Eat the Rich Part 2: no more [low-tax] carry for PE bros
The humble private equity investor is compensated in myriad ways. She earns a base salary, as is tradition for most office jobs. She receives a year-end bonus, in part based on performance and in part a reward for sticking it out for another gruelling year. She receives some stock in the company[i]. She attends all-expenses-paid glamourous retreats to Monaco and Miami with her colleagues. She enjoys the kudos of her peers for working in private equity, if they care about that sort of thing. She gets free egg-freezing, health insurance, and mental health support. And the pièce de résistance: she receives carried interest (‘carry’). Labour is coming for carried interest tax in the next UK election, but why are the PE bros so upset about it?
Private equity investors buy private companies or take publicly listed companies private. The investment thesis is broadly that privately held companies have more flexibility to create value through operational changes, taking on more debt, and growing the business. They are free from the demands of being publicly listed, like quarterly earnings updates, and have support and oversight from their investors. Most PE firms eventually sell the company within a defined period to realise a profit from its sale.
PE investors (‘general partners’ or GPs) do not invest their own money. They raise funds from other investors (called ‘limited partners’ or LPs) and buy companies on their behalf. For the privilege of finding good deals for LPs, GPs charge fees and carried interest. The classic model was a ‘2 and 20’ model, charging 2% of fees per year on funds under management, and 20% carry.
Carry is another name for a profit share in the proceeds of a deal. In simplified terms, if the GP buys a company for £100 million and later sells it for £200 million, they get to keep £20 million: 20% of the £100 million profit.
These profits are distributed among the employees of the funds and can be lucrative. In 2022, 3,000 people in the UK declared carried interest payments worth £5 billion (£1.7 million apiece).
Carry is currently taxed as a capital gain, at 28%. In the UK, the highest income tax rate is 45%, kicking in for earnings over ~£125,000, plus a couple of percentage points of National Insurance (similar to Social Security). It’s not clear why carry is taxed as a capital gain, as it is not based on owning any stake in an asset but rather on the profits gained for someone else.
Labour is proposing to close this loophole, and rightly so. PE professionals pay the income tax rate for salaries, bonuses, and even health benefits. Indeed, my carried interest payments at a PE fund were taxed as income, because the fund was designed to hold assets indefinitely and they still compensated staff with ‘carry’ for value creation.
Rachel Reeves has thrown a bone to PE investors, however, by suggesting that if they have skin in the game, i.e. invest their own money in deals, then they can receive carried interest. I’m not sure this loophole is wise.
Many GPs put their own money into their funds already, partly to signal to their LPs that they believe in their investment product. This amount is typically small – 1-2% or less – and in no way tied to the carry incentive they receive. In addition to their carry, the GP receives their portion of the profits from invested capital like the other LPs. Staff can also invest ‘side-by-side’ on deals.
It is reasonable that profits from investing your own money should be taxed as capital gains. However, it is not clear why putting up, say, 1% of the total funds should entitle you to pay discounted capital gains tax rates on your 20% profit share, versus taxing it like a performance bonus.
One reason to advocate for this tax system is to keep finance jobs in London. Tax rates in the UK are already elevated, and this would be a heavy hit to the high earners who might take their talents to other countries. The UK only last year removed a cap on banker bonuses to boost London’s financial services industry, originally implemented as part of an EU-wide restriction to disincentivise risk-taking at banks. This tax change would be a blow to a small number of people, but have wider effects on the investment landscape in the UK.
I still think taxing carried interest as income is the right move, and I don’t think we should make exceptions for GPs who invest their own money in their funds. They profit from their investment like other LPs, and make a performance fee on top. If we need something to sweeten the deal for private equity investors beyond the large sums they already make, the top marginal rate could be lowered as an alternative. This would be more equitable, applying to all forms of income and not just carry.
[i] Which may be paid (‘vest’) over time