IVCA Feature: Highlights of the 2017 IVCA Spring Luncheon, Part One – The Panel Discussion on ‘Will Carried Interest Get Carried Away?’

May 24, 2017

The mahogany halls of the Chicago Club, in the traditional Burnham Room, was the setting for the annual Spring Illinois Venture Capital Association (IVCA) Luncheon, a centerpiece for the year, that took place on May 16th, 2017. The event was sponsored by accounting/advisory firm Baker Tilly (their 10th year) and the legal firm Ropes & Gray (their 8th year). The luncheon program featured a panel discussion on “Will Carried Interest Get Carried Away?: How the Trump Administration Could Affect Venture Capital and Private Equity,” followed by a session entitled “The Son of ‘G’ Interviews the ‘C,’” which was a celebratory back-and-forth between David Golder – the son of Private Equity pioneer Stanley Golder – and one of Golder’s PE pioneer partners, Bryan Cressey.
 
The luncheon program began with remarks from the sponsors. Matt Richards, partner at Ropes & Gray in their Private Equity practice, anticipated the panel discussion on events in the nation’s capital by saying, “the news from our colleagues from Washington is usually somewhat dry, but I am sure this year it will be a little more colorful.” Representing Baker Tilly Virchow Krause was Bill Chapman, Partner & Leader in Due Diligence, who spoke about the firm’s recent international expansion, “we’ve assisted our clients both inbound and outbound in Canada, the United Kingdom, Germany and Australia.”
 
Dave Stricklin, the government affairs specialist for the IVCA in Illinois, followed with updates on legislative actions at the State Capitol in Springfield. “This year, we’ve been actively engaged in opposing two particular measures... Senate Bill 1719 and House Bill 3393. These are bills proposed by the National Federation of Teachers, and its Illinois chapter, which suggests that Illinois should tax at the state level the income that is lost at the federal level through the carried interest of income that partners receive through their investment acumen.” He added, “We think we’ve have these bills headed off at the pass for the moment...it has unanimous Republican opposition, and our focus has been on Democratic members at the city and collar suburbs districts, who have a lot of residents that work in Private Equity and Venture Capital, to help them understand why this is a bad idea.” He ended his remarks by reminding everyone to contact their legislative representatives to find out their positions, and lobby them to oppose the measures.  (Click here to find your legislative representatives.  Click here for their contact information.)
 
In Part One of the luncheon program overview below, the focus will be on the panel discussion, “Will Carried Interest Get Carried Away?: How the Trump Administration Could Affect Venture Capital and Private Equity.” Moderating the discussion was Lee M. Mitchell, Managing Partner of Thoma Bravo, and adding their perspectives were Mike Sommers, the President & CEO of the American Investment Council (AIC), and Bobby Franklin, the President & CEO of the National Venture Capital Association (NVCA).
 
WILL CARRIED INTEREST GET CARRIED AWAY?: How the Trump Administration Could Affect Venture Capital and Private Equity
 
The Atmosphere in the Nation’s Capital
 
Moderator Lee Mitchell began by asking the simple question, “What is Washington like these days?,” as the newly minted Donald Trump administration takes root.
 
Bobby Franklin began, “Certainly Washington looks different than it did in the 1980s, when I began there. You have as a result of the last election... we see the latest tweet from the President, and figure out how many days this particular tweet will take in sucking the oxygen out of Washington.”
 
Franklin then spoke of the initial euphoria after the election, as the Republicans were the majority in both legislative houses, and the executive branch, “We’ve come through these first 100 Days, and we’re still waiting to see how will things will happen. Can Washington function and get legislation through? From my perspective, it’s unclear.”
 
Mike Sommers weighed in. “I was thinking as I came here, what is the best analogy I can give to an audience in Chicago? Washington today is like the Chicago Cubs from 1909 to 2015. In that period there were a couple of division championships, followed by epic collapses. Ultimately, that’s what we’re seeing right now in Washington. We have a consolidated government for the first time in awhile, with the House and Senate in Republican hands, and President Trump in office as a Republican... but probably he’s the most unconventional politician we’ve ever seen.”
 
Sommers quickly added, “But they still have an incredible inability to get anything done. The two marquee reforms – healthcare and taxes – I will say are very much on the rocks these days. It’s hard to see in the next few months any legislative accomplishments. Now the President’s unconventional approach to governing has been a distraction, but that shouldn’t distract you also from a very dysfunctional House and Senate, and it is making it difficult for anything to get done. That’s not good for America, and it is one of the reasons it’s important for you to be active in the IVCA, the NVCA and the AIC, because it’s important to engage in the political process.”
 
