rlucas.net: The Next Generation

The L.A. Times’ “Money & Co.” has a piece on the carried interest loophole for Private Equity (including V.C.).  Frankly, almost nobody really understands this issue outside the industry and our advisors, but people outside of our industry are going to be reading all kinds of nonsense populist propaganda saying “soak the bastards!” as well as our own industry’s propaganda of “God bless America and profit and mom and innovation and apple pie!”  (Incidentally, it is true that we VCs are different qualitatively from private equity buyout guys — and there are arguments for why we should be treated differently — but everything I’m about to say applies pretty equally to any kind of limited partnership.)  None of the propaganda and hype, however, actually helps us get to the understanding needed to solve this problem in a way that is both equitable and helpful to the Republic.

If you’re not more than merely superficially familiar with this policy issue, let me give you a relatively objective overview of the three elements: LPs, taxation, and liability.

LPs (Partnerships): The LP (limited partnership) structure is a way to recognize formally and legally the age-old practice of having a “silent partner” in your business.  Joe wants to open a factory, but doesn’t have the money; Bob has money but doesn’t know from factories.  Joe and Bob go in, Joe contributes knowledge and work, Bob contributes money.  They agree to split the profit 33/67, even though Joe doesn’t put in actual dollars.  (Win-win: Joe bootstraps up from penury and Bob fattens up without working too much.  It’s been going on at least since the Venetians organized expedetions as “commendas” in the 1300s.)  Now, on the surface, this SOUNDS a lot like the case where Joe starts a corporation and sells 2/3 of it to Bob for the money, but there’s an important difference: taxation.

Taxation: In the corporation (Bob as “shareholder”) model, the profits will get “doubly” taxed at the corporate level first (income tax), then get taxed at the individual level (dividends, or maybe cap gains).  In the LP case (Bob as “silent partner”) model), the profits are NOT taxed at the partnership level — instead, they’re “passed-through” and treated as though each partner did the activity directly (or his share thereof).  You might immediately note that for most all businesses, this would seem to make the LP structure a lot more attractive — so what gives?  What’s the tradeoff?  It’s liability.

Liability: In a corporation, the managers and shareholders are generally NOT liable for the debts of the corporation (except for blatant malfeasance).  (This also breaks down in small companies because banks basically ^!@#$ you over and won’t finance you without personal guarantees.  But the bigger the corp, with more negotiating power, the more true this “limited liability” is.)  In a partnership, in contrast, there must always be at least one “general partner:” a person who controls and is personally liable for the partnership, with unlimited liability.  (The “limited liability” of an LP applies only to the silent, or “limited” partner, who must not exercise control.)  Hence, the essential tradeoff between these structures has to do with whether the controlling manager is personally liable — and frankly, when faced with the possibility of unlimited personal liability for a risky business, paying a “double taxation” rate starts to seem not so bad.

That’s it.  That’s the historical reason for this “loophole,” and frankly it’s pretty understandable when broken down that way.  If you want to take advantage of the legal fiction called a “corporation,” and its made-up, state-conferred advantages including limited liability, you pay more taxes.  If you are willing to associate personal control with personal unlimited liability, you get to dodge them.  You can argue if the tradeoff is right, but it’s a tradeoff.

THE PROBLEM

The problem, today, is that the tradeoff is completely disrespected.  A new corporate form that has caught on since the 1970s, the LLC (Limited Liability Company), allows you to create a legal “person” with the same tax treatment as a partnership, but without the personal liability for any individual.  Hence, any LP whose managers have half a brain today is set up like this:

Acme, LP.  Limited Partner (investor): Rich Dude.  General Partner (manager, liable): Acme Managment, LLC.

Acme Management, LLC.  Owner and Manager: Skilled Guy.

As a result, you still have Rich Dude and Skilled Guy acting out the roles of silent (limited) partner and managing (general) partner, but Skilled Guy has now inserted an LLC “shield” in the middle to protect himself from personal liability. Since that LLC is also a “passthrough” entity, the whole structure is transparent for tax reasons.  As a result, Skilled Guy’s profit distributions (“carried interest”) get the favorable tax treatment, even though he doesn’t have to make the tax vs. liability tradeoff.

So, to me, the answer is simple.  That kind of structure should not be permitted to receive the same tax treatment as one in which the general partner is a “true,” personally liable, general partner.

My proposal for legislation:

• Carried interest gets passthrough tax treatment for individual general partners IF there is true bona-fide personal liability risk borne for the partnership.
• Carried interest OTHERWISE can’t be passed-through.  It must be taxed as income either at the intermediate LLC level or the personal level.
• All existing partnerships have a 3-year window from today in which to elect to recharacterize their intermediate entities to enable true personal liability for passthrough treatment without penalty and with “shall-issue” consent etc. from the IRS and states (but are not required to do so).
• The IRS will be empowered to seek the “substance” of convoluted structures to prevent tomfoolery.

