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Saving Private Equity

Posted on October 24, 2007 by Joann M. Weiner

Document originally published in Tax Notes Today
on October 24, 2007.

Roughly 63 years after the Allied landings at Normandy, the private equity industry launched its own version of Saving Private Ryan.

Faced with a double-barreled assault on its tax position from the House and the Senate, the private equity industry turned to its big guns — the Private Equity Council Group and its commander in chief, Bruce Rosenblum of the Carlyle Group — to save private equity.

The lobbying efforts intensified in June following the Blackstone Group's efforts to raise more than $4 billion by going public. The Blackstone initial public offering (IPO) attracted congressional attention both because of its relative novelty — only one other large private equity (leveraged buyout/venture capital) firm, Fortress Investment Group, had gone public in the United States — and for the revelation of the astronomical reward that some Blackstone Group partners stood to receive from the IPO. Blackstone's filing with the Securities and Exchange Commission showed that Blackstone's two founders, Stephen Schwarzman and Peter G. Peterson, together would collect $2.33 billion.

Armed with the SEC information, which opened up the structure of the Blackstone Group to the public for the first time, some members of Congress began an intense counter-assault. It decided to no longer merely undertake a study of the tax treatment of private equity firms, hedge funds, venture capital funds, real estate funds, funds of funds, mezzanine debt funds, and structured debt fund and other alternative asset management and financial advisory business activities, but to undertake a frontal assault and consider introducing legislation attacking the tax-favored status of those activities. (For ease of exposition, these various funds are referred to as alternative investment funds.)

Interest in the compensation arrangements of the alternative investment sector had been simmering but was focused on conducting studies rather than introducing legislation. In March an aide to Senate Finance Committee ranking minority member Chuck Grassley, R-Iowa, indicated that the examination of hedge funds included considering whether carried interests should continue to obtain preferential tax treatment relative to other forms of similar compensation. Grassley announced that the committee had no plans to introduce legislation at that time

The issue boiled over in June when former Treasury Secretary Robert Rubin said Congress should give serious consideration to taxing some compensation of these fund managers at ordinary income rates rather than at capital gains rates. Although Rubin was not expressing the view of his current employer, Citigroup, many corporate investment firms and rivals to private equity firms support the private equity legislation on the view that it would level the playing field. (See Sarah Lueck, Jesse Drucker, and Brody Mullins, "Congress Hunts for Tax Targets Among the Rich," The Wall Street Journal, June 22, 2007.)

The possible tax change struck a nerve in the tax community. Congressional committees have held several hearings on this issue since July, dozens of conferences have taken place, and thousands of pages of analysis have been written on the tax treatment of partnership carried interests and related issues.

Private equity fund managers are known for making shrewd investment choices that lead to spectacular returns on their investment. During the summer, these managers may have made one of their most spectacular investments, earning an astronomical rate of return.

How did these private equity fund mangers earn such returns? Not the old-fashioned way of Smith Barney ("we earrrrned it," according to their slogan). They earned it the new-fashioned way — via lobbyists.

Taxation of Private Equity

One potential legislative measure would have treated net income from an investment services partnership interest as ordinary income for the performance of services (H.R. 2834, cosponsored by House Ways and Means Committee member Sander M. Levin, D-Mich., and Committee Chair Charles B. Rangel, D-N.Y.). Another measure would have treated all publicly traded partnerships that directly or indirectly derive income from investment adviser or asset management services as corporations (S. 1624, cosponsored by Finance Committee Chair Max Baucus, D-Mont., and Grassley).

In other words, the tax rate that applied to a significant portion of an alternative investment fund manager's profits might have risen from 15 percent to 35 percent or more.

The tax change was the equivalent of a declaration of war.

Given the more than doubling of the tax rate, alternative investment fund managers began investing in a campaign designed to persuade Congress that the tax rate applied to their compensation (the carry) should not more than double. Dozens of lobbying firms jumped into action, including the Washington-based Private Equity Council, which spearheaded the effort to head off any tax bill that would increase the taxation of private equity firms.

And, unlike the soldiers on Omaha Beach, the lobbyists did not have to cross mine-studded beaches and scale escarpments to achieve victory. They simply needed to spread the word that private equity was under attack.


