Changes to the carried interest taxation regime appear to be bolted onto Labour Chancellor Rachel Reeves’ Autumn Statement.
But depending on the recipe, changes to this confusing pocket of the private equity sector risk putting an unfair burden on a key growth engine in the UK mid-market funds space.
What is carried interest?
Carried interest essentially works as a performance incentive.
If the return on an investment exceeds a certain threshold, or ‘hurdle rate’, the PE manager receives a percentage sum on anything above that rate.
This is often set at around 20%, according to Investopedia.
For instance, if an investment has a hurdle rate of 10% and the investment generates a 20% return, the general partner will earn 20% carried interest on 10% of the return.
Carried interest is currently taxed as a capital gain, which is currently capped at 28%.
However, carried interest’s status as a capital gain has become matter of debate. On the one hand, it does represent a profit made on an investment, but it is also the primary source of compensation for PE managers.
The argument is that, as a performance-based compensation, it is more akin to income, thus should be taxed as such.
Reclassifying carried interest as income would have dramatic consequences for PE managers.
While the highest rate of CGT is 28%, income tax can be as high as 45% (47% in Scotland) for the highest earners (PE managers fit in this category, typically).
Mid-market matters
They’re not going to go hungry, but if Reeves fails to balance the scales fairly, she risks putting an undue burden on mid-market and regional PE managers.
According to Victoria Price, a managing director in Alvarez and Marsal’s private capital team, there is a concern that a “one-size-fits-all approach is taken” that could impact “investment and funds that really help entrepreneurial businesses scale in the UK”.
Mid-market funds, Price added, “invest in UK assets that create employment in the UK, that help the economy in the UK significantly, as compared to some of the very bigger funds, where not all of the benefit is felt in the UK”.
Price explained to Proactive how managers at mid-market PE firms tend to stump up more of their own capital compared to the big hitters.
“If you take it on a pro-rata basis, then they are putting in more of their own funds, and they have more of their own capital at risk,” she said.
This is important because while a case can be made that carried interest resembles income and should be taxed as such, the case is harder to make on funds invested by the PE managers themselves.
Thankfully there is the possibility, if not likelihood, that Reeves will acknowledge this in tomorrow’s Budget.
The two likely scenarios seem to be:
- Switch the tax burden on carried interest from capital gains to income, but with an exemption for PE fund managers’ own capital, or
- Increase the capital gains charge across all carried interest by a few percentage points
What’s clear is that something is going to happen.
“If (Labour) did nothing, I think that that could potentially look weak on their behalf,” said Price.
“The truth is that we've already seen people voting with their feet and people physically leaving the UK and indeed funds starting to structure themselves in a different way,” Price said of the larger funds.
The mid market, however, doesn’t always have that luxury.