Highlights of the May 27, 2009 IVCA/NVCA Luncheon: What a Difference a Year Makes

Highlights of the May 27, 2009 IVCA/NVCA Luncheon: What a Difference a Year Makes

June 2, 2009

CHICAGO - “ The wood-paneled Monroe Room of the august University Club of Chicago was the setting for annual IVCA/NVCA Luncheon where members and guests mingled, dined and listened to an impressive roster of speakers.

IVCA executive director Maura O'Hara kicked off the proceedings commenting, ""what a difference a year makes-  and reviewing projections from last year's presentation from Carl Tannanbaum entitled ""A Pregnant Pause"".  The extraordinary changes in the economic and political landscape were the subject of this year's panel discussion, which was titled - œThe Impact of the New Administration on Venture Capital & Private Equity- .

Luncheon sponsor Virchow, Krause & Company, LLP, which after June 1, 2009 will be named Baker Tilly International, was represented by Partner and Managing Director William Chapman. Also sponsoring the luncheon was The German Private Equity and Venture Capital Association (BVK), whose remarks were given by association Chairman Dr. Peter Terhart.

The following is a summary of the featured speakers and subjects they tackled within the panel discussion. It was moderated by Chicago Tribune business columnist and chief business correspondent David Greising.

William Welke, tax partner, Kirkland & Ellis LLP
Subject: Taxation in the New Obama Administration
Introductory Quote: - œWhen President Obama was on the campaign trail and said he was going to lower the taxes of 95 percent of Americans, he wasn't talking about people in this room.- 

Welke talked about a potential tax on carried interest, which is a share of future profits and appreciation for which a fund hasn't had to buy the underlying equity. The two rules have always been carried interest wasn't taxed (it becomes income over time) and it takes its tax character and flows out to a partner in a fund or a partner in a general fund.

That had been well settled for 20 years or more. The basic change focuses on the second rule. The new administration is talking about changing the nature of the income that flows out in carried interest and making it ordinary income regardless of the underlying income and partnership or fund. The first rule remains unchanged as far as when carried interest will be taxed (i.e. in advance).

The basis for the proposal is that carried interest is services income and it's subject to taxation accordingly. In this political climate, the lower tax rate on carried interest is now looked upon as unfair. The economic downturn - “ with the need for additional government income - “ is also a factor for this change being implemented.

The Obama proposals regarding these changes would be implemented starting Jan. 1, 2011. This would also cover appreciating real estate and sales of carried interest as income under this proposal. Income payroll allocations or interest that represents invested capital would be an exception.

Mark Heesen, President, National Venture Capital Association
Subject: The Politics of Taxation in the New Obama Administration
Introductory Quote: - œThe last time Congressman Sander Levin introduced this taxation plan bill, he had several co-sponsors. He has zero co-sponsors this time.- 

Heesen went on to explain that the Obama budget deals with this carried interest tax proposal in one line. He also talks about zero tax on capital gains when investing in emerging growth companies.

The main intuition is that both of these budget statements are undefined. Still, the Obama administration optimistically understands and wants to see a marked distinction between investing in Fortune 50 multi-national corporations versus investment in small emerging growth companies.

Even though it's undefined, Heesen says it's considered that tax proposals on carried interest and zero rates on capital gains are in the same basket because that's where the administration has put them. The U.S. Senate has indicated that the carried interest issue will not be debated in 2009.

The stimulus package has to play out for tax reform to become more defined. That's a 2009 circumstance. The bottom line is that carried interest currently doesn't bring in any money to U.S. Department of the Treasury. If the need is for more cash to the coffers, big-ticket items will be sought. For the rest of 2009, look to do business as usual.