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SIDEBAR: Private Investment Fund Structure

      The figure below presents a chart from the Joint Committee on Taxation that illustrates a typical private investment fund structure.

      In the typical structure, the fund manager is a separate partnership whose partners are the individuals with investment management expertise. The fund manger partnership is itself a partner in the investment fund partnership. The investors are limited partners in the investment fund partnership.

      In this typical structure, the carried interest held by the fund manager is a profits interest in the investment fund partnership. The IRS takes the position that the receipt of a partnership profits interest for services generally is not a taxable event. Because the character of a partnership's income passes through to partners, the fund manager's share of income has the same character as the income has when it is realized by the underlying investment fund. Accordingly, income from carried interests may be reported as long-term capital gain to the extent that the income is attributable to gains realized by the investment fund from capital assets held for more than one year.


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For the price of relatively minor lobbying expenses of some $5 million to $6 million, these fund managers stood to save taxes of some $4 billion to $6 billion or more in 2006 alone. If they succeeded in maintaining the status quo, they could generate benefits of $60 billion or more over the long term. It didn't take a "master of the universe" to do the math and figure out that the rate of return on the investment in lobbying expenses would be impressive.

Thus, the lobbyists went to work and shortly thereafter achieved their goal. With barely a whimper, the Democratic and Republican leaders in Congress simply raised the white flag.

As The Washington Post reported on October 9 ("Buyout Firms to Avoid a Tax Hike"), Senate Majority Leader Harry Reid, D-Nev., confirmed a statement he made last July that the Senate would not push through legislation concerning the taxation of carried interests this year. Grassley had made a similar statement in July that the private equity lobby had effectively killed any legislation dealing with the issue. Given the election year in 2008, this means the issue is off the table for at least two years.


Figure 1. Ordinary Income and Capital Gains Tax Rates, Individuals
1998-2010 (projected)




Source: Gregg A. Esenwein, "Capital Gains Tax Rates and
Revenues," Congressional Research Service Report RS20250


The lobbyists could do the math once again and calculate that their efforts had preserved a $10 billion tax benefit over the next two years. With a greater than 800 percent return on investment, the investment in lobbying expenses turned out to have been well worth the effort.

Mission accomplished.

It's Only Taxes

Federal tax law treats hedge and private equity funds as partnerships, and investors in these funds become general or limited partners. In general, a relatively small number of individuals, who are the general partners, manage these funds and provide investment advice concerning the use of the funds' assets.

In exchange for their services, the fund managers generally receive a management fee plus a share of the partnership profits as compensation, which is divided between an asset-based management fee as a share of the fund's capital plus an interest in the fund's future profits. The typical compensation structure is known as "2 and 20." The 2 refers to the management fee percentage, and the 20 refers to the percentage of fund profits received without a requirement to contribute capital to the fund. This right to receive a share of future profits is known as the "carry" or "carried interests."

Not all fund managers are compensated under the 2 and 20 formula. James Simons, the head of Renaissance Technologies, earned $1.7 billion in 2006 under his 5 and 44 compensation formula. Other relatively successful venture capital funds have increased their profit shares to 25 percent or 30 percent.

According to The New York Times, Simons's fund earned an 84 percent gross return and a 44 percent return after fees. That return, while sizable, does not approach the returns that investors may earn in other sectors. The CBN 600, for example, returned 272 percent while the Turkey Titans index returned more than 100 percent in the past year. Investors could also have made better returns than Simons by investing in index funds in India or China, which increased by more than 45 percent and 75 percent, respectively, in 2006.

If investors were uncomfortable with the emerging market risk, they could have invested in T. Rowe Price's European mutual stock fund, which returned a respectable 35 percent in 2006 and had a trivial 1.03 percent expense ratio. As René Stulz said in the context of hedge funds, "an investor in such a fund is paying hedge fund fees for mutual fund risk and returns."

A Sweet Deal on Sweat Equity

Managing an alternative investment fund is a lucrative business. The top 25 hedge fund managers made more in one year — $14 billion, or an average of $560 million each — than the CEOs of the S&P 500 companies combined. Individuals must have a net worth of $1.3 billion to make the Forbes 400 list of the richest Americans, and roughly 20 of this year's new members manage private equity or hedge funds.


