How NYC Regulations Impact Private Equity Firms
In today’s fast-paced economy, private equity has come to control a massive swath of the American economy. According to US government estimates, the private equity industry employs almost 12 million people through its portfolio companies. Given the important role that private equity now plays in every industry, government regulators have begun to look at the industry more closely. As a result, private equity is subject to a number of key current and proposed regulations – some of which impact private equity specifically, and some of which impact corporate America more broadly.
The first – and likely the most talked about – regulatory area of concern regarding private equity is the tax treatment of carried interest. As you likely know, private equity firms typically receive 20% of the profits generated on their deals in the form of “carried interest”. This economic profit interest is then distributed to the private equity professionals who make up the general partnership (in the GP/LP structure). Generally speaking, carried interest is taxed at the long-term capital gains rate, which tops out at 20%. By comparison, ordinary income can be taxed at a marginal rate nearing 40 percent or greater in New York City.
Given that this favorable tax treatment benefit accrues mostly to high-earning private equity professionals, many politicians and regulators have targeted the so-called “carried interest loophole” with the intention of taxing carried interest at the tax rate for ordinary income. This has attracted interest from politicians on both sides of the aisle, from Elizabeth Warren to Donald Trump (who called the policy “unfair to American workers”). This preferential tax treatment was actually almost eliminated under the Inflation Reduction Act of 2022, but holdout Senator Krysten Sinema (Arizona) refused to sign the bill unless the carried interest loophole was preserved. While this treatment is safe for now (thanks in large part to the American Investment Council, private equity’s industry lobbying group), it will be important for private equity professionals to monitor this closely – the potential financial impact to you personally can be massive.
“Corporate Tax Policy”
Private equity is also subject to corporate tax policy more broadly, for a number of key reasons. The first is that corporations’ after-tax-free cash (i.e., what is available for distribution to equity investors) is directly impacted by tax rates. The corporate tax rate was 35% for many, many years before being reduced to 21% in 2017 as part of the Tax Cuts and Jobs Act (the “TCJA”). This had the effect of increasing corporate equity values by reducing tax burdens and increasing equity-free cash flows (generally speaking).
Tax rates and policies also have other knock-on impacts on private equity investments. Private equity firms typically use a high degree of financial leverage (i.e. debt – hence “leveraged buyout”) to finance their acquisitions. This is financially advantageous for a number of reasons, one of which is the tax deductibility of interest. More precisely, this means that corporations can treat interest on debt as a regular way expense (like salaries or sales and marketing costs). While the lower corporate tax rate reduced the so-called “tax shield” provided by interest payments, this remains a key component of the private equity playbook. The TCJA took further steps to reduce the benefit to private equity firms from leverage, including limiting how much interest a private equity firm could deduct for tax calculation purposes – specifically, the law limited the amount of interest that could be deducted to 30 percent of adjusted taxable income.
While there are many additional aspects of tax policy and regulation that impact private equity, many of them are beyond the scope of this article. That said, it is important for any aspiring private equity professional to be keenly aware of their existence and follow closely for any developments or changes in the law. These include but are not limited to, the capitalization treatment of certain cash outlays such as research and development or capital expenditures, structuring and taxation of certain partnership structures, among many others. Private equity professionals will often consult third-party experts such as lawyers or tax specialists on these matters but must be well-versed in the basics to maximize value for their investors.
Beyond these existing regulatory considerations, there are a number of brewing political developments that have the potential to massively change the structure and economics of private equity. Much of this is due to animus toward the industry, which – rightly or wrongly – is often maligned for its high levels of compensation and the (oftentimes misguided) view that private equity simply cuts jobs and utilizes financial engineering to drive returns.
“Stop Wall Street Looting Act”
Of greatest concern to the private equity industry is the “Stop Wall Street Looting Act’, sponsored by Senator Sherrod Brown of Ohio (Chair of the Senate Banking Committee) and a number of other Democratic politicians. This law has a number of stipulations that would fundamentally disrupt the private equity industry, and if passed could potentially end the private equity industry as it stands today. This includes a range of provisions, including making private equity partnerships liable for the debts of their portfolio companies, banning dividends and job outsourcing within two years of initial investment, reworking the priority of debt claims in bankruptcy such that workers receive preferential treatment to financial creditors, and increasing overall reporting transparency around fees and performance. In statements supporting the law, Democratic politicians go as far as to call out specific private equity firms by name (such as Sun Capital, which is criticized for the bankruptcy of portfolio company Shopko). While this law has little to no chance of passing in a divided Congress, the fact that these ideas are being bandied about should spark great concern in private equity firms across the country. Quite ironically, this law is supported publicly by a range of groups including the American Federation of Teachers, the country’s second-largest teachers union. The reason this is ironic is that many teachers have their public pensions with groups such as the Teacher Retirement System of Texas, which counts itself as one of the largest private equity limited partners in the world.
All of this goes to show that the legal, regulatory, and political climate can have a direct impact on private equity firms, and on your life as a private equity professional. While many of these things will be out of your control, you would be well-served to stay up to date on these topics so that you are positioned to adapt and succeed regardless of any developments in a regulatory framework.
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