What happens if the carried interest loophole is closed
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President Trump is increasingly unlikely to get his way on closing the carried interest loophole, based on draft tax bill language from House Republicans. Apparently even the death grip has a few fissures.
- But while the change remains in theoretical play, it's worth gaming out its practical consequences.
Disclaimer: Let's stipulate that the devil would be in the legislative details. For example, could there be exclusions for ultra-long hold periods? Would it be grandfathered in for existing funds?
- What follows is assuming a vanilla switch for all carry from capital gains to ordinary income.
Scenario 1: Fund managers raise their carried interest percentages to compensate for the increased tax.
- It's the most elegant solution from the GP perspective, but is sure to repulse LPs.
Scenario 2: Fund managers reduce or even eliminate hurdle rates.
- Many buyout pros have argued for years that standard 8% hurdles are too high, although that case got harder to make over the past few years of high inflation. This one might come down to what impact tariffs do, or don't, have on CPI.
Scenario 3: GPs seek to significantly increase co-investing from their own balance sheets, some of which could be levered, thus allowing returns still to benefit from capital gains treatment.
- This also could mean more GP stake sales, including in venture capital, so that firms can amass internal capital pools.
Scenario 4: Funds may seek to flip portfolio companies quickly, since there's no longer a tax incentive to hold.
- Doing so could lead to accelerated fundraising cycles, thus increasing GP fee streams.
Scenario 5: GPs suck it up and nothing really changes, except for internal compensation structures.
- Fundraising is very tight right now, and those seeking to upset the apple cart may get left by the side of the road.
The bottom line: The smart money right now is on the status quo (and PE lobbyists) prevailing. But stranger things have happened at the end of big tax bill debates.
