Obama fund plan more sizzle than steak

Taxing "carried interest" has long been a hot-button issue in the $1.4 trillion (980 million pounds) hedge fund and $2.5 trillion private equity industries and it exploded on Thursday as Obama's new budget proposes raising about $24 billion over ten years by eliminating what has been called the "carried interest" tax loophole.

Carried interest, or carry, is the cut of profits -- typically 20 percent -- that private equity and hedge fund firms' partners keep as compensation.

For years, they have had to pay only the 15 percent long-term capital-gains tax rate on carry instead of the roughly 35 percent tax for ordinary income.

"There is a very strong argument to be made that the 20 percent (managers charge in performance fees) is real income but it is a moot point today because it will take the funds years to get back to their high water marks," said Cornelius Hurley, director of Boston University School of Law's Morin Centre for Banking and Financial Law.

Managers and industry experts note, with some irony, that the plan is being announced at a time these once high-flying fund firms are not earning much money and years before the proposal is set to take effect in 2011.

Facing tumbling financial markets, private equity funds have been making large writedowns on their portfolios, while many hedge funds suffer heavy losses. This means their managers are nowhere close to earning their lavish 20 percent performance fees.

"Proposing the plan now, creates more noise now than is probably necessary," Hurley said.

NOT A DONE DEAL

Looking ahead to the day such a proposal might have real teeth, experts say that raising the carry would be a hit for private equity and hedge fund firms but would not kill the industry.

Steven Kaplan, a professor of finance specializing in private equity at the University of Chicago, said some private equity firms may in response try and raise the carry from the typical 20 percent to perhaps 25 percent.

"The second thing is smart lawyers will try to manoeuvre around this," Kaplan said. "There is a case that this is capital gains not ordinary income."

The Private Equity Council, an industry group, said it believed that profits generated by increasing the value of capital assets should continue to be treated as capital gains.

"We recognize that our country is facing enormous economic challenges," Douglas Lowenstein, PEC president, said in an emailed statement. "With more than $500 billion in new capital to invest, private equity partnerships can and will be part of the solution."

But even if still classed as capital gains tax, managers might have to pay more on carry anyway. The capital gains tax could revert back to 20 percent on January 1, 2011, unless lawmakers extend cuts that brought the rate down.

In addition, the proposal may not be approved by Congress.

"Hedge funds and private equity funds gave a lot of money to the Democratic party in the last election cycle," said Kaplan. "Why did they do that? Because they were hoping this wouldn't happen. There's an incentive from the part of the Democrats to threaten this but not pass it."

Some experts said it was included to capture the public's outrage that million-dollar fund managers squandered average Americans' nest eggs but pay lower taxes.

"Punishment is in the air," Hurley said, noting that many wealthy investors in hedge funds have not been able to access their money as redemptions have been suspended amid a flood of red ink at the funds.