Joe Biden has claimed presidential victory. The potential for swift and fundamental legislative change has many implications, even within the private equity industry alone. The main point of contention, however, is what happens to capital gains tax (CGT) assuming Democrats gain enough senate seats to drive legislation forward.
• 5 min. read •
Implications on Capital Gains Tax (CGT)
Trump’s sweeping tax reform in 2017 is expected to be reappraised by a Biden administration, CGT being a loophole that politicians have long danced around. The plan is to raise CGT for those who earn over $1m a year to around the 40% mark, evening the playing field by bringing the levy in line with the income tax rate.
So, who does this affect exactly? For many LPs this is not a direct concern. Non-US investors in US PE funds are tax exempt, as are many classes of LPs within the US including pension plans, private foundations and charitable trusts, which are some of the industry’s biggest clients.
The 20 in the PE industry’s “2-and-20” fee structure refers to the 20% share in profits that the GP takes over and above an agreed preferred return. Currently GPs in the US pay around 20% tax on this carried interest. A doubling of CGT is definitely a worry for GPs and their star dealmakers. Weaker compensation incentives also have the potential to influence behavior that does affect LPs, their cashflows and risk-return profile.
Assessing the possible impacts
For one, anecdotal evidence suggests that entrepreneurs, business owners and PE funds are taking action by prepping assets for sale. Certainly deal activity has picked up significantly since the market freeze earlier this year. The hope among sellers is that they can lock in profits ahead of any change to the tax regime. Although no such change is likely to be passed for another year or so, any legislation could take effect retroactively.
Any lift in M&A activity motivated by a new administration’s tax plans would be short term. The longer term consequences on future fundraising and deal making activity are more complicated. One solution for GPs is to simply negotiate more attractive carry share structures with LPs. As Jon Foley at Thomson Reuters points out, managers would have to increase their carried interest from 20% to 26% of profits to break even with the current CGT rate – and few but the very best and most persistent performing firms will be successful in dictating such GP-friendly fund terms.
Another possible outcome is that GPs will be encouraged to re-strategize with longer-hold funds. These fund structures have already become increasingly popular in recent times, providing managers ample time to scale up businesses free from the time constraints of typical PE funds, which broadly speaking invest over five years and harvest over the subsequent five years. Extending holds can help compound returns. An added benefit in the face of an unappealing tax regime is that assets can be held long enough to see out presidential terms, allowing value to be liquidated under potentially more favorable conditions.
If this trend towards a higher volume of long-hold funds were to manifest, coupled with plentiful fundraising, it would likely fuel the secondaries market. This is because LPs, many of whom are tax exempt, would seek to trade in and out of longer-term situations to access liquidity. An increase in longer-term funds would also likely encourage LPs to expand their secondaries strategies to shorten what would become a more extended and flattened J-Curve.
Other domino effects could emerge. Inflationary monetary policy in the form of pandemic stimulus and rock-bottom interest rates means there is already an incentive to borrow. If PE fund managers have their returns stifled by higher CGT, there may be a positive bias towards borrowing more heavily in leveraged buyouts to juice up returns, increasing leverage and risk across the asset class.
Why PE prefers Biden, on balance at least
Employees of private equity firms donated $132m to candidates, parties, political action committees and outside groups through September 30, according to the non-profit Center for Responsive Politics. Not only was this the highest showing for any election on record, Biden was the clear favorite. Of this $132m, $69.5m constituted “soft money” that is not allocated to either side. However, of the $62m direct funding to candidates and parties, 59% went to Democrats and 41% to Republicans.
This may seem counterintuitive given what’s at stake with CGT, however PE appears to see Biden as a safer bet. Trump’s term in office has been marked by unpredictable diplomacy, trade tariffs that have had far-reaching negative consequences for industries and their supply chains and a sub-optimal response to a pandemic that has hammered the economy. PE’s tried-and-tested long-term investment strategy does not like unpredictability as it can unexpectedly derail investment outcomes – even if the trade-off is a predictable tax raise.