Frankly, this is probably heresy in the VC world.  Our cross-town neighbors at OVP seem to think that their carry is an “asset … which we contribute cash to own” which amounts to a pretty tortured reading of the flow of dollars into an LP.  The National Venture Capital Association has its own pretzel logic that addresses how wonderful, beneficial, good-looking, and high in anti-oxidants we VCs are, but doesn’t address anything about the fundamental tradeoff itself.

It’s easy to see why our brethren knee-jerk against carry taxation.  For every $1 M in expected value, getting LT cap gains rates instead of top marginal rates means an extra $200k-ish, which is real cheddar even to big-shots.  But that’s fine: if you want to preserve your pass-through prerogative, you should be able to, just like every other general partner of every partnership could prior to the widespread adoption of LLC passthrough-sans-liabiltiy forms: by taking personal liability for the entity’s obligations.

So, to be clear: VC most certainly is a valuable and unique part of our economy; VC is absolutely and necessarily distinct from buyout and hedge funds, and importantly, there is a longstanding historical precedent and clear legal tradeoff justifying differential treatment of carried interest for taxation purposes.  But that tradeoff has now been rendered obsolete, and should be put back into whack — and it’s quite possible to do so in an equitable and rational way.

Look at “Bubble 1.0” (as it’s known in the relatively young tech industry: the 1997-2000 tech-media-telecom bubble and the general IPO / equity bubble that went along with it).

1. A real change occurred — the uptake of Internet technology — and created some initial successes (think Netscape IPO). This got folks thinking about how to turn a profit, lighting aflame the animal spirits, and buoyed the mood of the markets.

2. Accommodative monetary policy made money cheap, and in combination with the buoyant mood and the animal spirits, led to compressed risk premia in the capital markets. Think insatiable demand for IPOs, and Fed rate-slashing due to LTCM in 1998.

3. Sensing opportunity (and driven to madness by their proximity to money with no ability to make it themselves), those in charge of telling the truth, like auditors, started fudging things in order to keep the good times rolling and to get a slice o’ Cheddar for themselves. Think Arthur Andersen and Enron.

Now, let’s take a look at Housing in 2002-2007.

1. A real change occurred. Think a palpable change in national mood and priorities post-bubble and post-9/11. In the realm of personal finance, we saw an aversion to “paper” assets and a move toward the real and tangible. To many people, this meant plowing what was left from equities into real estate, which had already been enjoying decent returns from the wealth effect of Bubble 1.0.

2. Accommodative credit. Think not only macro level, Fed funds rate stuff, but no-doc loans, NINJA (no income, no job or assets) loans, ARMs, option ARMs, interest-only loans, etc.

3. The truth-tellers started lying. Think the house appraisers here who were being incentivized to keep the party going at risk of losing business from the real estate agents, and the mortgage “officers” who were effectively the “buyer apraisers,” incentivized to keep the party going directly due to fee structures. Nobody in either group called foul on the prices or the creditworthiness in question.

This formula works pretty good, although it’s loose enough that its predictive power is probably fairly weak (better for validating a thesis than for scouting out a new bubble in progress). Any other ideas as to bubbles where we can look for these factors?

Here’s how F’ed the U.S. Dollar is right now. If you go for a bit of shopping in Montreal over the weekend these days, you probably pay with your credit card to try and get the best exchange rate. When you next get online and look at your credit card statement, you will be shocked to find:

the USD-CAD exchange rate is so poor right now that, after taxes, you pay more U.S. dollars for your purchase than the price tag in Canadian dollars originally said!

Cheers to our northerly neighbors, I guess. (Although it does kind of put the lie to the whining I heard from some Ontario snorkelers when in Florida, that the boat skipper ought to give them a break on account of exchange rates.)

Yesterday the Seattle Times brought us this gem:

… the couple — with no savings and about $20,000 in credit-card debt — shopped for a mortgage to buy their 1,200-square-foot house in Tukwila last year, they heard the same thing from lenders and in a home-buying class they attended: Forget it. “You basically had to be Scot free, no massive credit debt, which we had, and to have money in the bank, which we didn’t,” said Swartz, 31. “How do people buy houses in America anymore?”

In a nutshell, the country is going to hell in a handbasket. When people are so poisoned with the mindset of entitlement that they literally can’t comprehend why having no cash and a negative $20k net worth doesn’t qualify one to incur a quarter million in debt, well, it’s hard to believe that these are the attitudes and values that built the greatest economy in the world.

