Private equity and tax: a reputation issue?

While the administration’s motivations are sound, we must remain alert to any unforeseen outcomes of this tax shift – namely, what it could mean for the private equity sector.

If you’re not already aware, the carried interest tax loophole reduces the tax levied on investment profits from up to 37% to 20% — with the catch that firms hold the investment for at least three years. In layman’s terms, the loophole incentivises investors to hold assets for the longer term and deters them from exiting too early. It rewards GPs for investing mindfully with a lower CGT rate.

That’s at least in part because Trump has been somewhat of a standard bearer of best practice across private equity. As part of the 2017 Tax Cuts and Jobs Act, he changed the holding period – required to be eligible for this tax benefit – from one to three years.

This was a sorely needed and undeniably positive move. Extending the holding period motivated firms to take a more holistic, supportive approach to their portfolio companies. Rather than seeing them as little more than a money-making exercise and jeopardising their future success, they were encouraged to drive genuine, sustainable growth. Trump bolstered US businesses and the wider economy, as a result.

Now, though, President Trump is expected to close the loophole. In many ways, I can completely understand why. We are all aware of the US budget deficit and that the President has made it his mission to slash government spending. But there is one unintended consequence of removing the loophole that needs addressing.

Namely, that it could unintentionally encourage predatory practices across private equity.

‘Predatory’ is a term that has followed PE since the beginning. Asset-stripping, premature exits, and the like are all qualities that have dogged the industry for years – and are practices and methods already far too prevalent across the sector. There was a record number of PE-backed bankruptcies last year. No one wants that to increase.

Private equity should be a force for good. It should give businesses the firepower, expertise, oversight, and collaboration needed to realise their potential and see exponential growth. It should not be careless, thoughtless, distant, or emotionless. Without the right incentives and deterrents, however, these could hypothetically become commonplace.

M&A activity is expected to increase this year, and in this more favourable monetary environment, I know funds are itching to unleash all the dry powder at their disposal. High-growth, high-potential businesses all across the US will be looking for that boost of capital to take them to the next level.

However, without guarantees of a long-term – and not transactional – relationship, the appetite for investment could possibly fall. Over a third of PE-backed companies now say the reputation of the firm is important to them. Without the behavioural guardrails and incentives in place, which the President rightfully implemented in his first term, we could even see PE suffer.

Private markets could take a hit. It’s in everyone’s interests – of all parties included in the investment lifecycle – for the carried interest tax loophole to remain intact.

The US Government is right to pursue spending cuts, and I am all for measures that ensure there is more money in the pot to bring meaningful change to the country. I can see how closing the carried interest loophole has the potential to help the administration achieve its goals, but worry there could be unforeseen consequences to this particular move.

Ultimately, the carried interest tax loophole has provided the incentive for private equity to operate and invest for the long term. Without it in place, we could see firms fall back into the bad short-term habits that have no place in our sector.

I’d urge the US Government to reassess this decision. The reputation of our sector cannot and should not sour, and we can’t undo the good work that has shifted approaches to portfolio growth and development since 2017. Instead of purely pursuing IRRs and profits for the short term, private equity should build its relationships with the business community and strengthen ties.

At the end of the day, my core message is simple. We need to mend private equity’s reputation and not do anything to inadvertently worsen it.

Kade Thomas is the founder and CEO of Emory Oak Partners