Calm Down, and Govern
 
Moderator Mitchell was then curious about the next 100 days, whether the climate would modify and the branches of government would begin the process of passing new legislation.
 
Mike Sommers brought up the Affordable Care Act, and the attempt of Congress to repeal and replace it. “While it was passed in the House, the Senate version will be long and arduous to pass, and get done.” He then asked, “Why does healthcare matter to anyone in this audience, aside from investment opportunities?”
 
He answered his own question with “The most important component of tax reform, for the House and Senate Republicans, is the Healthcare Bill. Because Speaker Paul Ryan and Majority Leader Mitch McConnell want to get healthcare repealed, so that it will lower the tax baseline. That needs to be done so when they get to tax reform, it will be easier to fulfill the revenue baseline, and make the Tax Reform Bill revenue neutral. So the view is that the first step to tax reform is repealing the Obamacare legislation. That’s why it should be important to everyone in this audience.”
 
He continued, “The second step in that process is they also have to pass a fiscal year 2018 budget [FY18]. They need to use the reconciliation procedure on tax reform – as they are doing with the healthcare legislation – which allows them to pass bills with a simple majority, rather than 60 votes, because it is going to be accomplished on a Republican-only basis. So if they are unsuccessful in repealing Obamacare, and passing a FY18 budget, tax reform becomes much harder.”
 
The Next 100 Days?
 
“To answer your question, Lee, I don’t see the next 100 days being better,” Bobby Franklin observed. “To take the tax reform conversation into the weeds a bit more, in my mind there is a question as to whether or not Washington is looking for tax reform or just tax cuts. This has implications for AIC, NVCA members and those of you in this room. To go down a tax reform road, it’s a lot more likely that they’ll have a lot more questions about things like Carried Interest and capital gains taxation. Congress will look at parts of the code and conclude that such a tax will impact a small amount of people, in the grand scheme of things.”
 
“So if we’re talking tax reform,” Franklin added, “the debate will generally be what the best tax policy will be. But if they go down simply a tax cut road, and if we look at what President Trump put out there, it was only a one-page summary of what he hopes rates will be. So how are they going to pay for it? As Mike said, it’s back to the healthcare repeal. If they don’t get that through, it’s a trillion dollars left on the table.’’
 
“If you want to lower the corporate tax rate, it’s about 100 billion dollars per point lowered, so we’re talking about significant numbers,” he asserted. “So how will the Republicans find a coalition of 218 votes in the House, and at least 51 votes in the Senate? Then it gets really challenging on how to get agreement. At one point, the Freedom Caucus members were all about not running up the deficit, and now you hear many of them just saying let’s get a tax cut through.”
 
Franklin concluded with, “there is so much dust still in the air, that hasn’t settled into a procedural path, it’s very difficult to see how it all moves forward. And just because we’re giving negative prognostications over something happening, doesn’t mean we should all just sit and hope. We have to be engaged all the time, because you never know when something will break. We were all surprised to see healthcare revision get through the second time around  in the House... so we have to be vigilant.”
 
“Let me give you a snapshot that can help you with folks in Springfield, he added. “If you look at the Venture Capital industry, and what they have done in creating iconic companies, 20 years ago 90% of global VC investment were in U.S. startups, and ten years ago that number was at 81%. Last year, it was 54%. That means the pie has gotten bigger for companies around the globe, but now that the U.S. – who invented Venture Capital – is now at a 54% share, this is startling. That is how policies in government create an impact on Venture. If they make policy decisions now, it will affect how the VC industry looks 20 years from now.”
 
What About 2018?
 
Lee Mitchell followed up with, “So I assume if something doesn’t happen in 2017, they’re not likely to happen in 2018, is that a fair assumption?
 
Franklin answered, “if they get to 2018, I think the likelihood of just doing a tax cut goes way up, because the Republicans will need a win before the election period.” 
 
Sommers added, “I would agree with that the Republicans will be looking for an accomplishment that they can run on in the midterm elections. So if they get through 2017 and tax reform doesn’t look like a possibility, I think it’s more than likely that they pivot to a 2001 or 2003-style tax cut to get some kind of accomplishment through. But again, that is dependent on their ability to pass a budget for FY18, which will be a difficult thing for them to do. The fiscal situation is no better today than it was a year ago, and the consequence is that many of the Republicans in the House will be voting for a budget they don’t agree with, and that also makes tax reform  – or even the tax cuts – difficult in that prospect.”
“That’s why we must remain vigilant, as Bobby said,” Sommers said, wrapping up the topic, “and that’s why you’re members of the IVCA, NVCA and AIC, so we can be your insurance policy against political risk. And there is a lot of political risk out there.”
 
