Imagine you are a professional musician who is building a performance career. You hire an artist manager to promote you, obtain performance gigs, and to negotiate contracts for your gigs for a period of five years. Your manager’s primary compensation is a percentage (let’s say 20%) of the compensation you receive from your gigs, plus reimbursement of certain of the manager’s costs. This arrangement is designed to incentivize your artist manager to work hard to get you as many bookings as possible as soon as possible.
The artist manager in this arrangement may be compared to a sponsor of a real estate or manager of a private equity or hedge fund (I will use the term “fund sponsor” in this post to refer to all of these). Although many fund sponsors invest cash into the funds they sponsor, fund sponsors also receive what is known as a “carried interest” in addition to reimbursement for their costs and certain other fees.
When the fund is formed, the fund sponsor receives an interest in the future gains or income from the fund, for which the sponsor pays nothing. However, the carried interest entitles the fund sponsor to receive a percentage of the proceeds upon the sale of the fund’s assets and/or a percentage of operating revenue received by the fund during the hold period for the assets.
Details vary, but typically, the fund sponsor will not receive payment on the carried interest until at least the investors receive a return of capital, most frequently with an additional return on their investments. Payments resulting from a carried interest typically will be a percentage of the fund revenue/proceeds, and it is not uncommon for that percentage to increase so that the fund sponsor receives a higher percentage as the fund’s performance improves.
Although there is debate and there are misconceptions about the nature of carried interests (which are beyond the scope of this post), carried interests do benefit fund investors by providing incentivize compensation for the fund sponsor that does not require a cash outlay from the fund unless and until the fund is profitable, and usually not until the fund investors have received a return of all of their capital.
Simply put, the carried interest, like the music manager’s compensation, aligns the fund sponsor’s incentives with those of the fund investors. The fund sponsor has every reason to manage the fund so that the investors receive a return of their capital plus their minimum return so that the fund sponsor can receive payments on its carried interest. Plus, the fund sponsor is incentivized to maximize the fund’s performance, because that may result in the fund sponsor receiving a higher percentage of the revenue/proceeds as performance increases.
However, let’s go back to the professional musician. Imagine that in years two and three of your five-year contract, your manager receives only ten percent (10%) of your compensation, but that in years one, four, and five of your contract, the manager receives twenty percent (20%) of your compensation.
It’s clear in this new arrangement that the artist manager’s and the professional musician’s interests are no longer aligned, because your manager is incentivized to obtain bookings for you in years one, four, and five rather than in years two and three. After year one, the artist manager would have a conflict of interest, as the artist manager would be tempted to encourage venues to book your performances in year four, rather than year three, for instance, which of course, would slow the growth of your career and income and therefore, not be in your best interest.
Although this new artist manager scenario makes little sense, this is the situation Congress created in the 2017 tax law with regards to carried interests.
Under federal tax law, payments resulting from a carried interest upon sale of fund assets traditionally have been treated as capital gains. They idea is that when acquired, the carried interest is worthless and therefore, has a tax basis of zero. As a result, any payments resulting from a carried interest due to sale of a fund asset represent a gain, the same as a gain on a fund investor’s investment.
Before 2018, if the fund asset sale occurred less than one year after the fund sponsor received the carried interest, then it would be a short-term capital gain, taxed at ordinary income rates. But, if the fund asset sale occurred more than one year after acquisition of the carried interest, then it would be taxed at the lower, long-term capital gains rate. Since the fund investors’ returns (after return of their equity) receive similar treatment, until the 2017 tax law was passed, the fund sponsor’s and fund investors’ interests were aligned with respect to asset sales.
However, the 2017 tax law changed this. Now, although fund investors still will be taxed at long-term capital gains rates upon sale of fund assets held for one year or more, a fund sponsor must wait for three years before it can claim long-term capital gains treatment for these same assets. As a result, like the artist manager in the second scenario, the fund sponsor’s interests no longer are aligned with those of the fund investors.
Depending on the investment goals of a fund, this change could create a conflict of interest for the fund sponsor. For existing funds, this conflict of interest did not exist when the fund was created and therefore, has not previously been disclosed to fund investors. More critically, carried interest structures and fund exit structures for existing funds may not be consistent with the new tax law.
Under the 2017 tax law, it still makes sense for fund sponsors generally to hold fund assets for a year so that the fund investors can claim long-term capital gains treatment. However, in a time of increasing interest rates, it could be advantageous for a real estate fund to dispose of some assets fewer than three years after acquisition. This will particularly be the case if, for instance, those assets are encumbered by a below-market, assumable mortgage. Indeed, many funds may have been formed with that specific exit strategy in mind. Although the interest rate spread and investor return might end up being greater after a three-year hold, there is the old saying about a “bird in the hand being better than three in the bush.”
Yet, the 2017 tax law changes likely will impact the forecasted sponsor return on its carried interest. Even though the fund sponsor’s return under the fund documents remains unchanged, the after-tax return to the fund sponsor has changed. This may create a significant incentive for the fund sponsor to wait out the three-year old period. To extrapolate on the saying, the fund sponsor may have “six birds in the bush” to the fund investors’ “three birds,” because if the fund sponsor can extend the hold period on the asset to three years or more, the fund sponsor will have larger after-tax return on its carried interest.
In addition to creating an unanticipated conflict of interest for fund sponsors of existing funds, the 2017 tax law could impact the way new funds are structured, so that longer hold periods are planned and change the assets that are attractive to fund sponsors. It is important to remember that fund sponsors put together the funds at the outset, and although they want to produce a fund that provides an attractive return to the fund investors, fund sponsors also expect to make money for their efforts.
Since fund sponsors will know that their after-tax returns on their carried interest will be reduced after a three-year hold period on fund assets, it makes sense for the fund sponsor to structure new funds to contemplate at least a three-year hold period. Needless to say, the types of assets appropriate for a three-year (or greater) hold might not be the same as those with one-year hold period. For instance, funds geared towards buying value-add real estate, renovating it, and reselling it or funds established to buy distressed debt instruments likely to result in foreclosure or maturity in less than three years might not be as attractive of a business model for fund sponsors not wanting to pay high tax rates on the resulting gains from their carried interests.
One of my favorite reminders to clients is “be careful what you incentivize.” Here what probably was a compromise designed to make it look like Congress was being tough on wealthy fund sponsors may well end up creating incentives which hurt fund investors by creating conflicts of interest for fund sponsors, delaying return of investor capital, and reducing the availability of funds for investors desiring a shorter-term investment.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.