In Targeting Carried Interest, Republicans Sadly Only See The Success

It’s easy to forget that Blackstone Group co-founder Stephen Schwarzman didn’t start out as a private equity investor. Private equity is what he and co-founder Pete Peterson (1926-2018) migrated to after successful investment banking careers. In private equity, they saw that “you could really improve the companies you bought.”

What brought Schwarzman and Peterson to private equity rates serious thought as President Trump encourages House Republicans to raise taxes on carried interest. The higher taxes would penalize performance, which means they would in effect raise the cost of going into the proverbial burning building to save it. That’s what private equity investors not infrequently do when they put investor capital to work. See again why Schwarzman got into private equity in the first place.

As opposed to raising a fund for him and Peterson to invest in blue chip corporations, they would find the businesses in trouble, the ones on fire in a figurative sense, and that the typical investor had given up on. They would improve businesses that were at times at death’s door, and they would be compensated for reviving businesses not expected to make it. Which is a long way of saying that carried interest is the opposite of income exactly because carried interest is so hard to attain in the first place.

Translated, “carried interest” is much more than a performance-based fee, it’s a performance-based fee that rewards private equity managers for doing the dirty work of investing, of fixing what appears unfixable to most. It’s what is paid out to the manager of a private equity fund after the manager has compensated investors in their fund at a pre-set rate. In other words, if private equity investors succeed in achieving returns agreed to in advance for investors based on successful investments made in businesses that aren’t blue chip, carried interest is their compensation for doing so.

Yet as you’re reading this, Trump and Republicans are contemplating raising the tax on carried interest. They see the earnings of private equity managers, and plainly view them as an easy source of abundant tax revenues. What they miss is that the attainment of the carried interest they’re so eager to tax at higher rates is anything but easy. Evidence supporting this claim can be found in occasionally enormous returns paid out as “carried interest.” Put another way, if it were easy to buy ailing companies before turning them around, then carried interest would reflect the previous truth via reduced payouts. Carried interest is high in the rare instance that it’s achieved precisely because it’s so difficult to achieve.

Trump and the Republicans would be wise to contemplate this truth before taxing the bright, shiny object. The simple, crucial truth is that capital goes where it’s treated well. Which means if Republicans raise the tax on extraordinarily difficult to achieve carried interest, the marginal cost of for private equity investors to enter the proverbial burning building will rise. Seriously, why risk not just capital but enormous amounts of time and energy for activity that members of Congress are contemplating taxing as typical – and yes – ordinary income?

Schwarzman answers the above question. As he noted in his incomparable memoir, What It Takes, “Once you succeed, people only see the success.” It’s so true, but it’s also so sad. Formerly the party that cheered economic achievement and its myriad societal benefits, the Republicans have become the party that sees success as just another thing to tax.