Figure 2. Capital Raised by U.S. Private Equity Funds
(billions of dollars)




Chart taken from "The Taxation of Carried Interest," statement
of Congressional Budget Office Director Peter Orszag, before the Ways
and Means Committee, Sept. 6, 2007, p. 4.


By contrast, the Census Bureau reports that the median income for American households was about $48,000 in 2006, and the real median earnings of men and women working full time, year-round fell last year for the third year in a row. (There are no publicly available lists for private equity managers.)

Even though each dollar of earnings has the same purchasing power whether it is in the hands of a private equity fund manager or an autoworker, the tax code treats the income of the manager and the autoworker very differently. Private equity managers generally pay taxes at a 15 percent capital gains rate on their earnings. Everyone else pays at rates up to 35 percent or more on their income. The rate on wage earners can also go higher because wages are subject to employment taxes but capital gains are not.

Victor Fleischer, a University of Illinois law professor who has advised Congress on this tax issue, seems to understand the inequity of the situation. He refers to the tax treatment of partnership profits carried interests as "the single most tax-efficient form of compensation available without limitation to highly paid executives."

Local tax experts also understand that the tax code treats some forms of income as more equal than others.

Shifting ordinary income into capital gains income is what Eugene Steuerle, a former Treasury deputy assistant secretary for tax analysis and now at the Urban Institute, calls "tax arbitrage" that allows the recipient of the income to take advantage of the different tax treatment that applies to different types of income. As long as the capital gains rate is lower than the ordinary income rate, there is an incentive to engage in this type of arbitrage. (Capital gains receive a secondary benefit because, unlike ordinary income, gains are taxed only when realized and thus gain the benefit of deferral so that the effective capital gains rate is significantly lower than the statutory tax rate.)

In testimony before Congress, Steuerle said tax arbitrage opportunities reduce national income, drive talented individuals into less productive jobs, and add substantially to the debt in the economy. He also noted that regardless of one's political view, reducing tax differentials across types of income helps promote a "more vibrant and healthy economy."

Despite this bipartisan agreement on the adverse effects created by rate differentials, the differentials are essentially a permanent feature of the tax code. Figure 1 shows the difference between the ordinary income and the long-term capital gains rate for the past two decades. The two rates have diverged since 1990 when both forms of income were taxed at 28 percent. Since 1991, when the maximum tax rate on ordinary income rose to 31 percent, capital gains have had a favorable treatment, and this favorable treatment has generally increased as income tax rates have increased while capital gains rates have fallen. The current 15 percent rate for long-term capital gains is the lowest rate since Franklin D. Roosevelt was president.


Figure 3. Flow-Through Shares of All Business Returns,
Receipts, and Net Income, 1980-2004




Figure taken from Chart 3.1 (page 14) of Treasury Conference on
Business taxation and Global Competitiveness, Background Paper, July 26, 2007.


Outside the period 1988-1990 when both ordinary income and capital gains were taxed at 28 percent, capital gains have received a preferential treatment relative to ordinary income since 1921. With a projected revenue effect of $252 billion from 2008 to 2012, the capital gains tax preference is the fifth costliest tax expenditure in the code.

What's at Stake

Hedge fund assets and capital under private equity management are both significant and growing. According to Thomson Financial, assets in 8,500 hedge funds increased by 20 percent last year and totaled more than $1.2 trillion. The 566 domestic private equity companies manage slightly under half that amount.

In testimony before the Ways and Means Committee in September, Congressional Budget Office Director Peter Orszag showed that private equity firms raised more than $240 billion in capital last year and now manage about $1 trillion. Investment is significantly skewed toward a few successful firms. Over the last five years, five firms have raised an average of $30 billion in capital. (See Figure 2.)

Capital gains represent a large share of the income that flows through private equity and other partnerships and S corporations. Orszag shows that in 2005, capital gains from these flow-through entities made up 22 percent of current long-term gains on individual income tax returns. Attempts by the Blackstone Group to maintain partnership tax status after going public (that is, to maintain exemption from the corporate income tax) demonstrate how important the favorable taxation of the partnership form is to the private equity industry.

