Private equity firms fear a Democrat topping Trump in 2020

Private equity firms will rush the exits if they believe that a Democrat is likely to defeat President Trump, investors tell me.

The state of play: Each of the four leading Democratic candidates have pledged to eliminate beneficial tax treatment for capital gains among top earners.

Elizabeth Warren has proposed the most dramatic change, raising capital gains rates to all earners and requiring annual, mark-to-market taxes (i.e., not just when an asset is sold).

• Bernie Sanders would eliminate the rate differential for households making $250,000 or more. Joe Biden would do it for those making $1 million or more. Pete Buttigieg also has proposed a cap gains rate hike and mark-to-market taxation for the top 1% of earners.
• All four also plan to raise ordinary income rates on top earners so, for many private equity investors, this would be a double whammy.

What's happening: The result is that private equity investors are talking about clearing the portfolio decks this year, locking in profits under the current taxation scheme.

The big picture: This is different than the decades-long debate over carried interest, which was about if PE investment profits should be taxed as capital gains or as ordinary income. If you no longer have a difference between the two rates, it no longer matters how carried interest is classified.

• But, but, but: Exits are a double-sided door., requiring both sellers and buyers. There could be a slowdown in sponsor-to-sponsor opportunities due to both the tax issue and a growing PE consensus that portfolio companies are overvalued.

• On the other hand, many strategic buyers are flush with cash.
• Private equity funds also must be careful not to run afoul of their fiduciary responsibilities, as most of its limited partners are nonprofits that don't pay federal taxes at all. If LPs believe that their general partners are selling for personal tax benefits, it could turn into a legal liability.

The bottom line: Pay greater attention this year to why a private equity firm says it sold a company, particularly if it's been a short hold period.

Go deeper: How private equity could disrupt the 2020 election