The VC Carried-Interest Tax Debate

Today was an exciting day on Twitter. Huge debate/fight regarding the proposed "Carried Interest" tax treatment for private equity and venture capital fund managers. I mostly sat on the sidelines and retweeted the excitement (Chris Dixon told Jim Robinson IV of RRE to fuck off!). And in the middle of all this, my man Eric Wiesen, a newly appointed General Partner at RRE sent me this email…

From: Eric Wiesen
Subject:     Here's the problem
Date: June 5, 2010 9:58:21 PM ED
To:     Matt Mirele 
It's a problem because this tax will come in taxing carried interest, a sort of quasi-principal investing structure that GPs and LPs came up with decades ago to create the 80/20 split on the fund's upside that everyone agreed to. Post this change, LPs will be taxed at 15% which GPs are taxed at 35 or 40 or 45% (or wherever the marginal income tax rate winds up). And that will be true for current funds. But those who think this is a steady state are probably naive. Some future funds will be set up in a way that will pass some, possibly much of this tax increase onto LPs. And that lowers returns. Lower returns yield lower allocations to the asset class.
The alternative is actually more likely, in my view. GPs will simply come up with a different way to structure funds to simply avoid "carried interest" altogether. That's a structure that, as I said above, was merely convenient given the economics everyone wanted. Now it will be a shitty structure because despite risky, highly-uncertain returns that come many years after the original investment, GPs will be taxed as if it were "revenue". Most likely, everyone will simply get together and come up with another way to structure funds that avoids carried interest altogether. One way would be to simply say that GPs contribute "intangible assets" the way startup founders do as consideration for their founder shares. And for these intangible assets GPs will get a straight up 20% equity stake in the fund. And that will be fine for everyone (except Uncle Sam). But it's actually not as good for LPs because it's a lot harder to claw back a straight up equity ownership by GPs than it is for carried interest. 

Eric Wiesen :: General Partner, RRE Ventures

Eric is a man I know and respect. The added emphasis is mine, but the email is reprinted here with his permission. 

Now I'm not a money manager and I don't claim to be an expert on the inner workings of venture capital, but this whole argument strikes me as wrong headed…

Essentially, what the proposed law will do is recognize that money management is actually just a form of labor like any other, and tax the fees that money managers earn just like normal income as opposed to giving their management and "carry" fees capital gains treatment. Chris Dixon called this fair. VCs, acting according to their own self-interests, revolted. 

Now, back to Eric's argument: 

Future funds will be set up in a way that will pass some, possibly much of this tax increase onto LPs. And that lowers returns. Lower returns yield lower allocations to the asset class. 

Sure, SOME future funds will be setup in a way that screw LPs, but who the hell is gonna want to invest in those funds? Changing the standard fund structure across the venture capital industry will require the formation of a VC cartel. And that ain't gonna happen. Huge collective action problem. 

The reality is that VCs compete for LP money. And LPs are profit maximizers. I refuse to believe that they'll just passively accept shittier returns. I also refuse to believe that newer, younger VCs won't step up and say "Hey, I'll gladly take these management fees regardless of whether they're taxed as ordinary income or not. It's still good money!!"

More realistically, any fund manager who tries to game the system in a way that screws LPs to avoid this tax treatment better either have the last name Khosla or have very rich and very stupid friends. 

Honestly, I don't see this law affecting LPs one iota, nor do I see it diverting money from venture capital as a class. The only people I see this affecting are the VCs themselves. And really, they should pay their taxes just like everyone else. They ain't special.