“Carried interest” is extraordinarily misleading. It implies a fixed and very certain income stream in the way that interest bearing accounts at banks do. Which is the problem. Carried interest is the opposite of certain, and it’s not even income.
It’s a share of the “profits” on an investment that is paid to the investor who committed the capital in rather intrepid fashion. Which explains the placement of profits in quotes.
They aren’t gains borne of putting money to work in a blue-chip corporation, or an index fund. As evidenced by the small fees investment firms charge on index or basket-of-blue-chip style investments, there’s little financial reward when investors find the known. But when investors courageously discover the unknown or unexpected while taking big risks, the gains can be enormous. Let’s just not shrink the latter by referring to it as “carried interest.”
Let’s not because private equity managers are largely in the business of improving the businesses invested in. Improving is italicized simply because it frequently implies investing in a business that is in a distressed situation of some kind.
Which means the profits gained from an investment in what’s distressed only reveal themselves after the investors fix what’s wrong; whether it’s management, too many employees (or too few), faulty product or service offerings, improper financial structure and financing, and surely much more. Put another way, carried interest is what – maybe – comes after an investor puts capital to work in what most investors wouldn’t touch.
Except there’s more. It’s not just about fixing what’s broken, or worse. Not infrequently private equity investors are buying businesses that, by most measures, aren’t broken. Yet they do so because they feel they can make spectacular what’s already great.
Which is arguably a more perilous capital commitment than the investment in the distressed commercial entity. Think about it, and in thinking about it, imagine putting capital to work in what broadly informed markets already think is fully valued on the supposition that you see what the markets do not. Talk about taking risks for highly uncertain profits.
Yet there’s even more. Never forget that capital is precious. Which perhaps explains why politicians and those outside the proverbial arena talk so blithely about closing the alleged carried interest “loophole” to tax what they deem “income.” They imagine a world that doesn’t exist, one defined by the impossibility that is “easy money” to put to work in easy-to-find investment opportunities.
How we know the “easy” part is utterly nonsensical can be found in the investment committee meetings at which private equity investors must pitch fellow employees and partners on their specific, and highly risky investment ideas. Those meetings are known to be brutal, and they are precisely because money is never easy exactly because private equity investing is far from easy. The questions lobbed at the investors making the pitch are detailed, endless, and frequently pregnant with skepticism, disdain, and usually both.
Never forget that taxes are a price, or worse yet, a penalty. Politicians who should know better are presently floating the notion of penalizing some of the most crucial investing of all whereby capital is put to work to resuscitate what’s on life support, and much more challenging, enhance what’s already thriving.
We need much more of this investment, not less. Which means instead of penalizing “carried interest” as regular income to be taxed, we recognize its singular importance to economic progress and cease penalizing it altogether.
