Short-term pain, long-term gain

It’s ultimately in the best of interests of fund managers to accept tax increases, such as the UK's new 28% capital gains rate, and move on.

In the UK, Prime Minister David Cameron has repeatedly warned of the 'pain to come' as it becomes evident that increased taxes and spending cuts will be brandished as weapons in the battle to chop an intimidating fiscal deficit down to size.

Part of this pain came in the form of today's announcement in the UK budget that capital gains tax would rise from 18 percent to 28 percent – though this was less of an increase than many had predicted.         

The word ‘pain’ has also been frequently employed in the US, not least when taxpayer money was being shovelled into bank bailouts.

Welcome, in other words, to the age of austerity.

In this brave new world, everyone is being asked to make sacrifices – and that includes investment fund executives. In the UK budget it was announced that capital gains tax – which applies to carried interest schemes – would be raised from 18 percent to 28 percent for top-rate taxpayers. In the US, a more complex formula is being grappled with which involves a percentage of carry being treated as income.

Whatever rates and methods of taxation are finally agreed in the US, it is clear that the wind is blowing in only one direction on both sides of the Atlantic. General partners will no longer enjoy the tax treatment that prevailed at the height of the private equity boom, and which led one seasoned London investment professional to famously proclaim that fund managers paid less tax than their cleaners.

From the hostile responses of industry bodies, it is clear that some in the alternative investment universe believe that – instead of paying less than their cleaners – they are now being taken to the cleaners.

They had argued that the mooted idea of treating CGT as income would be disproportionate since it would mean a 40 percent or 50 percent rate and would have made the UK’s capital gains tax regime the harshest in the Western world. This fear has now dissipated but there will probably still be some disappointed at any kind of CGT increase.   

In London, there has been talk of a mass exodus of fund managers to Switzerland or other tax-friendly jurisdictions. Some evidence of this occurring is apparent in the hedge fund world but it may be exaggerated in the context of other types of alternative investment funds due to the need to stay close to portfolio assets.

In the US, the Private Equity Council – which represents LBO firms – believes data going back 20 years proves that higher taxes mean less private equity investment. And this, in turn, would have a harmful effect on the economy, the recovery and job creation. The council estimates that doubling the tax rate on carried interest would reduce the amount of private equity investment in the US by between $7 billion and $27 billion per year.

On the face of it, this is a forceful argument, though cynics might point to the excesses of the leveraged buyout boom and ask us to consider whether a more subdued level of investment activity is necessarily as harmful a development as the council invites us to believe. (For example, didn't over-leveraged mega-buyouts ultimately harm the economy?)

For all the arguments and counter-arguments, alternative investment fund managers are not facing up to reality if they believe the status quo can be maintained when it comes to taxation. To be fair, many industry professionals acknowledge this and some may even welcome the transition. They might conclude that making financial sacrifices will hit the pocket but help win public acceptance. In other words: short- term pain for long-term gain.