For years, private equity funds have benefited from favorable tax rates on long-term capital gains and carried interest, often paying tax rates 2,000 basis points lower than ordinary income. Lauded by promoters as an incentive for capital investment and a deserved reward for savvy capital deployment and condemned by detractors as a loophole exploited by the wealthy, capital gains tax policy has long been a contested political topic. However, despite much discussion by politicians, commentators, and special interest groups, capital gain tax policy has remained largely unchanged since 1990, with private equity firms and managers reaping the benefits.
In 2021, the incoming Biden administration threatens to disrupt the status quo through a progressive tax policy that includes closing the so-called “carried interest loophole.” This tax policy will have near-term and long-term ramifications throughout the private equity market as fund managers, investors, and company owners adapt strategies to the impending Biden era.
In the near-term, BCE expects to see a flurry of transactions executed while existing tax policies remain in place. Company founders and entrepreneurs will be more willing to transact immediately to limit the value of taxes paid rather than wait. Additionally, funds will look to accelerate the sales of portfolio companies to lock in profits and maximize carried interest. While the timing of tax policy changes remains unclear, it is important to note that tax policies enacted in late 2021 could be applied retroactively to include all transactions in 2021. Look for an active deal market in the final days of 2020.
Over the long term, the ramifications of the proposed Biden tax policy are expected to be transformative and long-lasting. Under the current tax policy, a typical fund retains 20% of the profit from investments, income that is considered capital gains and taxed at 20%. In a future scenario where capital gains are taxed as income at 40%, funds would need to increase fee percentages to 26% to preserve the same after-tax value. Increasing fees will prove a hard sell for investors, forcing funds to make a difficult decision: maintain the current 20% fee structure and absorb increased taxes or increase fees and convince investors to absorb some portion of the increased taxes. Additionally, increased capital gains rates have the potential to elevate sellers’ valuation expectations to maintain take-home, after-tax profits. If sponsors are unwilling to meet valuation expectations, look for sellers to delay liquidity events in favor of retaining their businesses and associated cash flows.
While the future remains uncertain, a Biden administration is projected to propose tax policies that alter the private equity market and the outcomes of Senate runoffs in Georgia will have great impact the new administration’s ability to enact change. Years of favorable tax policies have led to strong returns and rapid fundraising, leaving funds with record amounts of dry powder. As funds deploy this capital, tax policy changes will dictate sponsor, investor, and company owner strategies.