Advisers may eschew private equity deals if tax plan passes

Financial advisers are likely to cut back on using private-equity investments or look for lower-fee products if President Obama’s plan to change the tax on carried interest from capital gains to ordinary income rates is approved.

“I would have to rework the way I do things, because there’s no in-centive for me to have that carried income if it’s going to be taxed as ordinary income,” said David Blain, president and chief investment officer of D.L. Blain & Co. LLC, an investment advisory firm in New Bern, N.C., that invests $25 million of its $65 million in assets in private-equity ventures he manages.

Under Mr. Obama’s proposal, which would raise an estimated $2.7 billion in tax revenue in fiscal 2010, the change would affect partners of hedge funds, private-equity funds and venture capital funds.

Current long-term capital gains rates are 15%, compared with 35% for the highest marginal ordinary income tax rate.

Mr. Blain has invested his clients’ funds in private-equity partnerships he has managed, but he said he may be less likely to put the ventures together if tax rates are raised.

“The returns in that area are going to be more difficult going forward than they have been in the past,” he said. “It’s just part of what we offer to clients. It may not be worth it anymore.”

Carried interest is the share of profits that general partners of private-equity funds receive as compensation for managing a new venture, despite not contributing any initial funds. The compensation method is aimed at motivating the general partners to improve the fund’s performance.

FEES COULD RISE

Private-equity fund managers could raise management fees and lower or remove performance fees if the proposal is adopted, fears Shana Orczyk, research analyst for Peak Financial Management Inc. of Waltham, Mass., which manages $300 million, including about $20 million in private-equity funds.

Most private-equity fund managers charge 1% to 2% in management fees to cover the cost of managing the fund. Such fees could rise to as much as 3% to 4% if the proposal is enacted, Ms. Orczyk predicted.

An increase in the fees would be harmful to investors, she said.

“You want your manager motivated. If they’re just getting a set management fee, what’s the motivation for them to perform?” Ms. Orczyk said.

“I would be more particular with some of the managers we use,” if the proposal were adopted, she said.

“If there’s a change in fee structures, I might consider one that’s more advantageous to me and my clients,” Ms. Orczyk said.

Management fees are already taxed at ordinary income tax rates. If profit levels of the funds exceed an agreed-upon threshold, private-equity managers typically earn 20% to 25% of the profits as performance fees, or carried interest, on which capital gains taxes are assessed. Such interest is the primary source of income for private-equity fund general partners.

Partnerships pay no federal income tax directly. Income or losses flow through to the partners, who bear the tax liability when they pay their personal taxes.

Changes in investments would depend on any new fee structures created, said Tom Orecchio, a principal with Modera Wealth Management of Old Tappan, N.J. The advisory firm manages about $350 million, of which $30 million is invested in hedge funds, private-equity funds, real estate funds and other alternative investments.

“We’re looking for fair incentives” for managers to perform, Mr. Orecchio said.

“If [the private-equity managers] come up with something that provides incentives [for themselves], we’d consider it,” he said.

The current business model of charging relatively low management fees and high performance fees results from the favorable capital- gains-tax treatment accorded the performance fees, Mr. Orecchio said.

“So whatever they come up with, they’re going to look to take advantage of some other existing tax rule. We’re dealing with some pretty smart people here,” Mr. Orecchio said.

If the tax proposal goes through, real estate partnerships will be hit hard, said Jeff DeBoer, president and chief executive of The Real Estate Roundtable, a Washington organization that represents the commercial-real-estate industry.

“It will discourage activities, and it will cause a reduction in construction work and a reduction in property values,” he said.

About half (46%) of the 2.5 million partnerships in the United States are real estate partnerships, and an estimated $1.5 trillion worth of commercial real estate is held by partnerships whose general partners earn carried interest, Mr. DeBoer said.

SENDING A MESSAGE

Real estate interests and other private-equity groups are attempting to get their message across to members of Congress, he said.

“When policymakers step back and think about the proposal, particularly in light of the current economic situation, many members of Congress may pause and rethink whether now is the appropriate time to be raising taxes, particularly on commercial real estate,” Mr. DeBoer said.

While private equity does not make up a large share of assets managed by financial advisers, some advisers use such investments to get better returns for clients and to provide absolute returns during down markets.

The proposal would also hurt investments in cutting-edge technology, which Mr. Obama said he wants to promote, such as the life sciences, information technology and green technologies, said Mark Heesen, president of the National Venture Capital Association in Arlington, Va.

E-mail Sara Hansard at [email protected].