Private Equity Eyes Tax and Financial Reform in the Trump EraBy
Industry watching carried interest, deductibility, regulations
Blackstone legal chief sees potentially “sweeping” changes
Private equity has the President-elect on speed dial. That may benefit the $2.5 trillion industry as several key issues are put in play.
Wilbur Ross, who made his private equity fortune restructuring bankrupt companies, will as Commerce secretary be the voice of U.S. business in Donald Trump’s cabinet. Blackstone Group LP Chief Executive Officer Steve Schwarzman will chair the President’s Strategic and Policy Forum, a committee of business leaders that will advise Trump on job creation and economic growth.
Jay Clayton, a lawyer at Sullivan & Cromwell LLP who has advised on a host of private market deals, will regulate Wall Street as chair of the Securities and Exchange Commission. And though he wasn’t given the job, retired General David Petraeus, a partner at KKR & Co., was shortlisted for Secretary of State.
While it’s unclear how closely Trump will follow their guidance once in office, it benefits the industry to have some of its titans manning top posts.
“There seems to be more interest in the advice of real-world practitioners than in the past,” said James Maloney, vice president of public affairs at the American Investment Council, the private equity industry’s lobbying group in Washington. “This is encouraging.”
Aside from assigning official posts, Trump has hosted a steady stream of private equity executives since the election. Carlyle Group LP co-CEO David Rubenstein, Blackstone’s real estate head Jon Gray, KKR’s Henry Kravis and Cerberus Capital Management’s Steve Feinberg have been among his visitors.
Here are the private equity industry’s top priorities as Trump prepares to take office:
1) Carried Interest
Disapproval of the tax treatment of carried interest, the portion of a private equity fund’s profits paid to fund managers, was one of the few issues that Trump and rival Hillary Clinton agreed on during the 2016 election.
Carried interest is currently taxed at 23.8 percent -- a long-term capital gain plus an Obamacare surcharge -- versus a top rate on ordinary income of 39.6 percent. The thinking is that fund managers should receive tax relief as entrepreneurs who bore risk, rather than treat the earnings as traditional income.
According to the plan posted on his website, Trump wants to tax carried interest as ordinary income. The income tax for top earners, including most private equity managers, would sit at 33 percent, Trump proposes.
That change would trim millions of dollars from top managers’ wallets. Blackstone’s Schwarzman would take home $8.1 million less if his 2015 carry, the most recently disclosed payout, were taxed at Trump’s top rate. KKR co-CEOs Kravis and George Roberts, who awarded themselves equal amounts of carry in 2015, would shave off about $4.7 million each.
But it’s not that simple. Trump said in May that he wants to tax business income of all stripes at 15 percent, though it’s unclear how exactly that rate would apply to pass-through income. Pass-throughs are the preferred legal structure for private equity firms to pass profits to individuals. The rate for pass-through income currently under review by House Republicans is 25 percent.
If carry becomes taxed at ordinary income rates and current Republican proposals take effect, many private equity managers could structure their carry to be taxed at 25 percent -- only marginally higher than the current 23.8 percent rate.
2) Interest Deductibility
The ability to finance a buyout by saddling a company with debt is key to the private equity playbook. Under current tax law, buyout shops can knock the portfolio company’s cost of debt -- interest expense -- off of its taxable income. Firms use this allowance to reduce the target company’s tax liability. It also makes leverage more attractive.
“Any new tax policy targeting interest deductibility would harm the economy by raising costs on businesses of all sizes and types, which would reduce investment and growth,” said Maloney of the American Investment Council.
Trump wants to make companies an offer: either keep interest deductions or forgo them but gain the ability to immediately expense capital investment. The tax blueprint proposed by House Republicans gives no such choice.
The House plan replaces net interest deductibility with immediate write-off of new equipment in the first year of ownership, freeing up tax dollars to reinvest in the business. While this encourages spending, it also deals a huge blow to the debt equation for private equity firms.
“If you eliminate the interest deduction or limit it, and therefore limit the amount of debt, you change the entire return calculation of a deal,” said Bob Press, the CEO of TCA Fund Management Group.
3) Changing Dodd-Frank Registration Requirements
Trump has said he wants to “dismantle” Dodd-Frank, the massive reform act passed by the Barack Obama administration in 2010 in response to the financial crisis. While he hasn’t elaborated on which parts may change or in what order, a Dodd-Frank roll-back plan that House Republicans proposed last year may provide some indication. Lawmakers are expected to introduce an updated version of the measure in the coming weeks.
The Financial Choice Act, as it’s known, would exempt private equity funds from registering with the SEC. That obligation was created by Dodd-Frank, which mandates the disclosure of information such as investment positions and credit risk. Private equity firms don’t pose systemic risk and the examination requirements impose unnecessary costs, according to a summary of the proposed legislation.
Since Dodd-Frank became law, firms such as KKR, Blackstone and Apollo Global Management LLC have paid tens of millions of dollars in fines after SEC examinations uncovered what regulators said were insufficient disclosures of some fee and expense practices to clients.
While eliminating registration requirements for all private equity firms may be an industry fantasy, there could be greater bipartisan political support for exempting more small firms, according to Josh Watson, a private-funds attorney at Morse Barnes-Brown & Pendleton. Under current rules, firms managing private funds with at least $150 million are required to register with the SEC.
“There seems to be some agreement on both sides of the political aisle that the $150 million threshold is too low and that the registration burdens on the smaller firms are significant,” Watson said. “If small to mid-sized managers are able to spend less of their resources on compliance, they will have more resources available for making and managing investments.”
While policy changes affecting the private equity industry -- and the political will to implement them -- are largely still unclear, one thing is certain: Dealmakers big and small are watching every move closely.
“There’s a real opportunity for regulatory and tax policy to go in a dramatically different direction and we’re looking very carefully at all the implications,” said John Finley, the chief legal officer at New York-based Blackstone, the world’s biggest private equity firm. “There’s a possibility that the changes could be pretty sweeping.”
— With assistance by Lynnley Browning, and Elizabeth Dexheimer