Why private funds might have to give up profits

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The Weekend Pitch

September 26, 2021

Presented by Vanta

(Joey Schaffer/PitchBook News)

Politicians on both sides of the Atlantic who have long argued that the government should carve a larger slice out of private equity and venture capital profits could be closer to getting their way.

The end result could not only eat into private equity profits but could even undermine an important tool for aligning the interests of fund managers and their investors.

I'm Andrew Woodman and this is The Weekend Pitch. You can reach me at andrew.woodman@pitchbook.com or follow me on Twitter via @adwoodman.

Private funds might have to give up a bigger share of their profits

In the US, Democratic lawmakers have floated a proposal that could not only increase tax rates on so-called carried-interest profits but also extend the length of time general partners must hold an asset before they can benefit from a favorable tax rate.

Carried interest is the cut (typically 20%) that GPs get on the money returned to investors after a liquidity event. In principle, it gives managers incentives in a way that benefits limited partner investors like pensions and endowments. Alongside the management fee, a 2% annual fee on capital managed by a fund, carried interest is an important component of the "2 and 20" fee structure that underpins private funds. It also represents a lot of potential tax revenue.

Under the current system, carried interest earned is treated as capital gains. This means managers typically only pay a federal tax rate of 23.8%, which comprises the 20% net capital gains tax plus a 3.8% net investment income tax, instead of the 40.8% top rate. This is provided that the fund has held onto an asset for more than three years (until the Tax Cuts and Jobs Act of 2017, that threshold was one year).

This rarely poses a challenge for the private equity asset class, where typically the holding extends well beyond three years. But some Democratic lawmakers want to extend that to five years. What's more, that holding period may need to be even longer than five years for the manager to qualify for the preferential tax treatment. Cécile Beurrier, a tax lawyer with Debevoise & Plimpton, explains that under the proposals in the US, the clock won't start ticking until the fund is fully deployed.

"This is a very important nuance in the context of a fund that lasts eight to 10 years, because usually in the first couple of years the fund is in ramp-up mode, so it usually is not substantially invested until the end of the investment period of maybe three to five years."

This is a problem for fund managers, especially when it comes to investments made during this ramp-up period. According to PitchBook data, US buyout firms' holding periods have been getting shorter. The median time has fallen from 6.2 years in 2014 to 4.9 years so far in 2021.

For venture capital in the US, meanwhile, median holding periods—dated from the first VC round—have risen from 4.8 years to 5.5 years in the same period. But even if holding periods were to trend downward in the coming years, many investments could still likely fall outside preferential tax treatment. What's more, it could influence when managers decide to exit.

Quote/Unquote

(AndreyPopov/Getty Images)

"We are seeing venture capital firms increase total cash compensation across the board, most notably among associates and managing general partners, indicating VCs are willing to pay a premium to recruit and retain top talent."

—Jody Thelander, founder and CEO of compensation data provider J.Thelander Consulting.

Some 27% of venture capital, corporate venture capital and private equity firms lost a partner or key recruit in 2021, according to a recent J.Thelander-PitchBook survey of more than 760 respondents. Learn more about how the ongoing quitting spree has impacted compensation changes between 2020 and 2021.

Datapoints

From 2010 to 2020, the median late-stage valuation of VC-backed companies tripled in the four most active hubs across the US: New York, Boston, Los Angeles and the San Francisco Bay Area.

That increase is significantly higher than the next six most active US VC areas, indicating that factors such as an ecosystem's cost of living, employee compensation, commercial real estate prices and availability of talent have a major influence on deal size and valuation metrics.

Deal Flow

India has produced 41 unicorns to date—including edtech giant Byju's and ridehailing company Ola, which is reportedly planning to raise $1 billion in its upcoming IPO. More than 40% of the companies on that list were minted in 2021 alone, according to PitchBook data.

And, in light of the Chinese government's heavy-handed approach to private enterprises, investors' excitement around India is unlikely to abate soon.

Did you know ...

(KseniaBazarova/Getty Images)

… That 28% of transgender respondents in a recent survey said they had postponed medical care in order to avoid discrimination?

The LGBTQ community represents a largely underserved segment of the US population. This inequity can be attributed to several factors, including unequal care opportunities, fear of discrimination and lack of insurance coverage.

Our latest installment of Emerging Tech Research delves into the growing LGBTQ-focused healthtech sector and highlights emerging startups that provide gender-affirming treatments, mental healthcare and family-building services for these individuals.

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This edition of The Weekend Pitch was written by Andrew Woodman and Priyamvada Mathur. It was edited by Alexander Davis, Angela Sams and Sam Steele.

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Why private funds might have to give up profits

Private funds might have to give up a bigger share of their profits

Quote/Unquote

Datapoints

Deal Flow

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