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By Douglas Lowenstein
President, the Private Equity Council


New President, New Congress: What It Means For Global Private Equity

With an historic election behind us – and the Democratic Party firmly in command of both the White House and Congress – 2009 is shaping up to be a year of stepped-up activity on key issues affecting the private equity industry.

President-elect Obama is committed to lowering taxes for persons with incomes under $250,000, expanding the availability of health care insurance to the uninsured, and investing in alternative energy technologies, among other costly proposals. These ambitious goals will run headlong into a deepening federal budget deficit stemming from the financial crisis, a crisis that in the past two months has imposed even greater pressure on Congress to find ways to "pay for" these new policy proposals and to develop a 21st Century regulatory regime to guard against a future market meltdown.

What this means for private equity is clear. First, the proposal to tax carried interest as ordinary income, estimated by congressional tax writers to raise $26 billion over the next decade, will be even more attractive than it was when initially proposed in 2007. Second, Congress is going to take a very close look at whether and how it should include private equity funds in the modern financial oversight system. Debate on these tax and regulatory issues will take place against a backdrop of great anxiety about the financial markets and a strong populist sentiment to punish the vaguely defined "Wall Street" financial interests that are being widely blamed for the economic downturn.

Let's start with tax issues. In late 2007, the House of Representatives twice passed legislation that would have changed the treatment of the carried interest earned by private equity and other investment partnerships from capital gains to ordinary income. In effect, it would have resulted in a 133 percent tax increase. The proposal was blocked by the Senate, which opposed any tax increases to pay for new programs.

But the dynamic in Congress will be fundamentally different in 2009. When Congress convenes following the inauguration of President Obama on January 20, the Democratic majority in the House will have expanded significantly, giving House Speaker Nancy Pelosi even more flexibility to assemble the coalitions required to push through the Obama agenda. Even more importantly, there will be a least (as of this writing) 57 Senate Democrats, up from 51, significantly reducing (though not entirely eliminating) the ability of the Republican minority to use the threat of a filibuster to block Democratic initiatives.

These developments are highly relevant to the carried interest issue. In 2007 and 2008, Senate Finance Committee Chairman Max Baucus lacked the votes needed to advance a tax measure containing the carried interest proposal (though he never explicitly endorsed the proposal). But in 2009, the firewall built by Senate Republicans and pro-growth Democrats against higher taxes on investment has a few more cracks in it. And this assumes that Democrats don't use procedural tools to put together a budget and tax plan that requires only a simple majority vote, thus end-running the filibuster threat entirely. This procedural gambit is exactly how President Reagan and President Bush pushed through their controversial economic agendas in 1981 and 2001.

Of course, there is also a scenario in which Congress opts to defer any major tax measures, fearful of increasing taxes on investment in the midst of the worst economic dislocation in 75 years. Stay tuned…

When it comes to financial reform, it is clear this will be one of the first issues addressed by the incoming 111th Congress. Rep. Barney Frank (D-Mass.), Chairman of the powerful House Financial Services Committee – which has oversight responsibility for the Treasury Department, the Federal Reserve, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission – has made that clear in recent interviews.

While Congressional leaders have suggested that strong action is necessary to strengthen government oversight of financial markets, boost lenders' accountability to borrowers and curb excessive leverage, it is not yet clear how the move to redesign the regulatory framework will directly affect the private equity industry.

It seems certain that Congress will seek to regulate some of the financial instruments seen to be central to triggering systemic risk. Some members of Congress argue that legislation is required so that the complex securities known as credit default swaps can be traded only through regulated exchanges, rather than over the counter by so-called swap dealers. Regulation also might entail imposing margin and collateral requirements on the trading of these securities.

Of more direct concern to private equity is the extent to which lawmakers and the new Obama financial team conclude that regulation should be expanded to cover not just traditional sectors like banks and securities firms, but also previously unregulated sectors, such as hedge funds and private equity firms.

Given the powerful concerns in government about the role of leverage in the financial crisis, and the basic role of leverage in the PE business model, it seems unlikely that PE will escape any regulation whatsoever. But handicapping beyond that is difficult. There is a spectrum of regulatory proposals that range from less than intrusive (for example, empowering the Federal Reserve to request information about a PE firm's investments, capital structure and other issues that, in the Fed's view, might cause the potential for systemic risk) to institutional regulation that could involve much more active intervention by the Fed (for example, setting standards and requirements for such things as private equity financial reporting and portfolio company leverage).

From the PEC's standpoint, our core approach will remain the same as it has been since we opened our doors in Washington 20 months ago. We need to continue to distinguish PE from other types of investment funds that buy and sell complex, hard-to-value securities, sell short as well as long, and trade in windows measured in hours or days, not years. We need to continue to drive home the fact that private equity partnerships invest in companies, often companies that are undervalued or have untapped potential, and that efforts to turn around or strengthen undervalued companies represent a very unlikely source of system problems in the capital markets.

We need to continue our efforts to explain to lawmakers and other public officials that private equity partnerships are taxed at exactly the same rate and in exactly the same manner as partnerships that invest in real estate, energy development and production or small family businesses. That is, private equity partners pay ordinary income tax rates of as much as 35 percent (for the time being, at least) on their salaries and bonuses and they pay capital gains rates of 15 percent on the profits they earn from selling capital assets that they purchased, grew in value, and sold after at least a year. They receive no special tax treatment.

And we need to point out the extensive disclosures about the transactions and activities that private equity firms make to their most important constituents – their limited partner investors. For the largest private equity firms, most of these investors are major public pension funds that depend on superior private equity returns to help ensure the retirement security of millions of police officers, firefighters, teachers and other public employees across the country. We also need to make clear that in addition to the disclosures made directly to investors, any private equity portfolio company that issues publicly traded debt is required to file detailed annual performance reports with the Securities and Exchange Commission, just like any company whose stock is traded on public markets.

In the end, we need to do what we have been doing since our inception: we need to explain to lawmakers, regulators, local officials, community leaders, and portfolio company employees how private equity contributes to the overall economic health of our communities and our nation. If we do that well, we believe we make a strong case for the private equity industry as the new Congress and the new President begin considering these important issues.

About the Author

Douglas Lowenstein

DOUGLAS LOWENSTEIN
President, Private Equity Council

Douglas Lowenstein became the first President of the newly-formed Private Equity Council in February 2007. Prior to launching the PEC, Lowenstein founded the Entertainment Software Association in 1994 and built it into one of the world's most influential and respected entertainment industry trade bodies. Under his leadership, the ESA developed and implemented government affairs, communications, anti-piracy enforcement, intellectual property policy, and research programs to advance and protect the business and public affairs interest of the $30 billion global video game industry.

Prior to joining the ESA, Lowenstein was an executive vice president in the Washington and New York strategic communications firms Robinson Lake Sawyer Miller (now Weber Shandwick). From 1982-86, Lowenstein worked for U.S. Senator Howard Metzenbaum (D-OH), serving the last two years as Legislative Director.

Lowenstein spent the first nine years of his career as a newspaper reporter with the Buffalo Courier Express (1973-74), the Capitol Hill News Service (1974-76), and the Cox Newspapers Washington Bureau (1976-82).

Lowenstein received a BA in Political Science from Washington University in St. Louis. He is the author of a book (Lowenstein: Acts of Courage and Belief), published in 1982 by Harcourt Brace Jovanovich about his late uncle, former Congressman, anti-war and civil and human rights leader Allard K. Lowenstein.