Franklin succinctly added, “If there was a vote today for our position on Carried Interest, or capital gains taxation or reform, it would lose. It’s a different equation if it’s tax reform or tax cuts, or if someone takes a populist position and calls for doing away with Carried Interest. We have a lot of challenges.”
 
Carried Interest
 
Lee Mitchell remarked that Carried Interest is a arcane tax subject that gets a lot of press and commentary, but from many people who don’t know what it is, or how it impacts any business. He added that most observers put it into the hedge fund category, and quoted the Washington Post, “... if political rhetoric alone killed tax rules, a favor to the rich known as the Carried Interest loophole, would have been dead and buried a long time ago.” He then turned to panel, “What are the prospects for Carried Interest in the next year or two years?
 
Mike Sommers started this part of the conversation. “There are two big ironies in discussing Carried Interest that frustrate me and Bobby. The first is that every politician in America in the course of the last several years has talked about short ‘term-ism,’ whether it is in public policy or an investment, while at the same time they are trying to encourage long term investment.”
 
Well, that’s exactly what Carried Interest does,” he explained, “it encourages long term investment. Private Equity firms usually take investment stakes that are five to seven years, but as Lee said, it’s often called the ‘hedge fund loophole.’ Very few hedge funds take advantage of this so-called ‘loophole,’ because Carried Interest is long-term capital gains – you only get it if you’re holding for a year. Bobby and I often say that if there wasn’t Carried Interest in the tax code, we would probably be looking for a provision that would encourage the kind of investment that Private Equity and Venture Capital take on every day. That is the first irony of Carried Interest.”
 
He went on, “The second irony, of course, is that the biggest opponents of Carried Interest are some of those who actually benefit the most from it. As Dave Stricklin said earlier, it is the American Federation of Teachers and some pension funds who are targeting the Carried Interest loophole, yet those are the folks that benefit most significantly from long term investment that they make. There is a reason that they invest in Private Equity, it has for the past 20 years been the number one asset class for pension fund investment. We should talk about that and be proud of it, and encourage politicians to look at the numbers. All 435 Congressional districts in the U.S. have Private Equity investment in those districts... every one of them.
 
He added, “Private Equity supports 14 million jobs in the United States, about 10% of the American work force. Those are the things we should be talking about to fight back on this issue.”
 
The Prospect of Changing Carried Interest
 
Sommers next created an inquiry...What are the prospects of Carried Interest being taxed as ordinary income through this process? He began with, “I think Bobby is right, it depends on whether it will be largely tax reform or tax cuts. If there is a big tax reform package, I think there are significantly more threats with reform rather than tax cuts.
 
In the three organizations that are working the hardest against Carried Interest change – the AIC, the NVCA and the Real Estate Roundtable – we work to educate the members of Congress and their staffs on the statistics that I just mentioned, and how it encourages long term investments, and how it is good for the American economy. I can also say that there are significant numbers in the House and Senate who are on our side. We work with them and encourage them to assure that they are doing the right thing on behalf of this industry that supports so many jobs in the United States.”
 
Franklin then countered, “I’m a little more pessimistic. I know we have blockers, but I still think it’s too easy for the majority of folks in Congress to vote to get rid of it... the current President and the Democrats have long attacked it, and that constitutes a significant threat. The only thing in my mind that has kept it from happening, is simply Washington’s inability to get anything done. That’s not a great defense.
 
To add to what Mike said, regarding all the Congressional districts having PE investments, we share the fact that in the case of a Venture fund, that many start a firm taking no salary at all. The only reason anybody would take a chance like that is because there is a carrot at the end. Most Venture funds don’t even see Carried Interest, so there is a huge amount of risk. Plus the average hold in Venture is seven-plus years in a company. How could that ever be described as ordinary income? In the example we give of a person not taking a salary, they still have to pay rent, pay a staff and have a team together... and it can be seven years until there is a prospect for Carried Interest. Those are the stories we keep talking about, and we should be thinking about what else we can do.”
 
Sommers then put forth an addendum, “To the extent that we have relationships with members of Congress, at least in the PE world, and in connection with the relationships you have with your Limited Partners, there is always a hurdle written into that contractual obligation. Your firm has to hit the eight percent hurdle rate before ever receiving a Carry. Most members of Congress do not know that, and it’s an important component to the lobbying we do on Capitol Hill. When members of Congress learn that you have to hit that eight percent hurdle, before receiving a Carry, the whole conversation completely changes.”
 