Examining Flow-Through Treatment

The Senate may be smart to delay a tax bill that would raise taxes on carried interests during an election year.

Yet it may be time for the Senate to take a closer look at the treatment of flow-through income in general. Chapter 3 of the Treasury report on business taxation and global competitiveness shows that the flow-through sector generates one-third of business receipts and one-third of salaries and wages and produces half of business net income. Moreover, the importance of flow-through entities is steadily rising, with the share of total business net income accounted for by partnerships rising from 2.6 percent in 1980 to 21.4 percent in 2006. (See Figure 3.)

Unlike corporations, partnerships don't pay an entity-level tax and the partnership income flows through to the partners for taxation at their individual income rates. This tax feature, combined with the ease of choosing the tax treatment since implementation of the check-the-box regulations a decade ago, may explain a great deal of the growth in this form of business organization. After taking into account the 2.9 percent employment tax that applies to ordinary income, the top marginal income tax rate rises to 37.9 percent. As the Joint Committee on Taxation notes in Part I of its partnership carried interests report, this nearly 23 percentage point rate differential "is thought to be a motivating factor in taxpayers' choice to structure income as a carried interest that can give rise to capital gain rather than as fees or other ordinary compensation income."

Thus, the classification of carried interest as compensation for services or as a right to income or gain from capital has significant tax consequences.

The Treasury study also showed that the top taxpayers in the flow-through sector had an average tax rate of just under 20 percent. The richest partners in the flow-through sector paid $113 billion in taxes on $573 billion in income in 2006. (See Table 1.)

 Flow-Through Income and Individual Income Taxes, 2006
 -----------------------------------------------------------------------------
                                               
Tax on
 
                               Flow-Through  Flow-Through  Average   Tax per
 
                     Number    Income/Loss   Income/Loss   Tax Rate  Taxpayer
 
                   (millions)  ($ billions)  ($ billions)  (percent)   ($)
 -----------------------------------------------------------------------------

 
All flow-through income

   All taxpayers      27.5          $938         $159         17.0%    $5,782
     Top 2 tax         2.1           671          131         19.5     62,381
       brackets
     Top tax bracket   1             573          113         19.7    113,000

 
Active, positive flow-through income

   All taxpayers      18.3           762          145         19.0      7,923
     Top 2 tax         1.4           433          109         25.2     77,857
       brackets
     Top tax bracket   0.7           349           92         26.4    131,429

 -----------------------------------------------------------------------------
 
Note: "Flow-through income/loss" includes net ordinary income
 from sole proprietorships, S corporations, and partnerships plus net long-term
 and short-term gains from partnerships, S corporations, estates and trusts.
 
Source: Table 3.3 (page 13) of Treasury Conference on Business Taxation
 and Global Competitiveness, Background Paper, July 26, 2007. Treasury Department and author's calculations.


Other Countries

The United States is not the only country with a thriving private equity/hedge fund industry and, thus, is not the only country that is struggling with how to tax the earnings of this industry.

A recent Congressional Research Service report shows that 13 European countries treat the carried interest as capital gain, 8 treat it as ordinary income, and 3 treat it as dividends or other forms of income.

The OECD has also weighed in, reporting that both the United Kingdom and the United States provide favorable tax treatment for carried interests. These tax rules may provide one reason why more than 1 in 5 European hedge funds, including the 14 largest European hedge funds, are located in the United Kingdom.

The tax benefits in the United Kingdom are even more generous than those available in the United States. United Kingdom law allows carried interests to receive a 30 percentage point tax rate break, compared with the paltry 20 percentage point tax rate break available in the United States.

The Redcoats Are Coming!

The British are also attempting to close a tax provision that allows private equity to benefit from such a large unintended tax break. On October 9 U.K. Chancellor of the Exchequer Alistair Darling announced in the prebudget report that all investors would pay a flat 18 percent capital gains rate. This rate is a sharp increase from the current 10 percent capital gains rate that applies under the taper relief system.

Unlike in the United States, private equity firms in the United Kingdom are providing powerful ammunition to the government to change the tax rules. As The Economist reported, Nicholas Ferguson, the chair of SVG Capital, argued that it is wrong that private equity executives are "paying less tax than a cleaning lady." In the United States, this call to equity is left to a single man, Warren Buffett.

