Private Equity Compensation

I have always been of the opinion that, as strange and ridiculous as the finance industry often proves itself to be, a complex financial system is a necessity for a modern economy. There are just too many massive projects requiring funding for us to rely on savings accounts at our local bank.

Hard-right Republicans detest societal engineering in any form, but the truth is that many of the advantages enjoyed by the financial industry occur due to economic engineering. Take the hubbub over what Mitt Romney made as a financial manager, for instance.

Mitt Romney was the manager of Bain Capital, a private-equity firm which generated profits by buying up companies with investor money, making changes to those companies which they hoped would cause the companies’ price to rise, and then selling the companies, often at an Initial Public Offering. (The nature of those changes has been a matter of some debate, but they’re not what I’m concerned with here. I suspect on the balance Bain attempted to do what most everyone in the corporate world tries to do—make companies leaner and more efficient, thus reducing overhead. People probably lost jobs as a result).

The investors in Bain Capital paid a 15% long-term capital gains tax on their profits, rather than the much higher rate assessed on ordinary income or short-term capital gains. It is a longstanding practice for the federal government to tax investment this way, because we believe it encourages people to invest in projects which will have long-term benefit for the economy.

But if Mitt Romney was collecting a salary similar to other equity managers, he was collecting 20% of the profits and paying an identical 15% tax rate, although none of the money invested was his own.

Is this fair?

It probably isn’t. Salespeople don’t pay 15% on their commissions, even though what they are doing is roughly equivalent in a low-level way to what Romney did. One of the best arguments for the 15% capital gains tax is that it avoids double-taxation—for most ordinary people, the money they use to make an investment comes from their own income, which is taxed at the normal rate. Doctors who buy stocks or buy a piece of a restaurant are using money from their salaries or private practice, all of which was taxed at either the ordinary income rate or business tax rates.

There are further complexities which I cannot decipher. Private equity exists in a fluid state. To me, it would make sense to let the investors collect all of the profits at the 15% rate then pay managers a 20% rate off of those profits, which would be taxed like ordinary income for the manager.

 Current System:

                $1000 Profit-      –> $200 collected by manager ($30 tax/ $170 to manager)

–> $800 collected by investors ($120 tax/ $680 to investors)

 My System:

$1000 Profit        –> $1000 collected by investors ($150 tax/ $850 to investors)

                |

                         $850       –> $680 kept by investors after-tax

–> $170 paid to manager ($110.50 kept by manager/ $59.50 tax)

The investors keep the exact same profits, and manager pay goes down by 35%. The government collects $59.50 more in tax.

The argument against such a change? Because private equity management becomes 35% less lucrative less “talented” people would want to become equity managers, and….what? Private equity firms become less effective? Well, I’ll believe it when I see it.

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About hubzbubz

Currently residing in Brooklyn.
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