Carried interest is back on the legislative negotiating table after President Joe Biden included the “loophole” as a financing mechanism in his latest spending bill. Let’s talk impact from the proposed legislation with the Riverside Co. vice chairman Pam Hendrickson in a Mergers & Acquisitions exclusive interview.
A cooling effect on entrepreneurship and investment is a likely result, notes Hendrickson. “What’s worrying is that entrepreneurs could just bail,” said Hendrickson, who is also vice chairman of the American Investment Council. “We have the leadership summit, all the things we do to help those portfolio companies get bigger, better, stronger — PE firms and entrepreneurs might say it’s not worth it to take the risk in our capital and labor, given the disincentive for long term investment.”
Funds and potential innovators alike could become more cautious about investing effort and capital in new ventures if the upside is limited by a higher tax bill. Fewer entrepreneurs mean fewer investment opportunities. Private equity as an asset class could dwindle from today’s some-5,000 firms to fewer, more niche outfits.
That might disproportionately impact small businesses. “Seventy-one percent of the companies the private equity industry invested in last year were at an enterprise value under $100 million,” Hendrickson said. “Riverside invested in 63 businesses and the average enterprise value was $55 million. We created over 2000 jobs.”
But Warren Buffet’s famous op-ed challenges this logic: he notes that even tax rates near 40 percent in 1976 did little to discourage investment. “People invest to make money, and potential taxes have never scared them off,” he wrote in 2011. Indeed, private equity profitability has soared alongside the valuation of its public champions Carlyle Group, Blackstone, and KKR. Funds are innovating new credit and asset management vehicles to increase market share.
Perhaps a likelier scenario is somewhere in between: some financial sponsors might well find themselves crowded out of a market focused on returns and innovation. Private equity might chase deals with slightly riskier profiles to meet demands on returns, becoming the rescuer of embattled companies portrayed by Mitt Romney in his presidential run rather than the go-to acquisition vehicle of established, steady growth firms. To the extent that the carried interest tax reclassification would slow deal flow, lending arms of banks might well step into the gap with more aggressive loans of their own.
One practical industry impact could be a scramble for talent. If investment income is taxed at a rate comparable to wages, the profit-sharing mechanism that entices high earning GPs to private equity could lose some of its luster. Investment banks and buyside positions at traditional asset managers might become more appealing.