In one sense, the British move is bolder than the moves under consideration in the United States. Under the U.K. taper relief regime that allows partners to pay a lower rate if they hold the investment for more than two years, the marginal rate on carried interest can be reduced from 40 percent to just 10 percent.

With a 30 percentage point difference, the United Kingdom has a strong incentive to narrow this gap. In so doing, it may reap an unintended benefit from increasing the capital gains rate to 18 percent. Coupled with a reduction in the ordinary income tax rate to 28 percent (or to 20 percent, as the opposition Conservative Party recommends), this increase will significantly narrow the gap in the rates of tax that apply to these two types of income.

And as the gap between the two tax rates diminishes, the incentive to shift income from one form to another diminishes. This action benefits both taxpayers and tax authorities, as it leads to reduced compliance costs and to reduced administrative costs.

But in another sense, U.K. policymakers have shown no more courage than their American counterparts. According to the Financial Times, private equity firms are "happy" with the chancellor's decision to increase the capital gains rate. Increasing the rate by a modest few percentage points seems likely to stave off calls for even greater tax increases or changes in the treatment of carried interests.

Not all U.K. businesses share this view. The Financial Times also reported that businesses are angry at the changes to the capital gains tax rate. These firms, which were not benefiting from the tax rate differential between capital gains and ordinary income, will now pay higher rates on their gains.

The new tax plans eliminate the taper relief that Prime Minister Gordon Brown introduced 10 years ago when he was chancellor of the exchequer. Taper relief reduces the capital gains tax payable according to how long the investor has held the asset and was designed to offset the impact of inflation on the value of assets as well as to provide a favorable tax to investments held for the long term. With the elimination of the favorable long-term rate, unless investors sell off their positions before April 6, 2008, they will be subject to a rate of tax levied on the gains that is 8 percentage points higher than it was the day before.

The British plan is far from certain to become law. Shortly after Darling released his proposal, the Financial Times reported that the leaders of four major business groups — the British Chambers of Commerce, CBI, Federation of Small Businesses, and Institute of Directors — condemned the proposal as putting the U.K.'s plans to create a pro-entrepreneurship economy "into reverse gear."

No 'Special Relationship'

The United States could follow the British move and change the way carried interests are treated. But neither the Treasury nor Congress seems likely to initiate a change.

Treasury Assistant Secretary for Tax Policy Eric Solomon admitted in his July testimony before the Finance Committee that tax considerations probably motivated private equity and hedge funds to organize as partnerships. Yet Treasury finds no reason to change this treatment, at least for now. As Solomon emphasized, the current rules provide certainty to taxpayers and are administrable to the tax authorities.

Congress also seems willing to wait. Since Levin introduced H.R. 2834 on June 22, and continuing through Finance Committee hearings on September 6, Congress has heard seemingly endless hours of testimony and received reams of reports on how to treat carried interests. No clear consensus has emerged because there is no clear consensus.

How should the tax authorities react in the face of this uncertainty? A responsible step might be for private interests and the politicians to work together to draft a bill that would narrow or eliminate the gap between the taxation of capital gains and that of ordinary income. Whether this step involves increasing one rate, decreasing another rate, or splitting the difference remains to be determined. Other attempts to modify the tax treatment of private equity may be just as likely to introduce more complexity and controversy into the system than exists now. This step would require modifying tax rules that have existed for decades.

However, just because a law has existed long enough to become a seemingly immutable law does not mean it cannot be changed. As an example, on November 5 the Supreme Court will hear a challenge to the nearly century-old practice in the states of exempting income that residents earn from their in-state municipal bonds while taxing residents on the income they earn from out-of-state municipal bonds. This practice clearly discourages residents from buying bonds from states other than their own. Yet, since the turn of the 20th century, the states have followed this apparently discriminatory practice, justified by "market participant" reasons. Only one state treats bonds identically.

Although legal arguments may allow the status quo to continue, economic principles indicate that the discriminatory state practice should be abolished. A Supreme Court ruling in favor of the economic principle might lead to an initial disruption of the municipal bond market as states figure out what to do, but over time, the elimination of the tax discrimination should lead to a more efficient muni bond.