AUDIENCE QUESTION
 
“There was an attempt eight years ago to change Carried Interest. Do you think they would put the same plan in place if they’re trying to change it today?”
 
Sommers replied, “I don’t know if we have an answer to that at this point. I would expect with any big tax change or reform there would be transition rules. We’re not focused on those rules right now, what we’re focused on is beating back any effort to increase taxes on Carried Interest.
 
One of the things that has been emphasized by the members of the AIC, is that the rate doesn’t matter as much as the character that it remains Capital Gains income, and we’re focused on that as well. The healthcare bill that recently passed included a cut of 3.9% to long term Capital Gains. I wouldn’t think that it will become law, but it is I think a harbinger of where members of Congress are coming down of where Capital Gains will be in the long term.
 
Franklin added, “If anybody saw what President Trump announced, as far as where he wants the three ordinary tax rates to be, as well as the corporate rate, there has been a lot of opinions that Carried Interest doesn’t matter, because everyone will get this pass-through rate that will be super low. The likelihood of something like that happening is next to zero. It’s another red herring we have to push back on.
 
Interest Deductibility
 
Lee Mitchell pointed out how this is very much in the news of late, that is the ability of a company to deduct its interest costs on its debt. That will affect firms that use leverage when acquiring a business. In paying for other tax reductions, there has been talk about eliminating the interest deduction. “Where does that all stand?”
 
Mike Sommers took this question, “This is an example of what Bobby mentioned. House Republicans are looking for ‘pay fors’ to get the corporate tax rate down. President Trump has proposed a 15% corporate tax rate. The U.S. has the highest rate, and every other country is lowering their rate to stay competitive. But there remains the fact of a$110 billion dollars revenue loss for every point taken off the corporate rate.
 
To get down to the 15% that the President proposed, we need to find $4.2 trillion dollars someplace else. One of the places they are looking at is to cut the ability to deduct interest, while doing these big deals. The AIC participates in the BUILD coalition, which is made of organizations who want to maintain interest deductibility. I think we’re having a measure of success, especially on the Senate side. If I were a betting man, I would guess that there would be a ‘haircut’ as to how much interest entities can deduct, but not complete elimination.”
 
Tax Issues of the NVCA
 
Bobby Franklin took the cue on this inquiry, “One the things that we try to do, is not to walk into any legislator’s office and start with Carried Interest. You usually see the staff fold up their books, and give a look like ‘it’s one of those meetings.’ So we go in and talk about what the tax code should to do to encourage new company formation. We talk about Qualified Small Business Stock [QSBS 1202]. We talk about the research and development [R&D] tax credit, as that most of the start-up funds in a new business is going toward R&D. With no profits, R&D does nothing for most startups. In Canada, for example, they have fully refundable R&D tax credits, no matter if that startup is profitable or not.
 
We also talk about net operating loss [NOL] issues, and how NOLs in the 1980s, when companies who bought companies who had a bunch of tax losses on their books, and there was tax arbitrage on those losses. Washington got it right, and rewrote the rules, but it now impacts startups. It triggers the rules through the financing rounds, because essentially there is a change of control, which slices into the value of that investment. As I said, those are the expenditures we should be encourage, but the unintended consequences is that when rules are written in Washington, they write them with the biggest companies in mind.
 
There are not legions of lobbyists representing startups, but many of the laws, rules and regulations inadvertently hit them. We go in and talk about how the tax code laws should encourage new company formation. So we hit that hard, and only at the very end are we asked about Carried Interest.”
 
Is This Congress Reacting to These New Approaches?
 
Franklin expanded on this thought, “Yes, there is a greater resonance, and it boils down to this. If we want to see economic growth in this country climb above one percent, it’s going to take embracing innovative companies, and making sure those companies are formed in the U.S. There are constant stories, for example, of entrepreneurs who can’t get a green card. They have great ideas that are ready to go, and with 46% of global venture capital being spent outside the U.S., that entrepreneur will just go someplace else.
 
Regulation
 
Lee Mitchell shifted the conversation at that point, to regulatory requirements that have increased in the last eight years. There are new SEC rules that came about, and now there is talk of retracting them, and having different enforcement policies. “Mike, what do you think is going to happen on the regulatory side, especially with the SEC?”
 
