers of these funds are compensated for their services in two ways. One is the annual management fee, usually 1 percent or 2 percent of a client’s investment. The other is a share in the net profits of the fund’s long-term investments. …The management fee is taxed as ordinary income, but the long-term profits of investment are taxed as a long-term capital gain, for both clients (the investors in a venture fund) and…managers.”
Gordon contends that fund managers should not be entitled to a break, because they “share in the gains but not the losses. They do not put their own money at risk; the reality is that the compensation for their services is income and should be taxed as such.”
Gordon agrees that an entrepreneur should be entitled to capital gains treatment, because “he invests his time and his sweat equity… He is risking a lot: a substantial portion of his working life, his reputation, his potential current income, etc.” All a fund manager provides is advice, like a lawyer.” (That last analogy is particularly painful.)
Mr. Gordon’s descriptions of a founder pretty well describe the contributions of an early stage venture capitalist. These fund managers go through the same process as any founder, starting with an idea, organizing the company, raising funds and recruiting managers.
Venture capitalists clearly meet Mr. Gordon’s two principal requirements for capital gains treatment: Sweat equity and returns at risk. However, a venture capitalist faces an additional level of risk. Before he can take a share of the profits from any one investment, he has to repay the costs of all the other investments in his fund, plus all of the fees he has received. In fact, if the venture team had received options to purchase a 20 percent interest in the fund instead of a carried interest, they would be in exactly the same position as a management team granted stock options, which all agree qualify for capital gains treatment.
John Carey, senior editor at CNBC.com, points out that managers of private equity funds rightly expect to be taxed on the same basis as their investors, because the rate should be based on how the money was made—through investing in long-term assets—and not who received it. “In fact this [discrimination between investors and managers] seems a bit unfair: it rewards those who already possess wealth and punishes those who must raise it from others.”
While meeting the technical requirements is important, an even more compelling argument for capital gains treatment is the benefit to society of incentivizing venture capitalists to pursue the often quixotic task of starting new companies.
Before they can share in the profits from their portfolios, venture capitalists have to create a lot of value over a long time that benefits a lot of other people. Taking bio-venture as an example: A four-man team running a medium-sized fund of $200 million—let’s call it Improbable Ventures—must create and/or invest in companies that sell in total for more than $1.3 billion in order to make their first $1 of carried interest.
Since early stage financings are typically syndicated, a single fund might invest in 15-20 companies and expect to own about 15 percent of each. Last year’s crop of biotech companies took an average of nine years from first venture round to exit. A fund hitting .333—i.e. one out of every three startups survives—would have a very good record.
Where does the other $1,299,999 of capital value go? In our example, $200 million of the $1.3 billion (15 percent) would go to the investors in Improbable Ventures—pension funds, endowments, and other institutional investors—to repay their invested capital. The remainder goes to the other investors, founders, and managers of the portfolio companies.
Even more importantly, the pharmaceutical industry gets $1.3 billion worth of new products. All of the people who have worked on those assets paid taxes from property to income, and will pay more in future. Products that make it to the market can provide billions in profits for investors (and the IRS) and alleviate the suffering of millions of patients.
Those new drugs represent real wealth that didn’t previously exist. They will save lives and put people back to work. Each successful product paves the way to the next generation of medicine. As patents expire—$103 billion (44 percent of 2011 sales) of branded drugs in the U.S. will shift to generic through 2016—the cost of medicine falls dramatically and permanently.
The importance of venture capital lies in its role as a catalyst in stimulating commercial innovation and renewal. The fund structure enables experienced managers to leverage their skills across multiple companies (and multiple headaches) and should not be a means of disenfranchising them from the favorable treatment that other startup team members enjoy.
Raising the federal tax on carried interest by more than 2.5 times, from 15 percent to more than 40 percent, would make tax strategy a major factor in maximizing venture capitalists’ take-home pay. When they turn their attention from building new companies to managing their tax problems, they spend more time with attorneys and less with entrepreneurs. Contrary to what people might think, VCs don’t have cadres of lawyers to do this work for them.
If both fees and carried interest are taxed as ordinary income, it makes sense for a manager to focus more on fees than carry, because fees are guaranteed up-front payments, not dependent on the results of risky investments. Carry, if it ever comes, has to be discounted for the time it takes to grow and exit a business.
The best way to insure access to future fees is not to lose investors’ money by sticking to safe investments. The best way to maximize returns from carry is to invest in the most exciting and innovative opportunities a manager can find. Changing the relative value of fees and carry moves venture capital away from risky and toward “safe” investments.
However, the government should encourage aggressive investment, because society benefits disproportionately when managers make risky bets on innovative teams and technologies. The system needs more “Black-Swan” type opportunities. These home-run companies reshape the commercial landscape and take the world in unexpected directions. They change the quality of our lives through the creation of electronic media and break-through medicines.
Higher taxes on private equity and venture capital would be a step in the wrong direction, a disincentive for optimal behavior in a productive industry that is already struggling. The National Venture Capital Association estimates that the number of active venture funds has dropped by over a half since 2000, even more in the life-sciences sector, and the trend is expected to continue.
This is not the time to shift money and resources away from venture capital. The industry will create value that will more than compensate tax payers for their forbearance.