A similar argument occurs in the treatment of income earned in the alternative investment industry. There is little reason why two firms — say the Blackstone Group and Goldman Sachs — that perform the same investment functions should be treated differently on the income they earn on those functions.

Yet the tax law allows exactly such a difference. As The New York Times reported, Goldman Sachs paid $1.1 billion in corporate income taxes on its $3.4 billion second-quarter profits, while the Blackstone Group paid just $14 million on its $1.1 billion in first-quarter earnings. One investment firm pays about a 32 percent tax rate, and the other pays a 1.3 percent tax rate for doing essentially the same business.

Changing the tax treatment of carried interests might create a bit of market volatility initially. But the result would be a more efficient allocation of resources brought about by the elimination of the tax distortion.

Too Good to Be True

Although any legislative outcome is too uncertain to predict, one thing that is certain about the effect of any legislation is that modifying the tax law that allows carried interests to be taxed at a favorable rate will not mean the tax law is free of loopholes. The code is stuffed full of tax preferences that allow a clever tax manager to find a perfectly legal way to reduce taxation almost to any level desired.

The private equity industry has self-reported some spectacular returns. According to Rosenblum, a 25-year period the return on the best private equity investments was more than three times the return on the S&P 500 companies during the same period.

These data are difficult to interpret, however. A meaningful comparison of returns would compare the best private equity returns with the comparable share of the top S&P 500 firms to the S&P 500 average over that period. During the past 25 years, the S&P 500 has frequently reported annual returns above 20 percent, indicating that the best firms in that group earned somewhat more than 20 percent. Regardless of the overall average during that period, it is certain that the return earned by the top quartile of the S&P 500 firms exceeded the S&P 500 average, perhaps even more than three times.

Some researchers have examined the entire pool of private equity partnerships and found that they perform no better than the S&P 500. Using data voluntarily reported by the private equity industry, Kaplan and Schoar, for example, find that the average private equity fund return net of fees from 1980 to 2001 roughly matched the S&P 500 average. The substantial variation in the returns among firms, however, suggests that some spectacular losses exist among the spectacular gains.

Given the relatively small amount of capital managed by private equity firms until the past few years, it is also possible that these funds earned exceptional returns in the early years because of their ability to invest in the most lucrative ventures. In 1980 private equity funds managed less than $5 billion in capital.

The story is very different now, with total capital under private equity management above $1 trillion. As the pool of capital under private equity management expands, the law of diminishing returns kicks in so that the average return on $1 trillion will be much lower than the average return on $100 billion in capital.

Private equity fund managers attempt to achieve what is known as "portable alpha" by choosing investments that will do better than the market; thus, a manager strives for a positive alpha to show that the manager's investment skills are better than those available for a given systematic risk. An alpha of 3, for example, would indicate that the manager earned a return that exceeded the market benchmark by 3 percent. Investors look to beta to determine the systematic risk of a stock or overall portfolio; investors with a high tolerance for risk would choose a high beta, all else equal, while risk-averse investors would seek a low beta. Utility funds tend to have a beta value less than 1, for example. A fund with a beta of 1 would expect to earn the market return.

Of course, a higher return comes only by taking on a higher amount of risk. Introductory finance courses show that funds earn a greater expected return only by taking on greater risk. (Ex post, the return on any particular investment could be higher than another for a given amount of risk, but ex ante, this is not possible.)

A study from 2004 by Susan Woodward showed that the returns earned by venture capital and buyout funds are not above average for a given amount of risk. Reports of "super" returns are tainted by the fact that there are little pricing data available on private equity funds. In such circumstances, Woodward shows, the fund's beta will be underestimated, thus leading to an overestimate of the fund's alpha, that is, its managerial contribution. In other words, the underlying risk will be incorrectly seen as too low, while the contribution of the fund manager will be incorrectly viewed as too high. Correcting for these biases shows, for example, that in the case of venture capital, the estimated beta rises from 0.6 to 2, while the estimated alpha falls from 1.8 to essentially zero.

What You See May Not Be What You Get

One difficulty in examining the performance of the private equity industry is that the firms are not required to make their results public. Thus, to the extent that firms report performance results, it is conceivable that the reported results will be tilted toward the better results.