Sommers contemplated this issue. “We should expect a lighter regulatory touch, particularly from the SEC, because it now has a Republican chairman and two Republican commissioners coming in. At the same time, I would not discontinue from the significant due diligence that we’ve done in the post Dodd-Frank era, because we don’t know what’s going to happen. I don’t expect Dodd-Frank to be repealed, so the best way to operate is to keep operating as if Dodd-Frank is the law of the land, and at any moment the regulatory pressure would continue. Why won’t Dodd-Frank be repealed? Because in this case, it takes 60 votes for repeal. It won’t be repealed anytime soon.
 
There could be some one-off bills that could be enacted, including significant reform of the Consumer Financial Protection Bureau, because of recent cases that are heading to the Supreme Court. Besides that, I don’t see any more big changes to the regulatory environment.
 
The most important regulatory decision that President Trump has made so far has been appointing Neil Gorsuch to the Supreme Court, because there a whole slew of Dodd-Frank related litigation headed towards the Supreme Court, and I think we’ll be dealing with a much more business friendly Supreme Court. That is a vital component to the regulatory environment for the next few years”
 
Bobby Franklin added, “Two issues we’re spending time with, in relationship to Dodd-Frank, is changes to the Registered Investment Advisor, that ended up hitting a lot of firms that it shouldn’t have hit. Most venture firms are not at any systemic risk to the country, and having to take so much of operating expenses to register and stay compliant... when you’re a small Venture Capital firm it makes no sense.
 
The second issue is about how capital is spread to all the entrepreneurs all around the country, not just the East and West coasts, and that is the Volker Rule. So many firms had access capital from the middle of the country before the Volker Rule went into effect, and it has decimated a lot of capital. The average VC fund outside of New York, California and Massachusetts is about $20 million dollars. That’s not a lot. We have to make changes to the Volker Rule, so capital that is spread across can go into the newest and greatest entrepreneur ventures that take the greatest risks.”
 
Sommers also expressed, “One more point about regulation, that Bobby touched upon, the bill that’s going to make its way through the House in the next couple of weeks would eliminate the registration requirements for PE firms. We support that, of course. Of the amendments attached to the bill, one offered to take out that requirement, and that speaks to what we’ve been doing to influence members of Congress, to get rid of that ridiculous Dodd-Frank regulation.”
 
Will There Be a Pull-Back from the Registered Investment Advisor Rules?
 
Sommers, again, “I do think you should expect it, but I don’t think it will be at the independent agency level. It will be a consequence of how they are tailoring those rules, not the underlying statutory changes under Dodd-Frank.
 
Immigration
 
Lee Mitchell expressed that this is an issue not generally discussed in forums like this, and how at the Venture Capital level there is a reliance on immigrant workers, as well as a threat against immigrant entrepreneurs. “Bobby, what is happening to that issue that could affect our industries?”
 
Franklin said, “Unfortunately, nothing good right now. Studies have shown if you look at companies that are Venture Capital backed, almost half of the founders in those startups are foreign born. It makes sense, because if you are a foreign-born entrepreneur, you want to do your startup in the U.S. Were educating our best and brightest from all around the world in our institutions of learning, and then we kick them out. We need to keep those potential high-paying jobs here. It’s important to startups, because so many of the foreign-born entrepreneurs come up with the idea.”
 
Additionally, Franklin said, “We’ve always worked on the idea that we could have a ‘Startup Visa,’ which made it through the Senate but didn’t become law. In the waning days of the Obama administration, the Department of Homeland Security had a law enacted  that simply says if you are a foreign born entrepreneur that has attracted startup money, and it creates jobs, then you should be able to stay in the country. Many of the regional associations have supported the law, simply because they don’t have as much of entrepreneurial activity that is desperately needed.”
 
AUDIENCE QUESTION
 
Has there been any discussions between your agencies regarding government funded basic research, like the National Institutes of Heath [NIH], and entrepreneurial circumstances with academia and startups?
 
Franklin answered this, “It’s going to be difficult for Congress to understand it has the opportunity to spend more on basic research. That’s different from the rest of the world, you look at China and they are spending more significant amounts on basic research than what we’re doing. Since I don’t anticipate more government dollars becoming available, we as a group must commercialize and do a technology transfer of research being done in universities and federal labs, to make sure there is a business at the end of that pipeline – so in turn we can generate some economic activity – and keep funding the research.
 
Sommers concluded, “Discretionary spending is going to be pressured until we address our huge entitlement problem. The government is basically an insurance company with a military right now. Until we reform that structure, NIH and academic studies are going to be crowded out.”

View event pictures here.
 
For PART TWO of the 2017 Spring Luncheon, “The Son of ‘G’ Interviews the ‘C’: David Golder Interview Private Equity Pioneer Bryan Cressey,” click here.