Robin Painter, Partner, Proskauer Rose LLP
Subject: Hedge, VC & Private Equity Fund Transparency Legislation
Introductory Quote: - œThe proposed legislation applies to venture, private equity and hedge funds. It has the catchy name of the Hedge Fund Advisor Registration Act. This was designed to adjust the hedge fund industry and has quickly morphed to cover all the private investment funds.- 

The point that Painter began with is that most venture and private equity funds are not registered like mutual funds because of exemptions in past legislation (i.e. Section 3C1 and 3C7). This avoids the extensive registration procedures for public mutual funds dictated by the act from the 1940s.

Also, if you don't hold yourself out as an advisor to the general public and if you have 14 or fewer clients annually, then the VC and private equity managers are exempt from registration under the Hedge Fund Advisor Registration Act. There are two proposals - “ one in the U.S. House and one in the U.S. Senate - “ that are taking approaches to eliminate those exemptions.

The U.S. Senate bill is for funds with $50 million or more of committed capital to register under the 1940 act (though not as comprehensively). This would be a dramatic change and all the fund managers would be subject to registration under the Hedge Fund Advisor Registration Act.

The U.S. House bill, which is gaining more traction, is essentially again saying that all managers to funds will need to register. The exemption of 14 or fewer clients would simply go away. This is cleaner than the U.S. Senate bill because it doesn't impact so many ancillary regulations that would blow up around it.

The U.S. House Bill, which isn't as preferable to the status quo, is relatively manageable from a fund perspective.

The second subject Painter brought up had to do with placement agents. Placement agents search for investors and are typically used in an outsourcing basis. Because of some New York state corruption indictments on pay to play, placement agents were banned. New York then put together a task force for 36 other states and started issuing subpoenas to private equity and venture capital firms.

They have been lining up around the country. Bans on placement agents are also in place in Illinois, Ohio and New Mexico. There are also disclosure-based plans in process in many other states.

In association with campaign contributions in these disclosure packages, Mark Heesen commended the IVCA on their organization in forming pacts of statewide campaign contributions. These take the onus of disclosure off individual firm contributions. Heesen has for years been advising other states to follow this same procedure.

The Q&A

Moderator David Greising kicked off the Q&A period with pointed inquiries on the viability of the current potential legislation as it's written.

William Welke commented on the carried interest proposals. He noted that a 40 percent penalty is already included if companies try to get around it. Welke also pointed out that it's too early to change business practices based on what might happen within the bill.

Robin Painter expressed that the hedge fund transparency bills are in their infancy. She observed that the registration of managers (as investment advisors) in venture capital and private equity is going to happen and will add more complexity and infrastructure. Small funds and lower-end managers will take a hit because of costs associated with these new regulations.

Audience questions began with an inquiry into Robin Painter's description of a placement agent as well as pay-to-play regulation on the state level and how it will it occur on a federal level.

Heesen said that SEC Chairman Mary Schapiro is reevaluating some regulations proposed 10 years ago, which were not implemented, to potentially come into play for all funds. This national standard might be an advantage because firms wouldn't be dealing with 50 different laws from the individual states.

Another audience participant asked for a follow-up question on how the effects of regulation will hit the smaller funds. Painter opined that the larger funds simply have more options (as in anticipating the carried interest changes) and therefore more flexibility. The smaller funds don't have that flexibility, which puts them at a greater risk.

Speaking in relative terms, an audience member asked if the carried interest dollars that Obama's budget is projecting in 2011 and 2012 will be negotiable.

Welke spoke of how Obama's numbers will not only cover both venture capital and private equity but other partnerships as well (real estate, etc.). Heesen added the NVCA has been trying to ask the Congressional Budget Office about the basis for the particular numbers, to no avail.

The final inquiry dealt with the importance of the current administration's emphasis on emerging energy technologies (and the VC funding therein) versus the squeezing of dollars through the carried interest taxation changes. Heesen said this emerging tech funding will come through venture capital and the policy people will connect these dots.

In the differentials between policy and partisan campaign politics, who will win will determine the next step in legislation.
In conclusion, Maura O'Hara thanked the sponsors and participants in the panel discussion and then adjourned the luncheon.