The lack of transparency in the alternative investment community does not bode well for financial markets. An increasing share of financial transactions occurs away from public scrutiny as the prices of more and more securities are established outside the marketplace.

In a front-page story on October 12, The Wall Street Journal recalled that the Long-Term Capital Management hedge fund collapsed after "bad bets on opaque bond markets." Some $25.2 trillion of bonds now do not trade on markets with readily available prices. As one former trader noted, many prices are obtained by asking traders what they would like to receive for the position, a process she said was "akin to a homeowner valuing a house based on how much he wants for it, not how much a buyer is willing to pay."

It is The Wall Street Journal, that has once again raised the issue of Enron. In discussing the risks to the markets created by the off-balance-sheet structured investment vehicles, the Journal noted that because "off-balance-sheet liabilities played a major role in the 2001 collapse of Enron Corp., the makers of accounting rules have generally sought to get affiliated entities back on the balance sheets of the companies creating them."

The Smartest Guy in the Room

Changing the tax treatment of private equity won't kill the industry. Simple math shows that even if the income of top fund managers was taxed at twice the current rate, their returns would still be positive.

Likewise, requiring firms to provide information about their investment structure and their rates of return would not hurt the industry.

One expects that the private equity industry thrives because of its expertise in making superior investments, not because it receives favorable tax treatment or because it reports the good news and hides the bad news. A fundamental principle that all business managers learn is that if a project makes sense only because of its tax treatment, then it is not a worthwhile project. If the private equity industry needs this tax break and nontransparency to survive, perhaps it is time to question whether the tax code should be extending a lifeline to the industry.

Otherwise, it may turn out that the sequel to Saving Private Equity is The Smartest Guy in the Room, Part 2.

Where to Find More Information

A list of the articles referred to in this story appear below.

For a flavor of the debate, see Donald J. Marples, CRS Report RS22717, "Taxation of Private Equity and Hedge Fund Partnerships: Characterization of Carried Interest."

For details on the tax treatment of partnership carried interests and related issues, see the documents prepared by the JCT, "Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part I," (JCX-62-07) and Part II (JCX-63-07).

For additional discussion of the tax issues, see Mark Jickling and Donald J. Marples, CRS Report RS22689, "Taxation of Hedge Fund and Private Equity Managers."

For further explanation, see the testimony of Treasury Assistant Secretary for Tax Policy Eric Solomon before the Finance Committee on the taxation of carried interests (July 11, 2007).

For a discussion of tax arbitrage, see "Tax Reform, Tax Arbitrage, and the Taxation of Carried Interest" testimony of C. Eugene Steuerle, senior fellow at the Urban Institute, before the Ways and Means Committee (Sept. 6, 2007).

For an analysis of the compensation structure, see Victor Fleischer, "Two and Twenty: Taxing Partnership Profits in Private Equity Funds," Legal Studies Research Paper Series, Working Paper 06-27, revised Aug. 2, 2007.

For a view from the private equity industry, see the statement of Bruce Rosenblum, managing director of the Carlyle Group, and chair of the Private Equity Council, before the Ways and Means Committee (Sept. 6, 2007).

For a discussion of beta and alpha, see René M. Stulz, "Hedge Funds: Past, Present, and Future," Journal of Economic Perspectives, Vol. 21, No. 2, Spring 2007, pp. 175-194.

For an analysis of how to evaluate private equity, see Susan E. Woodward, "Measuring Risk and Performance for Private Equity," Sand Hill Econometrics, Aug. 11, 2004.

For an evaluation of private equity performance, see Steve Kaplan and Antoinette Schoar, "Private Equity Performance: Returns, Persistence and Capital Flows," Journal of Finance 55, Aug. 2005.

For a criticism of the tax issues that arise under H.R. 2834, see Lee A. Sheppard, "The Unbearable Lightness of the Carried Interest Bill," Tax Notes, July 2, 2007, p. 15.

Data on income and earnings come from U.S. Census Bureau, Income, Poverty and Health Insurance Coverage in the United States: 2006 (Aug. 2007), available at /taxbasehttp://www.census.gov/prod/2007pubs/p60-233.pdf.