Important update:

This was my take on things back in 2007, when it was published.  As of 2010, both my opinion and the math have sharply changed.  I revisit the issue in a new post.

State-administered “529 plans” for education savings are another in the series of tax dodges doled out by the Bush administration (thereby further and regressively lowering the effective rate of taxation on the higher-income people most likely to avail themselves of such dodges). (Sticklers will observe that 529s predate Bush; true, but their extra tax favorability is a post-2001 invention.) On the bright side, they offer quite a good deal if you can find an investment that keeps pace with college tuition (and you don’t need to worry about also beating the tax rake, since 529 gains are tax free when used for qualifying tuition etc.). You do have to nominate a beneficiary when you set one up, but you as the controlling owner can change the nominee at any time to any blood relation (and it can even be yourself).

There are two types of 529 plans: one is like a 401k plan and involves picking a retail investment or mix of assets; I’m sure someone, somewhere has done the analysis to pick out correlates of tuition costs, so if you can find that, maybe you should look at the first form. The second 529 plan is somewhat more interesting. In the second form, the 529 plan is actually selling you “prepaid tuition.” This kind of thing is normally a terrible deal: fronting money for something way in the future is generally a sucker bet, one made against the collected wisdom of armies of actuaries by not-sophisticated-enough retail investors with both informational and scale disadvantages. But I have a few reasons for believing that the Washington State 529 plan (known as the GET: see their web site) offers an overlay in certain circumstances.

1. Each state may offer either or both types of 529 plans to its residents. As it happens, a couple of states that have offered guaranteed tuition programs have run into trouble with the plans being underfunded and unable to meet obligations, according to this article. Although this might raise an alarm in some folks’ minds, to me it says that tuition costs have been rising faster than can be achieved by even the professional money managers hired by state 529 plans specifically to meet that hurdle rate. Therefore, I see it as a sign that tuition is in general an expensive thing to guarantee and that if you can get a reliable guarantee (see below), you are getting the best of it (until or unless a mean reversion on tuition growth rates vs. inflation occurs).

2. Washington’s GET program is (ostensibly) backed by the full faith and credit of the State, unlike other states’ 529 guarantees. In my mind, combined with the evidence of other states’ underfunding difficulties, that means the WA GET is a good bet to get bailed out by the State at some point in the future. (In general, any time you see something other than a plain vanilla bond backed by the full faith and credit of an American government, someone in the government got snookered or corrupted, and the public purse is about to make its counterparties rich: see e.g. the PBGC, the S&Ls, the Federal Housing Enterprises, etc.)

3. The index for the GET tuition price is the most expensive state university in Washington, invariably the University of Washington, located in Seattle, a thriving and growing metropolis which is well positioned to weather many economic threats and therefore in which prices and incomes are likely to remain high enough to induce the University to charge steadily increasing sums for tuition. (Although I certainly don’t think that the outlook for Seattle is monotonically ever rosier, it seems a much better bet than somewhere like e.g. Montana or Idaho, where relatively small disturbances to nondiversified industrial bases could result in stagnation at all state universities.) The University also has competition in town from a number of private schools charging full freight to their students, therefore establishing the viability of increased tuition at UW.

5. The WA GET program has a scam built into its marketing strategy: rich people can buy the tuition units at the “buy-in price” (see below), but they try to sign up poor people for a payment plan where they charge them 7.5% interest on top of the buy-in price. Whether this is morally appropriate or not is a separate issue; the fact that we can spot the fish (and we ain’t it) is good for us.

6. The big catch to the WA GET is the difference between the buy-in price and the pay-out value (the bid-ask spread, if you will). For the past few years, that has looked like so:

Year	Purchase $	Purchase YOY %	Purchase CAGR
1999	$35.00	NA	NA
2000	$38.00	8.57%	8.57%
2001	$41.00	7.89%	8.23%
2002	$42.00	2.44%	6.27%
2003	$52.00	23.81%	10.40%
2004	$57.00	9.62%	10.25%
2005	$61.00	7.02%	9.70%
2006	$66.00	8.20%	9.48%
2007	$70.00	6.06%	9.05%

Year	Payout $	Payout YOY %	Payout CAGR
1999	$33.75	NA	NA
2000	$35.19	4.27%	4.27%
2001	$36.42	3.50%	3.88%
2002	$38.64	6.10%	4.61%
2003	$45.31	17.26%	7.64%
2004	$48.63	7.33%	7.58%
2005	$51.81	6.54%	7.40%
2006	$55.05	6.25%	7.24%
2007	$58.80	6.81%	7.19%

