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Tax Venture Capitalists, Ventures Go Unfunded — Does Reich Understand Incentives?

A liberal pitches a tax-and-spend idea with no basis in economic behavior or statistics. Ho hum.

by
Jeffrey Carter

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May 25, 2010 - 12:53 pm
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Robert Reich is advocating a rise in the tax on “carried interest” — the money that venture capitalists (VC) and private equity (PE) partners make after all their investors have been paid. Reich would like to see the tax on carried interest go from its current rate of 15% to the top rate of 35%. Of course, next year, the top rate will be 39.5%, and even higher for higher earners.

In Reich’s world, virtually every investment that a VC or PE firm makes has the Midas touch. They never lose. However, in the real world they do lose, often.

VC and PE partners raise money for their funds. They receive a management fee and a percentage of the funds raised. They are taxed for this effort, as they should be, since they have zero risk associated with this activity. No matter what happens with their investments, they still get paid. Hence, they pay the highest rate of tax, whatever it is.

But once the money is raised, they become bankers and investors. In VC, they make investments in up-and-coming companies on the cutting edge of new industry. Billions of dollars of capital have been invested in Silicon Valley tech firms, biomedical firms, green energy firms, and anywhere there is innovation in the world. If the firms they invest in are successful, the VC makes money by selling them, or taking them to an initial public offering (IPO) on a public exchange.

The investors in the fund are then paid off from the proceeds of the sale. The VC keeps the rest and is taxed at 15% on those gains.

However, nine out of ten of these ventures end in failure. VC is a risky business fraught with danger.

The PE world is much different. They raise funds, just like the VC. Then they invest the funds by purchasing existing, operating companies. They internalize the companies and float a large amount of debt on that company.

The next step is to restructure the company so that it runs more efficiently and can grow quickly — quick growth is necessary to pay off the debt load. As the debt begins to be paid off, the PE firm either sells the company or takes it to an exchange for an IPO. They are taxed at 15% on those gains.

If the firm doesn’t grow, the debt load eats the PE firm alive. It either has to wait longer for a return on investment, or lose. Leverage causes huge profit when the firm is right, but cuts mercilessly when wrong.

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