January's Georgia runoff, which determines who controls the U.S. Senate, will indicate the likelihood of President-elect Joe Biden's proposed tax changes being enacted, including a measure that will affect private equity's lucrative carried interest.
"Taxes are the primary topic of conversation" among the private equity industry following the election result, Brian Richards, chair of the Paul Hastings LLP global private equity practice, said in an interview. "I think the general mood is that people are concerned about the impact of tax policy."
Carried interest is taxed as capital gains. Under Biden's proposals, capital gains tax would increase to a potential 43.4% in 2021, including a 3.8% tax on net investment income, from 23.8%, for those with adjusted gross income exceeding $1 million. This will hit private equity's share in a funds' profits.
Carried interest has been threatened by proposed tax changes before, and previous administrations have considered taxing it as ordinary income, as opposed to a capital gain. But the current proposal changes the game. "You could still have carried interest treated as capital gains, so you win the battle. But if all capital gains are taxed at the same rate as ordinary income, you've lost the war," Richards said. Carried interest is a small fraction of the capital gains earned each year in the U.S. but the proposals would change both the taxation on carried interest, as well as real estate, or any other capital asset.
Phil Gross, the chair of Kleinberg Kaplan Wolff & Cohen P.C.'s Tax Department, agreed, and said a lot of people are concerned about tax increases. "If Biden takes it too far left, if there's a democratic senate [and] the rates to go up too much" it would "hit a lot of high net worth people," he said. A Republican senate means a capital gains tax is "much less likely to increase that much," Gross added. "There might be an increase in capital gains rates, but not up to regular ordinary rates."
But Nicholas Tsafos, partner-in-charge of EisnerAmper LLP's New York office, believes a new government will be controlled by overarching issues stemming from the coronavirus pandemic — controlling its spread in the U.S. and getting the economy into better shape.
"Whichever administration took over would have to be very careful in terms of how they raise taxes, and the taxes that they raised on people and corporations, to make sure that this economy can get back on its feet," Tsafos said.
Government knows the private equity industry has backed a range of companies and industries, like technology and healthcare, for example, "that made the last seven months or so easier to deal with," Tsafos said. " I think all politicians are taking that into consideration."
Spotlight on the listed alternatives
Capital gains tax is a "non-event" for listed alternative asset managers like The Blackstone Group Inc., KKR & Co. Inc., Carlyle Group Inc., Apollo Global Management Inc. and Ares Management Corp., Jefferies LLC Research Division analyst Gerald O'Hara said. "It is for the shareholder or unitholder, but it's not for the company itself anymore."
"Generally speaking, corporations pay corporate taxes and do not benefit from things like capital gains tax treatment or carried interest tax treatment," Keefe Bruyette & Woods Inc. Research Division analyst Robert Lee said, adding "At the end of the day, these are corporations and what matters to them is the corporate tax rate."
The current 21% rate came into effect in 2017, slashed under the Trump administration from 35%. The change was a sweetener for a number of these firms' conversion from a partnership structure to a c-corporation structure, the latter having more of a tax burden for companies. But under Biden's proposals, corporate tax is expected to rise by seven percentage points to 28%.
There is a negative earnings impact in a conversion to a c-corporation, but one of the key drivers of conversion "was to be able to expose your business to a much broader universe of investors who were precluded from owning you in as partnerships, and that part of the equation is intact, regardless of where the rates stay where they are or go up," Lee said.
Higher corporate taxes will negatively impact the earnings they report, but in that sense they are "pretty much like any other U.S. corporation in terms of there being some impact depending on each firm's unique kind of tax structure or business space," he added.
The general mood from the listed alternative asset managers is optimistic, O'Hara said. They expect "significantly less slings and arrows at various different heads of states, heads of corporations, a little bit more of a partnership effect, I think, in civility, if you will."
Maurice Collada, private funds partner at Kleinberg Kaplan, shared the sentiment. Stability will be helpful for private equity managers as they plan their investment programs over the long term timeframe typical of private equity investments, he said.
Biden's commitment to re-entering the Paris Climate Agreement as well as proposed infrastructure spending and a green stimulus package also creates opportunities for the asset class going forward.
Anything that relates to climate change, renewables, impact investing, ESG has "significantly less headwind — perhaps there's a greater tailwind as you listen to what Biden's going to be focused on," which will benefit alternative asset managers who have been beefing up their ESG capabilities, O'Hara said.
KKR, for example, has launched its own Impact Fund — yet another way it can diversify its business and capitalize on shifting demand. "I think you're going to hear more and more as we move forward" from the listed alternative asset managers "who are, in my view, largely ahead of the game as it relates to the traditional asset managers more broadly," O'Hara added.
The private equity industry is "very efficient in finding ways to capitalize in technology and areas where government is getting involved," EisnerAmper's Tsafos said. Clean energy and infrastructure are "areas where I think private equity is going to find opportunities because this is what this administration is looking for, and I think they might make it easier for investors to get into those industries."