Year	Purchase $	Payout $	Payout Ratio
1999	$35.00	$33.75	96.43%
2000	$38.00	$35.19	92.61%
2001	$41.00	$36.42	88.83%
2002	$42.00	$38.64	92.00%
2003	$52.00	$45.31	87.13%
2 004	$57.00	$48.63	85.32%
2005	$61.00	$51.81	84.93%
2006	$66.00	$55.05	83.41%
2007	$70.00	$58.80	84.00%

Observations on these numbers:

• 2003 saw a big bump in tuition and hence in both purchase price and payout values. This jibes with 2002 news reports of the same.
• The payout ratio (payout $ / purchase $) has been declining steadily, but has recently hovered around 84%.
• That said, WA GET is raising the price of purchase by 9% annually, while tuition has been increasing at 6-7% annually. If these two don’t converge, the payout ratio will get worse.
• This supports a 6-7% tuition increase rate, especially because that makes the 7.5% interest on the payment plans accretive to GET’s situation.

7. The time-lag spread between purchase and payout makes sense only if you assume that college costs rise faster than the rate of return you can make elsewhere, adjusted for tax treatment. Assuming a fairly conservative 5.25% risk free rate and a 28% tax rate, the line crosses with 7% annual rising educational costs after about 6 years:

Years Held	After-tax return risk free	GET Return	GET to risk-free %
0	$70.00	$58.88	84.11%
1	$72.65	$63.00	86.72%
2	$75.43	$67.41	89.37%
3	$78.36	$72.13	92.05%
4	$81.45	$77.18	94.76%
5	$84.69	$82.58	97.51%
6	$88.11	$88.36	100.29%
7	$91.71	$94.55	103.10%
8	$95.49	$101.17	105.94%
9	$99.48	$108.25	108.82%
10	$103.67	$115.83	111.72%
11	$108.09	$123.93	114.66%
12	$112.73	$132.61	117.63%
13	$117.62	$141.89	120.63%
14	$122.77	$151.82	123.67%
15	$128.18	$162.45	126.73%
16	$133.88	$173.82	129.83%

As you can see, given these numbers, it doesn’t make any sense to buy units for a teenager. You’re just going to get hammered down by the time-lag spread if you hold less than 6 years before redemption. Of course, it gets a lot worse if risk-free interest rates rise a lot compared to college tuitions, or if you’re paying more than 28% in tax.

However, if you think that college tuitions will maintain their higher growth rate relative to the risk rate, and if you can hold for well over 6 years, then you should strongly consider buying tuition in the GET. Why do this if you can get a higher return in a normal 529 in, say, the stock market? Well, remember that you need to beat UW’s tuition growth rate, and do so without a great deal of volatility. I’d be surprised if normal 529 plans let you use sophisticated tools like options to hedge against volatility.

I, like numerous others, believe that we’re entering a period of increased market volatility, and that if you can offload the risk of matching investment returns that are linked to a tax-free, inflating expenditure requirement to a full-faith-and-credit backed State obligation, you should seriously consider it.

Serious risks in this strategy include the possibility that Washington state politics will result in tuition increases that do not track inflation. Also, general mean reversion in higher education could threaten this strategy. I don’t think that there’s a lot of risk from falling behind a big run-up in equity prices that sustains for 15 years without a concomitant rise in inflation and tuition, but if equity returns beat my expectation and whoop up on tuition increases, you could stand to lose relative to a more traditional asset allocation. Also, waiting is not advisable; the bigger the gap between the purchase price and payout value, the longer you have to spend invested to catch up to risk-free.

Of course, remember that WA GET isn’t something you invest in for strict performance; it’s a way to cover a known expenditure requirement with lower risk. As far as I can tell, for periods well over 6 years (and ideally ~ 18 years, since you can purchase GET units naming yourself as a beneficiary and then transfer them later to your as-yet-unborn children), WA GET makes good sense.

I was reminded by an Economist article recently about a conversation I overheard at an Asian noodle shop a few weeks back. Some guy was talking to his buddy. The conversation went, roughly:

“Yeah, I just got a great deal on a boat.”

“Where’d you get the money? Did you hit the lottery?”

“Naw, I got a loan, but with a really good interest rate.”

“What, like 6%?”

“No, 1.5%. See, in Japan they got really low interest rates. I was able to get the loan in yen, and then just convert it over to dollars to buy the boat. But the interest is the same!”

Wow. Amaranth and all other wackiness aside, you know financial markets are getting screwed up when average noodle-shop patrons are using the yen carry trade to finance trivialities.